A Risky Effort to Mitigate Risk

Click here for a printer-friendly version of this article

The House of Representatives is expected to vote today or tomorrow on a plan to establish new regulation of the derivatives market.  According to the Office of the Comptroller of the Currency (OCC), U.S. commercial banks hold derivatives with a notional value of $203 trillion. Only 3.6% of these derivatives are traded on exchanges.  The rest are traded in the over-the-counter (OTC) market, which means they are bought and sold through dealers, principally large banks.  The main goal of the bill is to alter this relative balance by shifting more derivatives to exchanges or “swap execution facilities” and providing government agencies with broad oversight and enforcement powers.

Derivatives are nothing more than private contracts where one party agrees to make conditional payments to another based on some future event.  Prior to last year, there was no compelling reason why government should insert itself between the sophisticated parties involved in these contracts.  But this laissez faire approach was no longer tenable in the wake of the AIG bailout, which was triggered by reckless use of OTC derivatives.



OTC derivatives create “counterparty risk,” which is the risk that the firm on the other side of the trade will fail to make its promised payment.  This risk is generally addressed through a credit support annex (CSA), which is standardized contractual language that governs how much collateral counterparties need to post based on the fair value of the derivative and their credit rating.  The higher the counterparty’s credit rating, the less collateral it needs to post. 



After accounting for collateral requirements, OTC derivatives traders also use credit value adjustment (CVA) to reduce the fair value of their derivatives position for the probability that their counterparty won’t make the payment.  If a bank is owed $10 million by a party that has only a 50% chance of making good on the obligation, the bank would record that derivatives asset at $5 million.  During the fourth quarter of 2008, banks reported over $9 billion in losses on derivatives partly because the credit quality of their counterparties deteriorated and made the promised payments less likely.  The risks associated with OTC derivatives is already legally accounted for, actively managed, and hedged.



In fact, it was these legal obligations – not losses themselves – that ultimately doomed AIG.  As its credit rating was downgraded and the collateralized debt obligations (CDOs) on which it wrote protection fell in value, AIG was required to post more collateral to counterparties than it had in unencumbered assets.  The resulting liquidity crisis would have led to a Chapter 11 bankruptcy filing had the government not stepped in to bailout the company. 



The fact that AIG’s counterparties already accounted for the fact that the company was unlikely to meet its obligations in full is what made the government’s decision to pay AIG’s counterparties 100 cents on the dollar – $62.1 billion, $27 billion in cash and $35 billion in collateral, for $62.1 billion in par value – seem like a windfall.  Many believed the gratuitous payment was made to avert a systemic collapse.  The fear was that AIG’s default would cause its counterparties to default on their obligations, which would trigger even more defaults.  But it has since been disclosed that the “the financial condition of the counterparties” was not a relevant factor in the government’s decision.  As it turns out, the government was simply a bad negotiator. 



In recent testimony before the Senate Agriculture Committee, Secretary Geithner explained that the main goal of reform is to prevent “activities in the OTC derivative markets from posing risk to the stability of the financial system.”  But if then-New York Fed President Tim Geithner was not making the $62.1 billion in payments to avoid a systemic collapse, how can AIG be used as a case study to promote pervasive new regulation?  More significantly, if the worst OTC derivatives disaster of the financial crisis did not pose a systemic risk, shouldn’t this instead be an example of how existing law – private contracts enforced by courts – succeeded in managing counterparty risk?



The government cannot eliminate counterparty risk; it may be able to transfer it to other parties like exchanges, directly underwrite it on behalf of taxpayers by extending guarantees, or impose inflexible margin and collateral requirements that would make many transactions uneconomic.  But whether any of these arrangements would be better than current law is an empirical question without an obvious answer.  Forcing more trades to exchanges could actually create more systemic risk than current law if it provides a false sense of security that leads counterparties to be less circumspect. 



Rhetoric about this “lawless” market ignores the flexible, constantly evolving contract law that already governs it.  Policymakers should review this history more closely before passing something that could make matters worse.