Don't Let Dems Do to Derivatives What They Did to Mortgages

As the Democrats’ posture over stricter derivatives regulation, we would be wise to remember their role in the mortgage crisis that brought us to this point.

Last week, Treasury Secretary Geithner put forward some very broad brushstrokes regarding the Obama administration’s plans for regulating more thoroughly the over-the-counter derivatives markets, which he identifies as one of the chief culprits in the credit collapse last year.  In May, the administration proposed changes that would give U.S. regulators the authority to push more trading of derivatives onto regulated exchanges, which would make prices more visible. Many standard derivatives would have to go through a central clearinghouse that would guarantee that trades are completed even if a trading party defaults. Unique, customized trades would face stiffer reporting requirements. But to just blame credit default swaps (CDS) in particular or, worse, derivatives in general for Wall Street’s meltdown is like blaming “stocks” for the public’s thrashing when the internet bubble burst.  Just as not every share of stock is Drkoop.com, not every derivative is a car bomb pulling into the financial bazaar.  There are in fact many derivatives that provide a great deal of risk-management, flexibility, and protection for participants.  I do not think most in Congress however would recognize a structured derivative transaction if they stumbled over it on their way to a fund-raiser. More distasteful in my eyes, is that the Democrats’ posturing over stricter regulation betrays an air of plausible deniability over their role in the mortgage crisis that played such a pivotal role in bringing us to this point. The GOP needs to be more vocal in its criticisms of the actions of certain Democratic legislators, especially that lord of finance, Barney Frank, and drag him and others who “rolled the dice” with public moneys kicking and screaming into the spotlight. The fact is that a good amount of culpability for the subprime crisis that triggered the demise and even collapse of such firms as Lehman, Bear Sterns, Merrill Lynch, and AIG can be traced back to Fannie Mae and Freddie Mac who were able to practice their social engineering with such powerful representatives as Barney Frank providing them cover in the face of repeated attempts to reform the institutions.  In 2000, then-Rep. Richard Baker proposed a bill to reform Fannie and Freddie's oversight. Mr. Frank dismissed the idea, saying concerns about the two were "overblown" and that there was "no federal liability there whatsoever."  Two years later, Mr. Frank was at it again. "I do not regard Fannie Mae and Freddie Mac as problems," he said in response to another reform push. And then: "I regard them as great assets." Even after multi-billion dollar (and disgustingly obvious) accounting scandals that pushed out Fannie and Freddie’s top brass -- after paying them AIG like compensation mind you -- Frank was unwavering in his support.  Fannie and Freddie posed no risk to taxpayers, he said, adding glibly that "I think Wall Street will get over it" if the two collapsed. I am not laying the blame solely at the feet of Mr. Frank or the Democrats.  That would be utterly simplistic, and this past crisis is anything but simple.  However, it was the liberal Democrats like Frank who were pushing banks to defy common sense finance and write mortgages to those who had no right to such credit in the name of "affordable housing."   And he made sure that Fannie and Freddie were there providing much of the secondary and even primary market, positioning these GSE’s as integral cogs in the machine that culminated in a series of IB hedging that poured toxic subprime instruments into the bins of AIG and others to go off with a bang at a later date. The availability of easy money should not translate into throwing good lending practices out the window.  Yet this is what happened.  And the irresponsibility, with the encouragement of Mr. Frank et. al, continued even after rates turned.  As Michael Lewis explains:

In a normal economy, when interest rates rise, consumer borrowing falls—and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled—and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans—loans which for some reason or another can be dicey, usually because the lender did not require the borrower to supply him with the information typically required before making a loan.

How did this come about?   Jeff Jacoby of the Boston Globe has his suspicions: “Barney Frank's talking points notwithstanding, mortgage lenders didn't wake up one fine day deciding to junk long-held standards of creditworthiness in order to make ill-advised loans to unqualified borrowers. It would be closer to the truth to say they woke up to find the government twisting their arms and demanding that they do so - or else.” Now OTC derivatives are being targeted as if their very existence caused the calamity we now face.  Targeted by the very people who were so clueless as to the ways of finance the first time around.  Talk about irony.   Many of the financial concerns about derivatives are indeed legitimate, as the inexcusable risk profiles of certain complex portfolios uncovered when the bubble collapsed shows us.  But I think the Democrats’ concerns are more about political cover and distraction than real reform. The GOP must be aware that the push to regulate OTC derivatives is not so much a political slam dunk as it may first appear.  Remember, 90% of Fortune 500 companies use OTC derivatives to hedge risk.  It is telling that at least 42 nonfinancial companies and trade associations are lobbying Congress on derivatives.  As the Wall Street Journal reported: “Nonfinancial companies say it's unfair for them to be put in the same boat as Wall Street speculators, some of whom use derivatives to make bets on market movements. They also say they typically have collateral backing the risk and standardized contracts aren't necessary.” I agree there are flaws that need to be addressed in the derivatives universe.  But we must also remember that AIG F.P.’s $450 billion corporate CDS portfolio is healthy.  The losses were suffered in subprime CDS ($45 billion) and mortgage-backed securities ($50billion).  So we find ourselves circling back to the explosion in subprime mortgages written as the most potent underlying poison in the financial system over the past several years.  Many of the traders who participated in the debacle and took the wrong side of the transactions in question are now out of work. Many who took out mortgages they couldn’t afford are out of their homes.  Yet Barney Frank and his band of dice-rolling social engineers, so cavalier with others’ money because they have never had to risk their own, merrily strut from committee meeting to luncheon to plush Capitol Hill office without a hint of the culpability they share nor any general public outcry over the damage they have caused this country… and the damage they still can do if left unchallenged by an anemic and still ineffective Republican Party. The GOP should be careful to walk this derivatives regulation line carefully, lest we appear to be over-reactive business killers on one-side, or big business shills on the other.  I am not against any reform of the derivatives markets.  But this is a $500 trillion dollar (that’s trillion) global market, stunning in its depth and complexity.   I hardly think some of the architects of the subprime debacle are the best stewards of this massive ship of finance.  I am watching this process with deep concern that goes well beyond my little company, but for the financial system as a whole that, when the dust settles, we will still very much need to grow in the future.