Statement by Christopher Whalen
Committee on Banking, Housing and Urban Affairs
Subcommittee on Securities, Insurance, and Investment
United States Senate
June 22, 2009
Chairman Reed, Senator Bunning, Members of the Committee:
Thank you for requesting my testimony today regarding the operation and regulation of over-the-counter or “OTC“ derivatives markets. My name is Christopher Whalen and I live in the State of New York.1 I work in the financial community as an analyst and a principal of a firm that rates the performance of commercial banks. I previously appeared before the full Committee in March of this year to discuss regulatory reform. First let me make a couple of points for the Committee on how to think about OTC derivatives. Then I will answer your questions in summary form. Finally, I provide some additional sources and references to help you in your deliberations.
1) Defining OTC Asset Classes:
When you think about OTC derivatives, you must include both conventional interest rate and currency swap contracts, single name credit default swap or “CDS“ contracts, and the panoply of specialized, customized gaming contracts for everything and anything else that can be described, from the weather to sports events to shifting specific types of risk exposure from one unit of AIG to another. You must also include the family of complex structured financial instruments such as mortgage securitizations and collateralized debt obligations or “CDOs,“ for these too are OTC “derivatives“ that purport to derive their “value“ from another asset or instrument.
2) Bank Business Models & OTC
Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.
The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage - but are net destroyers of value for shareholders and society even while pretending to be profitable.
Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange.