With regards to the OTC market, the popular presumption -- one that Greenspan shared in his speech last week -- is that they perform the useful function of smoothing-out some of the otherwise exogenous shocks to the system by mitigating and dispersing risk:
“The use of a growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risk are key factors underpinning the enhanced resilience of our largest financial intermediaries.” Greenspan. May 8, 2003.
Greenspan goes on to say that derivatives have helped ‘unbundle’ risks and, due to this unbundling process, concentrations of risk have become manageable on a ‘portfolio basis’. He provides anecdotal, media ready evidence of this by stating “Even the largest corporate defaults in history (WorldCom and Enron) and the largest sovereign default in history (Argentina) have not significantly impaired the capital of any major financial intermediary.”
To begin with, Greenspan is correct: the advent of derivatives has made it possible for companies to better disperse and manage financial risks. However, we would argue that discussing the ideal-type function of derivatives in general is not the same thing as discussing the specifics of the OTC market in practice. More to the point, the most significant practical problem with the OTC market is the way in which the creditworthiness of each participant is determined. No doubt the procedures used to gauge counterparty credit strength have improved in recent years. Nevertheless, it is not possible to discern whether OTC participants are acquiring unsustainable financial leverage and/or keeping pertinent ‘proprietary’ financial information away from counterparties. Neither the contracting parties themselves nor the “neutral” credit rating agencies are obliged to disclose, or are privy to, all of the pertinent information
To be sure, the benefits of derivatives are self-evident. Yet Greenspan did not make the case (nor do we believe that he can) that the benefits of secretly traded derivatives outweigh the persistent potential for blowups. Needless to say, rather than trying to stop financial meltdowns by developing mandatory risk management procedures, Greenspan reiterated his long held belief that the largest financial market in the world should not be regulated for fear of stifling ‘trust’*.
Would Regulations Hurt OTC Derivatives?
“…the success [of OTC derivatives] to date clearly could not have been achieved were it not for counterparties’ substantial freedom from regulatory constraints on the terms of OTC contracts. This freedom allows derivatives counterparties to craft contracts that transfer risks in the most effective way to those most willing and financially capable of absorbing them.”
It is uncertain to what specifically Mr. Greenspan is referring when he mentions ‘regulatory constraints’ in the above quotation. Rather, he argues vaguely that “Except where market discipline is undermined by moral hazard…private regulation generally is far better at constraining excessive risk-taking than is government regulation.” Using the example of Long-Term, was it ‘moral hazard’ or the unmitigated use of leverage that brought the hedge fund down? How effective was private regulation in this case? We would argue that if someone had been monitoring Long-Term’s leverage its blowup would not have occurred or, at a minimum, the size and financial threat of its blowup would have been significantly smaller.
Suffice it to say, the internal risk procedures utilized by each Long-Term OTC partner may have been intricate and filled with good intentions, yet since no firm was privy to Long-Term’s outstanding contracts and the future risk exposure these contracts cumulatively represented (which were ‘proprietary secrets’), self-regulation failed miserably.
However, rather than be chastened by LCTM and justifiably concerned about the potential meltdown of the OTC market, Greenspan continues to argue that the proof is in the pudding. After all, LTCM was contained: the fact that a catastrophic financial crisis has not yet occurred must mean that it never can?
In short, Greenspan readily admits on the one hand that there will be blowups due to failed ‘risk management’ procedures, yet on the other hand he seems willing to accept these blowups as isolated risk management failures in an attempt to ensure that the market is not ‘constrained’ by regulations.
The Problem of Risk Management
The basic problem – one that Greenspan mentions but does not really cover – is the fact that the term ‘creditworthiness’ as it is used today is little more than a buzzword. To be sure, creditworthiness is not the God given right of every financial institution that has some cash in the vault and is carrying a positive mark-to-market OTC book. Nor is creditworthiness accurately defined by the letter A, offered cryptically by rating agencies.
Rather, given the massive size of OTC derivatives instruments, quality creditworthiness today must take into account all that is currently not seen. It is in the shadows that the real financial risk lurks, not in the broad daylight.
For example, an inquiry into the inner workings of Moody’s or Standard and Poor’s is not likely to reveal an ultra sophisticated program intensely monitoring the day to day affairs of JP Morgan. Rather, and here the Enron debacle comes to mind, it is more likely to reveal glimpses of woefully lacking accountants sitting around punching numbers taken from inadequate and dated financial statements into a calculator and calling up CEOs inquiring about why the company is broke: “you deserve to be rated junk, but since you seem like a nice fellow I’ll wait to see if that merger goes through…”
So what is to be done? We would argue vehemently for one basic regulatory enactment: that the credit position of each OTC participant should be subject to a full and mandatory disclosure, if not the specifics of their OTC contracts. To be sure, as the OTC market grows larger and credit risk rests in the hands of fewer firms (which increases the possibility of illiquidity), the ‘potential future exposure’ must be monitored by someone other than the firms directly involved.
“Some may now argue that the periodic emergence of financial panics implies a need to abandon models-based approaches to regulatory capital and to return to traditional approaches based on regulatory risk measurement schemes. In my view, however, this would be a major mistake. Regulatory risk measurement schemes are simpler and much less accurate than banks' risk measurement models.” Greenspan, March 19, 1999.
Why can’t ‘regulatory risk measurement schemes’ catch up to the more ‘accurate’ bank risk measurement models? Does this represent some kind of technological impairment or is it nothing more than an ideological a priori on the part of Greenspan?
Regardless, and referring to the above quote, one would expect Greenspan to provide a detailed report on how existing indirect private regulatory efforts (from rating agencies – those who establish the creditworthiness on which bank risk allocation models often depend) can better monitor the sophisticated models of OTC firms. However, in last week’s speech he left the accuracy of private regulation unexamined while implicitly lauding its stabilizing role:
”Counterparties in the OTC derivatives market are quite concerned about the potential credit risks inherent in such contracts and generally are unwilling to transact with dealers unless their credit rating is A or higher…
Market participants also establish credit limits for their counterparties and actively monitor their exposures to ensure that they remain within the limits established. Such monitoring, parenthetically, relies heavily on trust in the accuracy of the information forthcoming from the counterparties.”
While the ‘concerns’ of counterparties in the OTC derivatives market are self evident, what is not as clear is why Greenspan is suggesting that an A credit rating means anything. After all, in what way can the regulatory prowess of Moody’s and S&P match the sophisticated bank models? Suffice it to say, and to reiterate, Greenspan doesn’t offer any suggestions about how to increase existing risk management procedures (i.e. how to make an A trustworthy). Instead, he mentions A ratings as if they represent a complete and up-to-date disclosure of corporate health.
Finally, note that the word ‘trust’ is highlighted. Such is what the OTC debate boils down to: if you trust Moody’s, S&P, greedy managers/traders, Greenspan and the gang, then the OTC is safe and LTCM was a fluke. Of course there is a risk in taking such a position…
“To be sure, there undoubtedly will be further risk-management failures.” Greenspan. 2003.
Warren Buffett previously voiced grave concerns regarding the OTC derivatives market. In the context of an unregulated market allowed to grow without regulatory prudence, Buffett’s ‘weapons of mass destruction’ comment resonates, while Greenspan’s “the benefits of derivatives, in my judgment, have far exceeded their costs” does not.
Greenspan is spry; he points to LTCM and concludes that it was really not that big of a deal. However, if the next risk management failure in the OTC market hits a sweet spot, it could make Enron, Worldcom, and Long-term combined look like a day in the park.
The next 100-year flood may not take one hundred years to develop. Quite frankly, Greenspan needs to take a different lesson from history than the one that he is currently drawing upon: LTCM happened less than six years ago and did not cascade into a global financial meltdown only because the New York Fed was able to oversee orchestrated bank concessions. LTCM should have been a wake-up call to the Fed. Instead, Greenspan and company are asleep at the wheel as the OTC market grows unfettered, and the next risk management failure approaches.
*. Trust versus regulation: “Today, most banks rely partly on deposit insurance in lieu of reputation to hold below-market-rate deposits. And a broad range of protections provided by the Securities and Exchange Commission, the Commodity Futures Trading Commission, and myriad other federal and state agencies has similarly partially crowded out the value of trust as a competitive asset.”