Max Rifon

Research Paper Final Draft

Many firms use over the counter (OTC) derivatives and swaps the evil contracts that

have been blamed for the crisis to hedge risk in assets being held or goods being produced by

their clients. Unfortunately, the lack of oversight and conflicting incentives for these firms led

them astray, resulting in people taking on too much risk and not recognizing it. In our current

days, the US government has put into place the Dodd-Frank Act to curb these incentives

through more thorough oversight. In doing so, firms who deal with over the counter (OTC)

derivatives have had to change compliance practices greatly. Now OTC derivatives are valued

daily and risk is analyzed in real time, rather than being created, sold/bought, and left in

inventory with the assumption that they would yield profits. Now should the risk of a position

increase, firms are required to adjust collateral deposits (effectively margin requirements) to

ensure that they have the capital to payout should the position go against them or the liability

be called upon by the counterparty holding the position. Following the enactment of this

regulation, many market participants feel that quite a bit of stability has been gained. However,

while in the near-term stability has been added, not many people have considered the long-

term destabilizing effects. The focus of this analysis will be on the historical failure of pre-

regulation derivative market structure, regulation that followed the crisis, and the possible

future outcomes of this regulation.

After 2008 there was a panic, rightfully so, as regulators pulled back the veil on a big
ugly monster that 99% of citizens and most of our government had no idea existed. Massive

amounts of money were being wagered through swap contracts by the largest banks in

America, many of which were central to the entire economy. The reason that these bets went

unnoticed for so long was that nobody was required to report the existence of these contracts,

or how much was being risked when writing them. This secrecy was not malicious, and banks

never intended on losing money through this practice as the housing market they were betting

on was interpreted to be incredibly stable (Davidoff, 2009). Unfortunately, the profits

generated with these contracts incentivized an increase in their use to the point where there

was simply too much risk in the system, and the stability of the housing market was discovered

to be less than assumed. After the increase in volatility and massive losses to many banks, there

were quite a few casualties in the finance industry. Lots of small lenders and a handful of the

largest banks lost their operational lives, and it created a huge rift in the US economy. The US

Federal Reserve and Treasury were left with rotting business to dispose of and a new system of

regulation to install. The recovery procedure was not cheap TARP (Troubled Asset Relief

Program) reserved over $700 billion, and immediately injected $125 billion directly into 9 of the

largest banks (Davidoff, 2009). The combined financial guarantees outside of TARP earmarked

over 12 trillion tax dollars to guarantee money market funds, commercial paper markets, and

many other securities in the US economy (Times, 2011).

In the wake of this tragedy, Congress aimed to create an act that would limit risk in the

contemporary financial industry and limit the damage done in the event of another failure of a

large financial firm. One solution was to force derivative trading firms to move much of their

business from OTC to being exchange traded. By doing this firms would have less direct
counterparty risk, rather they would have the backup of the clearing house (exchange

middleman) as a point of support. Should one firm not be able to cover its debts on a

derivative, the clearing house would take over the trade settlement and still allow the

counterparty firm to close out their position without being defaulted on. Because this risk is

being moved from counterparty to exchange clearing houses, the clearing houses are required

to hold much more capital relative to their net positions to more fully backstop credit risk on

either side of the transaction. This central clearing would be forced upon firms by their

regulating body: commodity trading firms would be regulated by the CFTC, while all other

derivatives would be overseen by the SEC. These two regulators would determine what

products would be required to be traded on exchanges at their own discretion (Skeel, 2010).

Further, Dodd-frank took aim at the credit rating agencies that would exchange high

ratings for cash. A confounding factor in overconfidence in mortgage-backed securities was that

all of these mortgages were being rated A, AA, and AAA (the highest levels of creditworthiness)

when they certainly did not deserve to be (Dew, 2007). This combined with a hot real estate

made it easy for money to rush into a bubble of over valuation. The conflicting incentive here

was the if Standards and Poors did not issue a positive rating for a security, then the

securitizing agency would simply go to another firm like Moodys and pay for a rating there.

This competition and incentive system drove credit rating agencies to slap a label of approval

on any security that was backed by a firm with cash in hand. This competition was exacerbated

even more by the methods in which they advised corporations who were writing mortgages.

Instead of inspecting each mortgage-backed security manually, Standards and Poors began to

instruct firms on how to create a AAA rated pool of mortgages, as well as disclosing the
standards that were being used for their assessment (Fabozzi, 2016). This made it easier for

firms to keep churning out mortgages in such a way that they could be grouped and resold with

rapid turnaround and for a hefty profit.

The firms who wrote these mortgages were heavily incentivized to continue doing so, as

it was probably the most profitable way to spend their time and money. For public companies,

they had a moral obligation to return the highest possible profit for their investors, and so were

essentially forced to continue the practice (Dew, 2007). They assumed little risk, and knew

exactly how to structure their mortgage pools to pass off onto other investors. This conflict of

interest drove firms to issue sub-prime loans to people who couldnt really afford a home,

knowing that they could pass the loan off to other firms or investors. This act often crossed the

border into predation, targeting customers who didnt understand the contract they were

signing (Ber-Gill, 2008). Once the mortgages were securitized they were sold off to other firms,

and allowed the underwriting firms to wipe their hands clean. These mortgage-backed

securities consisted of mortgages all over the country and were considered safely diversified

despite the low credit rating of the borrowers. This made them attractive to those firms and

investors who needed to be invested in the housing market but wanted to do so in a wide

spread manner with high yield. The purchasers of these securities saw it as an opportunity to

make their portfolios safer, as investing in a local mortgage fund could be seen as risky. Should

housing prices fall, or local employers experience layoffs, many of the mortgages in a local fund

could go bust. Now investing firms could put their money in mortgages across the country, and

didnt have to worry about local economic fluctuations. In the beginning, this was an

outstanding process mortgage writers could profit more rapidly from their underwriting, and
mortgage investors could limit their geographic risk (Dew, 2007). It was only once the housing

market itself overheated, ballooning into an overconfident bubble, that a crisis began to

emerge. This is a classic phenomenon, where a good product gets better and better to the point

of attracting new business in droves, creating a positive feedback loop. The stronger the

growth, the more people want in, the more people who want in, the stronger the growth. This

was sustained until reality reared its ugly head, and wall street realized just what they had been

feeding into.

Once the bubble went pop we began to see a few large firms go bust, specifically those

that had optimistic leadership who allowed for exorbitant exposure to the housing market. First

was Bear Sterns, an institution that was deemed too big to fail by the government and so was

bailed out (Ayotte, 2010). The government guaranteed some of its liabilities, and arranged a

private buy out with the help of JP Morgan Chase. They also bailed out the American Insurance

Group (AIG), and began to manifest a trend of government guarantees on these large

institutions. Because of this trend, Lehman Brothers was haphazard in their organization of a

structured buyout. There was a moment when a South Korean institution was poised to

purchase a portion of the company at a 25% stake and spin off the failed assets, but in a final

act of hubris and stupidity the Lehman CEO demanded they retain the failed assets and buy a

50% stake (Haruni, 2008). He successfully destroyed the best solution possible that was

laboriously created by his team, and had the South Korean negotiators walk out on him.

The United States government decided not to bail out Lehman, as it simply could not

justify filling the gaping hole in its balance sheet with a cash injection. After the failed buy out

attempt, Lehman was forced to file Chapter 11 bankruptcy (Ayotte, 2010). This was the event
that kicked off market panic, and that many people inside and outside of the industry pointed

towards as the trigger of the financial crisis. Lehman held liabilities to numerous large and small

firms and nobody was sure if they would ever see the money they gave to Lehman ever again.

Essentially, Lehman stock became worthless when people realized everything left would go

towards attempting to repay its debts. The real issue was that there was no way for all of these

debts to be repaid, and so doubt filled the market as participants awaited the next domino to

fall. The next domino(s) were Chrysler and General Motors, who were bailed out by the Obama

administration when they realized allowing massive firms to fail would cause more harm than

good. This was a lesson learned from the tremors that emanated from the Lehman bankruptcy

(Skeel, 2010).

This left the United State economy cut down at the knees, crippled and writhing in pain

after layoffs drove unemployment towards historically high levels. By Q2 of 2009 the US

unemployment rate broke 10%, a level unseen since 1983 after a combination of energy crisis

and monetary policy misalignment (US B.L.S., 2016). This resulted in an immediate call to

action, the need for financial regulation that would prevent catastrophes like this in the future.

Unfortunately, the framework that the United states had been operating under thus far did not

provide an easy or simple approach for such an issue.

The two figure heads in the financial reform were House Representatives Frank and

Dodd, who spearheaded the projects in 2009. There were two ways that the government could

have approached this reform, bankruptcy reform or financial reform. Many were pressing for

new bankruptcy systems to be put into place, as ideally a failing institution would be able to file

for bankruptcy without taking down the whole system. This was a good looking alternate angle
in many peoples eyes once the initial financial reform got rolling, but the issue at hand was

that the leaders of the project, Dodd and Frank, did not have the jurisdiction to reform

bankruptcy (Ayotte, 2010). Such changes were reserved for the Judiciary Committees, and so

the House representatives were forced to maintain their initial approach. In doing so their

hands were tied to modifying structure, oversight, reporting, data collection, trade location,

and margin/collateral requirements. These are not bad places to make changes to decrease the

occurrence of failure, but there must be a high level of caution as to not make the less common

occurrence much worse when it does occur. Further, a loose structure for recovery was

constructed in the event of failure, detailing what federal corporations would take on failing

institutions and decide what to do with them.

In comes the regulatory bodies appointed by the Dodd-Frank Act to provide oversight

and categorization of financial bodies. First let us discuss the Commodity Futures Trading

Commission and the Securities and Exchange Commission, two regulators who gained similar

responsibilities after the crisis. As discussed earlier there was excessive use of derivatives by

firms like Lehman and Bear Sterns which precipitated exorbitant obligations that could not be

fulfilled, due in part to the fact that these derivatives were traded over the counter. There

werent any parties counting the total value of the derivative bets being made, and there

wasnt a central exchange where transactions could be tracked. Part of the Dodd-Frank Act

gave the SEC and CFTC the ability to mandate central exchanges for specific standardized

derivative products based on their interpretations of the specific product. The benefits of

central exchanges and clearing houses have been explained earlier, but the risks are not so

obvious. Should the clearing process be taken over by a small group of firms, there would be an
increase to systemic risk that wouldnt be so easily dealt with (not that the initial crisis was

easy). It is incredibly likely that this occurs as large firms would benefit most from conducting

business with the minimum number of clearing houses, this is due to the capital efficiency of

collateral compaction as cost competition among clearing houses (Nazareth, Polk, 2009). When

one clearing house holds a firms positions, the margin requirement can be lowered due to

offsetting positions. The issue arises when many large firms use the same clearing houses, and

more than one of these firms have a liquidity event similar to the previous crisis. In this case,

the clearing house itself would collapse due to it taking on its participants counterparty risk.

Should this happen the current plan of action would be for the Federal Deposit Insurance

Corporation (FDIC) to take over the clearing house, and subsequently manage or liquidate its

assets as it sees fit (Skeel, 2010). It seems that the current solution formed from the too big to

fail crisis was promoting the creation of even larger firms that are more formerly backed by

federal money. This would result in a much larger failure should one occur, and a much larger

bill for the taxpayers that finance the bailout.

The risks associated with this solution are not without their balancing merits. Because of

the preset allocation of federal funds to backstop the exchanges, there is a much lower risk of a

recurrence of a Lehman like bankruptcy. The specific feature of the Lehman bankruptcy to be

avoided is uncertainty having an action plan in the case of failure would make it much easier

for markets to continue as normal without rapid panic. As Lehman failed, all the products they

had a hand in became illiquid as there was no way for their counterparties to close their

positions. As a result, the value of many assets in the financial sector plummeted due to

liquidity risk, and the only firms who could borrow money were those who were able to close
positions and reallocate their value in more liquid and stable assets (Cornett, 2011). This means

that the more liquid the portfolio of a company, the more borrowing and lending they can do. A

major bottleneck in the recovery of the US economy was how corporate credit was not issued

by most companies as a direct result of liquidity risk, even as interest rates were dropped and

cash was provided in the bailouts. With the increased guarantee of liquidity that comes with

federal backing of the exchanges, the corporate credit market could see more activity after a

crisis, given that more assets would be readily tradeable on said exchanges. This is most

certainly the crowning achievement for the Dodd-Frank regulation, in that while a failure would

be damaging for the federal budget, the private sector and employment statistics would have a

diminished level of damage. This could turn an economic crisis into a milder recession, one that

might see recovery with less ad hoc spending (Skeel, 2010).

There are many good intentions behind the creation of the Dodd-Frank Consumer

Protection Act, however it in no way is a perfect solution. Some features of the reform do not

apply enough force unto risk takers in the marketplace, allowing derivatives and swaps to trade

off exchanges and without clearing by regulator discretion. A sad truth in our environment is

that regulators dont understand products that theyre regulating, and their discretion is not

something that can be trusted all too often an issue to be discussed elsewhere. Other

features of the reform apply too much force in the wrong direction, incentivizing a few large

clearing houses to proliferate and dominate the clearing process. This concentrates risk in a

handful of central locations without providing rigorous enough guidelines for their

collateralization (Skeel, 2010; Ayotte, 2010). All of this is set on the backdrop of new approvals

for government domain over failed firms, meaning that liabilities will be paid off with taxpayer
money by government agencies such as the FDIC. All of this adds up to the ability for markets to

continue trading with less fear of failure and more stability, but not in the most efficient or safe

manner. One could argue that our financial latex balloon has been turned into a rubber bladder

in that it is more robust and can withstand more pressure. The issue with this is that when a

rubber bladder finally bursts, it is much louder and hurts more if youre the one caught inflating

it.
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