Thursday, December 3, 2009

Deriving Derivatives

Tommy Gun Tim, The Man of A Thousand Silver Bailout Bullets, recently testified in Congress about the next act in the financial regulatory charade.

Mr. Geithner said that pending bills in the House which would carve out fairly broad regulatory exemptions for companies that use customized products to hedge risks should be reviewed and possibly tightened.

Mr. Geithner testified about administration's plan to bring new regulations to the over-the-counter market. A key part of the plan would require many routine products to be traded on platforms and processed through clearinghouses, which guarantee trades.

But businesses have warned such a move could have a dramatic cost impact because it would force them to post cash margin to a clearinghouse. In response to those concerns, two key House panels carved out exemptions for commercial firms in their derivatives bills.

Mr. Geithner on Wednesday reiterated his support for preserving a customized swap market in which products are still traded off-exchange. But he warned that any clearing exemptions should be narrowly defined so firms can't skirt the rules.

Just two thoughts. 
  1. The things that are going to get proposed exemptions are actually the only derivatives that should exist to begin with.  These derivatives are useful for real economy hedging and should clearly not be traded in a custom, opaque and high margin OTC fashion, because the companies that are using them to hedge will never know whether their counterparty is actually good for it or not.  Your not hedged unless you know you're hedged.  This, you will recall, is why we're having the "gee, maybe we should regulate derivatives," discussion to begin with.  So I can't tell whether the ploy here is to create a loophole so large that nothing important happens at all, or whether he's trying to force all the useless and speculative derivatives (like CDS) onto an exchange as a way to effectively kill them by raising the collateral requirements to the point where they're uneconomic.  And it could be both at the same time -- take away the shiny bauble the child keeps choking on, but give him a less dangerous and still highly profitable gift in its stead so as he keeps his yap shut.
  2. The idea that having to post cash margin will kill the useful commercial derivatives is nonsense.  I mean, what do we have banks for to begin with if not to assess the credit worthiness of a borrower and extend ... um ... credit ... aka ... cash ... which could then be used to post collateral.  Right now we've got all this opaque bullshit like increasing ownership of a utility's turbines serving as Goldman Sachs' collateral on some funky structure they've got with an aluminum smelter in China.  Please, guys, this is what we invented money for.  It makes things a hell of a lot clearer than bartering derivative exposure, which as we have seen, also has a cost that only comes out when everything goes bad, and in the meantime sweeps it under the accounting rug.  If the derivative is worth it to begin with, GS can loan the utility and the aluminum smelter some money to post as collateral to an exchange traded product which hedges both of their electric prices.  All this does is makes the cost clear and upfront and explicitly accounts for the implicit leverage involved.  Oh, and cuts into the vampire squid's margins -- money is, lest we forget, a commodity.

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