The Next Meltdown: How We Have Failed To Regulate Financial Derivatives

The biggest story about the financial crisis that began four years ago is what still hasn’t been done to make sure that the same disaster doesn’t happen again — and why.

As the crisis unfolded and since, many Americans heard about credit default swaps (CDS), the arcane form of insurance that ruined the huge American International Group. Yet while we all paid many billions for AIG’s mistakes, the effort to control so-called derivatives such as CDS has been no more successful than the attempt to prevent future bailouts of banks that are “too big to fail.”

With  $14 trillion outstanding at US banks as of March 2012, the CDS market is nearly equal to the gross domestic product of the United States. Even so, CDS represent just six percent of the overall derivatives market in the US banking system. The rest of the market – that is, the other 94 percent – is just as lightly regulated.

Yet it is hard to regulate a market few people — even experts — understand, especially when those who do understand it can still benefit by guarding its secrets.

Just ask the top managers at JPMorgan Chase.

The firm’s recent statements on its losses in the “London Whale” case show how poorly these financial wagers are understood. From the bank’s initial disclosure of $2 billion in losses, JPMorgan was estimating losses three to four times as large only a few weeks later. And JPMorgan is by far the largest player in the nation’s CDS business, with $6.1 trillion in contracts on its books. The net credit exposure of these swaps at JP Morgan in the first quarter of 2012 was more than 2.5 times the firm’s total risk-based capital.

In layman’s terms, a CDS — a two-sided contract — is insurance that protects against losses on, say, a specific bond. As with car insurance, the buyer pays a premium, and the seller covers the loss if an accident (in this case, a default) occurs.

But a CDS contract doesn’t require insurance buyers to own what they’re insuring. The reality is more like a casino bet — imagine neighbors taking out millions in collision insurance on your car. If you have an accident, they’re rich.

And unlike state-regulated auto insurance, there are currently no capital requirements for derivative insurers, and until recently, there was zero outside supervision. The little oversight created under the Dodd-Frank Act  has barely altered the market because the rules are easy to circumvent.

Behind the inertia can be found some familiar forces. First, the regulatory agencies are hopelessly outspent by financial companies, companies that also frequently offer higher-paying jobs to staff at the regulatory agencies.About 20 percent of American GDP comes from the financial industry, giving its lobbyists and political donors tremendous influence.

Moreover, aside from a few stunning losses (see Lehman Brothers, Bear Stearns and AIG in 2008, and JPMorgan in 2012), derivatives have become a big profit center for banks. The Treasury Department’s Office of the Comptroller of the Currency reported that the largest US banks earned an average $788 million each quarter trading CDS over the past two years.

So financial lobbyists are only too happy to help write legislation like Dodd-Frank (or to pen multiple bills curbing nascent regulation before it takes hold, as watchdog organization Americans for Financial Reform has repeatedly observed this year).

The resulting regulation is less effective than a sieve. Yes, Dodd-Frank does try to bring derivatives trading into the sunlight (via rules that regulators are still hashing out, with much industry input). Some simpler credit default swaps are now traded on exchanges, so volumes and pricing are visible. But since transparency shrinks profit margins by making it easier for customers to shop around — and will ultimately mean some capital requirements are imposed — don’t expect it to become the norm. If you think the rules contain loopholes the size of, well, a whale, you’re right.

Under rules drafted by the Securities and Exchange Commission and the Commodity Futures Trading Commission, there is an exemption for portfolio hedging of the sort that just allowed JPMorgan to lose $6 billion to $8 billion.  There’s also an exemption for swaps executed to smooth earnings streams for such businesses as consumer or mortgage lending, mining, agriculture, manufacturing, consulting or accounting.

But wait — there’s still more wiggle room for the banks! Even final rules come with comment periods, leaving plenty of opportunity for further banker influence. Earlier this year, complaints from finance companies about the cost of reporting trades led regulators to exempt (at least for a while) firms that do as much as $8 billion in annual derivatives trading, up from an earlier proposed limit of $100 million per year.

As things now stand, the financiers planting the seeds of the next financial crisis will profit heartily — until we all reap the consequences. And no one will go to jail when that day comes. They aren’t breaking any laws, after all.

Photo Credit: AP/Mark Lennihan