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.
The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the view of these agencies are largely duplicative of the views of JPM and the large OTC dealers .
3) Basis Risk & Derivatives:
The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or non-existent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the “basis“ of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection.
With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ “models“ that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see - and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.
In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.
What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing.
Jefferson said that „commerce between master and slave is barbarism.“ All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives, then how can we expect our financial institutions and markets to be safe and sound?
For our nation's Founders, equal representation under the law went hand in hand with proportional requital, meaning that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain. A situation in which one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans as a fraud. Whether through laws requiring disclosure of material facts to investors, anti-trust laws or the laws and regulations that once required virtually all securities transactions to be conducted across open, public markets, not within the private confines of a dealer-controlled monopoly, Americans have historically stood against efforts to reduce transparency and make markets less efficient - but that is precisely how this Committee should view proposals from the Obama Administration and the Treasury to „reform“ the OTC derivatives markets.
To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, „The Failure of the Economy & the Economists.“ He describes the CDS market in a very concise way and in layman's terms. I reprint his comments with the permission of NYRB: „The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.
„But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.
„This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention.“
4) CDS & Systemic Risk
While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.
Seen in this context, AIG was the most visible “sucker“ identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.
Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers.
5) CDS & Securities Fraud
One of the additional concerns that the Congress must address and which strongly argue in favor of outlawing the use of OTC CDS contracts entirely, is the question of fairness to investors, specifically the use of these instruments for changing the appearance but not the financial substance, of other banks and companies. The AIG collapse illustrates how CDS and similar insurance products may be used to misrepresent the financial statements of public companies and financial institutions.
In the case of AIG, the insurer was effectively renting its credit rating to other firms, and even its own affiliates, in return for making these counterparties look more sound financially than their true financial situation justified.
The use of CDS and finite insurance to window dress the financial statements of public companies is an urgent issue that deserves considerable time from the Congress to build an adequate understanding of this practice and create a public record sufficient to support legislation to ban this practice forever. For further background on the use of CDS and insurance products at AIG to commit securities fraud, see “AIG: Before Credit Default Swaps, There Was Reinsurance,“ The Institutional Risk Analyst, April 2, 2009
Q & A
Below are my responses to the Committee's written questions.
1) How can the Congress best modernize oversight of the over-the-counter derivatives markets to increase transparency and reduce risks?
The Congress should think of modernizing the oversight of OTC derivatives in terms of restoring the existing norms of disclosure, transparency, prudential risk controls and fairness that prevail in organized, regulated markets in the US, markets such as the NYSE or CME. The existing structure of OTC derivatives is not “innovative“ but rather is retrograde for the reasons suggested in the general points above regarding bank business models and the nature of the credit derivatives markets. Consider the fact, for example, that even today, market participants, regulators and the public still have no access to close-of-day prices for CDS and complex structured assets because the large dealers such as JPM and GS refuse to make this information available to the public.
In order to address this situation, Congress should take immediate action to immediately start to limit the risks posed by the operation of OTC markets. Specifically:
Congress should subject all OTC contracts to The Commodity Exchange Act (CEA) and instruct the CFTC to begin the systematic review and rule making process to either conform OTC markets to minimum standards of disclosure, collateral and transparency, or require that the contracts be migrated onto organized, bilateral exchanges. It is time for the Congress to right the wrong done over a decade ago to Commissioner Brooksley Born and her colleagues at the CFTC. This wrong was committed in part by the Congress and in part by then-Treasury Secretary Larry Summers, then-Fed Chairman Alan Greenspan, and former Treasury Secretary Robert Rubin, among others, who all worked together to effectively block action that would have subjected OTC contracts to the full supervision of the CFTC.
The Congress should admit that it made a mistake in 2000 by blocking CFTC regulation of OTC derivatives. The Congress should take the time to document how and why Greenspan, Rubin and Summers, and others, viciously attacked the reputation and integrity of Chairman Born and other members of the CFTC, and thereby blocked CFTC regulation of OTC derivatives. The actions of Summers, Greenspan and Rubin over a decade ago to block CFTC regulation of OTC derivatives arguably created the circumstances for the collapse of AIG as well as hundreds and hundreds of billions of dollars in losses incurred by financial institutions around the world. The Congress and the people of the United States deserve to hear the explanation of Summers, Greenspan and Rubin for the actions they took and did not take in their capacity as public officials subject to congressional oversight.
I agree with the statement by Secretary Geithner last week that how and whether to combine the operations of the CFTC and the SEC is a question that needs more time and consideration than the Obama Administration has allocated for the consideration of reform for the OTC markets in 2009. I urge the Congress to move first on subjecting the OTC markets to CEA, then to take further time for hearings and fact finding to consider what other changes should occur in terms of the law and the operational structure of the SEC and CFTC.
2) As the Congress weighs proposals to move more over-the-counter derivatives transactions to central counterparties or exchanges, what key decisions need to be considered?
It is important for the Committee to understand that the reform proposal from the Obama Administration regarding OTC derivatives is a canard; an attempt by the White House and the Treasury Department to leave in place the de facto monopoly over the OTC markets by the largest dealer banks led by JPM, GS and other institutions. For example, the centralized clearing model proposed by the Treasury has some notable attributes, but still leaves the OTC markets under the complete control of the dealer banks, with little public disclosure of prices, no transparency and no accountability to other dealers and market participants. The proposal, for example, to require centralized clearing still does not address the issues of pricing, basis risk and transparency that I have raised in my comments.
Why then are the large banks, led by JPM, engaged in such a desperate battle over the reform of the OTC derivatives markets? For the world's largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits -- and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPM, GS and the remaining legacy OTC dealers, the largest banks cannot survive and must shrink dramatically.
No matter how good an operator of commercial banks JPM CEO Jamie Dimon may be, his bank is doomed without its near-monopoly in OTC derivatives -- yet that same OTC business must eventually destroy JPM and the other large dealers. Seen from that perspective, the rescues of Bear Stearns and AIG were meant to protect not investors nor the global markets, but rather to protect JPM, GS and the small group of dealers who benefit from the continuance of their monopoly over the OTC derivatives market.
As noted above, since many OTC contracts for currencies, interest rates or energy, for example, have observable cash markets upon which to base their pricing, moving these contracts to an exchange-traded format is a relatively easy matter that does not pose significant hurdles for the Congress, investors or regulators. Indeed, most market participants would welcome and benefit from such change.
When it comes to CDS and complex structured assets, however, it is probably not possible to move these contracts to an exchange or to continue to tolerate them as OTC instruments. Because CDS contracts generally do not have a cash market or basis upon which to draw for the purpose of valuation, as a matter of law and regulation, these instruments are entirely speculative, unsuitable for most banks and investors, and thus should be banned entirely. It is not simply a question, as some observers have suggested, of buyers of CDS having an insurable interest in the underlying basis that is the problem. Rather, because there often times is not observable cash market for say a corporate bond or a CDO, the very act of a dealer offering these instruments to a customer must be viewed as entirely speculative and thus an act of deliberate securities fraud.
Pretending to price CDS contracts or complex structured securities using “models“ is a ridiculous deception that should be rejected by the Congress and by regulators. And members of Congress should remember that federal regulators and the academic economists who populate agencies like the Fed are almost entirely captured by the largest dealer banks. Even today, the Fed and other regulatory agencies raise little or no questions as to the efficacy of OTC derivatives and the absurd quantitative models that Wall Street pretends to use to value these gaming instruments. Why? Because the Fed knows that as the Congress properly regulates OTC derivatives, the largest banks will be forced to shrink their operations, the need for a “systemic risk regulator“ will fade and the role of the Fed within the financial regulatory framework will gradually diminish.
3) How would various proposals to enhance oversight of OTC derivatives affect different market participants?
Imposing appropriate prudential and legal limitations on OTC derivatives would have enormous benefits for investors in terms of better pricing, increase transparency regarding market and liquidity risk, and improved surveillance and oversight by regulators. The notion that requiring basic norms of price discovery and disclosure for OTC markets will hurt “innovation“ is an absurd position and only illustrates the grotesque conflict of interest that now infects the dealers and federal regulators.
If one equates “innovation“ with fraud and criminality, then yes regulation of OTC derivatives will certainly hurt innovation. But if the Congress does its duty and acts to conform the unregulated, opaque OTC markets to the basic standards of honesty and openness that have been the minimum requirement for markets in this country for over a century, then there should be no concern about stifling “innovation.“
Let's make a list of participants and suggest some winners and losers from OTC reform:
Investors in Financial Markets: Big winners. Better pricing, more transparency, less “innovation“ and thus reduced market and liquidity risk, fewer opportunities for severe loss and/or public bailouts.
Taxpayers: Big winners. Less systemic risk, less cost for bailouts of financial institutions, and less time spent by the Congress considering problems that should not exist in the first instance.
Consumers: Big winners. By limiting the complexity of financial instruments, the Congress can act to limit predatory behavior by lenders and major Wall Street dealer firms. If you do not allow overly-complex financial instruments to exist in the first place, then the Congress will effectively limit systemic risk in financial markets.
Dealers: Winners. Less risk, lower returns, makes dealers more stable and less likely to require a public bailout. The illusory, short-term returns for dealers will fall, and with it the supra-normal compensation for traders and executives of the dealers, but the long-term risk-adjusted returns for large dealers will rise and the shareholders of the dealers will benefit.
4) How does the issue of improved OTC derivatives regulation relate to broader regulatory reform issues such as the creation of a new systemic risk regulator, and to what extent do our efforts require international coordination?
“Systemic risk“ is a political concept that does not belong in law or regulation. The perception of “systemic risk,“ which is another way of describing the human emotion of fear, is a function of inefficient markets and opaque, illiquid financial instruments such as CDS and complex structured assets. If the Congress acts to impose regulation on the OTC derivatives markets, then the perceived need for a systemic risk regulator will disappear. The phenomenon of “systemic risk“ is a function of the fear among investors at least partly caused by the supra-normal returns earned by participants in the OTC markets. Once these markets are brought back within the established norms of fairness and transparency, and the nominal rates of return fall to the same levels as those earned in established public markets, then the problem of “systemic risk“ will fade.
The key thing for the public and the Congress to understand is that the „profits“ earned from unregulated derivatives markets are illusory and do not cover the true “systemic“ risk posed by the continued tolerance of OTC derivative markets. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time because OTC markets create risk and opportunities for loss that would not otherwise exist. The net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society.
If the Congress has the courage and the vision to act now to regulate and migrate to an exchange model those OTC markets that have a real, observable basis and ban those OTC instruments that do not have such a foundation, then the need for a systemic risk regulator will disappear and the only need for international coordination will be for the governments of the industrial nations to celebrate the end of one of the darkest, most alarming periods of speculative mania seen in many generations. Thank you.