derivatives regulation

8/3/2019 Derivatives Regulation

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Derivatives Regulation

New Rules for Derivatives

http://www.nytimes.com/2009/05/15/opinion/15fri1.html?_r=1&scp=3&sq=derivatives&st=cse

Published: May 14, 2009President Obamas new proposal to regulate derivatives would go a long way toward reining in thecomplex products and reckless practices that have been a big factor in the financial crisis. But it wouldnot go far enough. In apparent deference to those who have made major profits from unfetteredderivatives trading, the proposal stops shy of creating a fully transparent market.Transparency is the best way to avoid a repeat of the disaster triggered in recent years by theseunregulated financial products, which are supposed to help investors manage risks, like the possibility ofdefault or of interest-rate swings. As the financial bubble burst mid-decade, many of these derivativesdidnt work as advertised. Rather than reduce risk, they created or amplified it, to the point as in thecase of the American International Group that the failure of one party to various derivatives contracts

threatened to topple the entire system.Worse still, the debacle caught regulators flat-footed and taxpayers have been paying for bailoutsever since. The tab for A.I.G. alone, so far, is some $180 billion, and there are trillions of dollars morefor which taxpayers are on the hook. Derivatives are not entirely to blame for the fiasco, but they areimplicated in much of it.The administrations proposal rightly seeks to repeal much of a law from 2000, the Commodity FuturesModernization Act. It put derivatives beyond the reach of federal regulators. It calls for certainderivative trades, though not all, to be handled through clearinghouses. It also requires that derivatives

be backed by collateral, ensuring that a trader is able to make good if called upon to pay up. It wouldallow federal regulators to police the market for fraud and manipulation basic safeguards missingfrom current law.In a far-reaching change, the proposal also would subject participants in the derivatives market to capitalrequirements and to record-keeping and reporting requirements. These would allow regulators to tracktheir activities, presumably intervening as necessary to avert systemwide problems.For all that, the proposal pulls its punches. It does not call for trading derivatives on fully regulatedexchanges, the most visible and reliable way of reining them in. It also makes a distinction betweenstandardized and customized derivatives and proposes a lighter regulatory touch for the custom variety.That could open the door to gaming the new system, a door that would be shut if all derivative contractswere traded on exchanges. In some important respects, it appears to give regulators the discretion,though not the duty, to police markets more closely.The proposal also seems to invite tension between the Securities and Exchange Commission and the

Commodity Futures Trading Commission, the main regulators that would oversee derivatives.Regulatory jurisdiction must be clarified if the new rules are to have any teeth.Another tension is that, in carrying out the new rules, President Obamas nominee to lead theCommodity Futures Trading Commission, Gary Gensler, has a credibility problem. During the Clintonadministration, Mr. Gensler along with Lawrence Summers, Mr. Obamas top economic adviser championed derivatives deregulation. That caused two senators to place a hold on his confirmation,even though Mr. Gensler supported greater regulation during his confirmation hearing. They releasedthe hold on Thursday only after the new regulatory proposal was made public.The Obama proposal starts off in the right direction. It is up to Congress to shore up its protections and

provide regulators with the resources and political support they would need to carry out their newmandate.

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Comments:

Editors, I was curious how you'd deal with the issue of derivatives. Your opening understatement left mewith a smile: the Obama proposal to regulate derivatives "would not go far enough." You point atseveral serious flaws including insufficient transparency, conflicting regulatory bodies, and how easy itwould be to cheat, but your lack of hard -- or even speculative -- numbers as to the dimension of the

problem left me wondering.

You mention the A.I.G. tab of "some $180 billion," and follow with "there are trillions of dollars morefor which taxpayers are on the hook." How many trillions? I've read that the total derivatives outstandingcould be $1.28 Quadrillion- with 95 percent on margin. I've seen $1,000 Trillion and $684 Trillion. Icapitalize the T to emphasize this is not a typo. Anyone can Google "derivatives outstanding" and seethe spread of numbers and disturbing dimensions. While I am not saying we have a derivative problem aquadrillion bucks in size -- for presumably most of this is hedging and funny money of one sort oranother -- we do need to consider the astronomical scope of the problem. Which brings us to thequestion of what solution to try. Bolting the barn door after a few trillion horses have escaped is notgoing to solve the problem. What do you propose? What does Dr. Krugman or Dr. Stiglitz propose?What could possibly be done?Probably I'm dead wrong, but I'd like to hear debate on abrogating all derivatives contracts -- worldwide

-- with the stroke of a pen, or multiple pens by the G-20 nations and others. Just take everyone off thehook simultaneously and then put some reformed derivatives exchange in place. Or perhaps design theexchange and have it ready, then wham-o, all old bets are off and come to the new, transparent exchangefor something we can see. As to the "custom" derivatives, they'd be gone too, and we'd have to work outrules and boards to deal with these in the future.All this, of course, assuming that derivatives are even needed. Are they?

The really disturbing part of this regulatory proposal by the Obama administration is its intent todeceive. I thought those days were over. It pretends to regulate derivatives while including an enormousloophole for "customized" instruments, the riskiest form of derivatives, precisely the mysterious,opaque, impossible to price and poorly understood contracts that imploded. Geithner insults theintelligence with a regularity that is really starting to make me angry.While it is true that derivatives did not entirely cause this crisis, it is also undeniably true that withoutthe sudden, exponential growth in OTC "customized" derivatives activity, originating and emanatingfrom financial institutions in the United States, the global economic crisis does not occur. Look up thenumbers at the Bank for International Settlements. Face head on what business as usual became over the

past 10 years. Face the fact that massive unregulated derivatives activity is not just a problem of thebanks, but a problem in the secretive hedge fund world, the world that spawned Bernie Madoff. Stopbeing a coward, Mr. President.

Derivatives aren't the problem. Many banks in the U.S. that lent money went belly up because theborrowers' defaulted without any losses on derivative positions. In fact, these banks might havebenefited greatly if they had entered into credit default swaps as hedges of their credit risk. Don't think ifCDS are outlawed that companies will stop losing money from being exposed to financial risks. Airlinescan go out of business if jet fuel prices rise. Companies with foreign operations will suffer when theirforeign earnings depreciate as the USD rises. The world is full of risks and companies are constantlytrying to decide which risks the market pays them to take on, and those that they shouldn't. The CreditDefault Swaps are in reality, an elegant and very effective way to reduce credit risk to a counterparty.The irony is that companies are more sensitive to their exposure to credit risk more than ever before, andif anything, the CDS market is the way they can effectively manage it. Otherwise, companies will be

more cautious on any agreement that exposes them to counterparty risk and banks will find it difficult tolend - and both are bad for the economy. Treasury needs to find a way to reduce some of the systemicrisks that are inherent in the market since after all, doesn't the company that enter into the CDS to avoidcredit risk with a supplier also have credit risk to the entity that sold them the hedge?

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THE RECKONINGTaking Hard New Look at a Greenspan Legacy

http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?scp=6&sq=derivatives&st=cse

Not only have individual financial institutions become less vulnerable to shocks from underlying risk

factors, but also the financial system as a whole has become more resilient. Alan Greenspanin2004George Soros, the prominent financier, avoids using the financial contracts known as derivativesbecause we dont really understand how they work. Felix G. Rohatyn, the investment banker whosaved New York from financial catastrophe in the 1970s, described derivatives as potential hydrogen

bombs.

And Warren E. Buffett presciently observed five years ago that derivatives were financial weapons ofmass destruction, carrying dangers that, while now latent, are potentially lethal.One prominent financial figure, however, has long thought otherwise. And his views held the greatestsway in debates about the regulation and use of derivatives exotic contracts that promised to protect

investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than adecade, the formerFederal ReserveChairman Alan Greenspan has fiercely objected wheneverderivatives have come under scrutiny in Congress or on Wall Street. What we have found over theyears in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer riskfrom those who shouldnt be taking it to those who are willing to and are capable of doing so, Mr.Greenspan told the Senate Banking Committee in 2003. We think it would be a mistake to moredeeply regulate the contracts, he added.Today, with the world caught in an economic tempest that Mr. Greenspan recently described as thetype of wrenching financial crisis that comes along only once in a century, his faith in derivativesremains unshaken.The problem is not that the contracts failed, he says. Rather, the people using them got greedy. A lack ofintegrity spawned the crisis, he argued in a speech a week ago atGeorgetown University, intimating thatthose peddling derivatives were not as reliable as the pharmacist who fills the prescription ordered byour physician.But others hold a starkly different view of how global markets unwound, and the role that Mr.Greenspan played in setting up this unrest.Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulationof derivatives, said Frank Partnoy, a law professor at the University of San Diego and an expert onfinancial regulation.The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just twodecades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead

have stoked uncertainty and actually spread risk amid doubts about how companies value them.If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to2006, many economists say, the current crisis might have been averted or muted.Over the years, Mr. Greenspan helped enable an ambitious American experiment in letting market forcesrun free. Now, the nation is confronting the consequences.Derivatives were created to soften or in the argot of Wall Street, hedge investment losses. Forexample, some of the contracts protect debt holders against losses on mortgage securities. (Their namecomes from the fact that their value derives from underlying assets like stocks, bonds andcommodities.) Many individuals own a common derivative: the insurance contract on their homes.On a grander scale, such contracts allow financial services firms and corporations to take more complexrisks that they might otherwise avoid for example, issuing more mortgages or corporate debt. And the

contracts can be traded, further limiting risk but also increasing the number of parties exposed ifproblems occur.Throughout the 1990s, some argued that derivatives had become so vast, intertwined and inscrutable thatthey required federal oversight to protect the financial system. In meetings with federal officials,

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celebrated appearances on Capitol Hill and heavily attended speeches, Mr. Greenspan banked on thegood will of Wall Street to self-regulate as he fended off restrictions.Ever since housing began to collapse, Mr. Greenspans record has been up for revision. Economistsfrom across the ideological spectrum have criticized his decision to let the nations real estate marketcontinue to boom with cheap credit, courtesy of low interest rates, rather than snuffing out priceincreases with higher rates. Others have criticized Mr. Greenspan for not disciplining institutions thatlent indiscriminately.

But whatever history ends up saying about those decisions, Mr. Greenspans legacy may ultimately reston a more deeply embedded and much less scrutinized phenomenon: the spectacular boom andcalamitous bust in derivatives trading.

Faith in the System

Some analysts say it is unfair to blame Mr. Greenspan because the crisis is so sprawling. The notionthat Greenspan could have generated a totally different outcome is nave, said Robert E. Hall, aneconomist at the conservative Hoover Institution, a research group at Stanford.

Mr. Greenspan declined requests for an interview. His spokeswoman referred questions about his recordto his memoir, The Age of Turbulence, in which he outlines his beliefs.

It seems superfluous to constrain trading in some of the newer derivatives and other innovativefinancial contracts of the past decade, Mr. Greenspan writes. The worst have failed; investors nolonger fund them and are not likely to in the future.In his Georgetown speech, he entertained no talk of regulation, describing the financial turmoil as thefailure of Wall Street to behave honorably.In a market system based on trust, reputation has a significant economic value, Mr. Greenspan told theaudience. I am therefore distressed at how far we have let concerns for reputation slip in recent years.As the long-serving chairman of the Fed, the nations most powerful economic policy maker, Mr.Greenspan preached the transcendent, wealth-creating powers of the market.A professed libertarian, he counted among his formative influences the novelistAyn Rand, who

portrayed collective power as an evil force set against the enlightened self-interest of individuals. Inturn, he showed a resolute faith that those participating in financial markets would act responsibly.An examination of more than two decades of Mr. Greenspans record on financial regulation andderivatives in particular reveals the degree to which he tethered the health of the nations economy tothat faith.As the nascent derivatives market took hold in the early 1990s, and in subsequent years, criticsdenounced an absence of rules forcing institutions to disclose their positions and set aside funds as areserve against bad bets.Time and again, Mr. Greenspan a revered figure affectionately nicknamed the Oracle proclaimedthat risks could be handled by the markets themselves.Proposals to bring even minimalist regulation were basically rebuffed by Greenspan and various people

in the Treasury, recalled Alan S. Blinder, a former Federal Reserve board member and an economist atPrinceton University. I think of him as consistently cheerleading on derivatives.Arthur Levitt Jr., a former chairman of the Securities and Exchange Commission, says Mr. Greenspanopposes regulating derivatives because of a fundamental disdain for government.Mr. Levitt said that Mr. Greenspans authority and grasp of global finance consistently persuaded lessfinancially sophisticated lawmakers to follow his lead.I always felt that the titans of our legislature didnt want to reveal their own inability to understandsome of the concepts that Mr. Greenspan was setting forth, Mr. Levitt said. I dont recall anyone eversaying, What do you mean by that, Alan? Still, over a long stretch of time, some did pose questions. In 1992, Edward J. Markey, a Democrat fromMassachusetts who led the House subcommittee on telecommunications and finance, asked what was

then the General Accounting Office to study derivatives risks.Two years later, the office released its report, identifying significant gaps and weaknesses in theregulatory oversight of derivatives.

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The sudden failure or abrupt withdrawal from trading of any of these large U.S. dealers could causeliquidity problems in the markets and could also pose risks to others, including federally insured banksand the financial system as a whole, Charles A. Bowsher, head of the accounting office, said when hetestified before Mr. Markeys committee in 1994. In some cases intervention has and could result in afinancial bailout paid for or guaranteed by taxpayers.In his testimony at the time, Mr. Greenspan was reassuring. Risks in financial markets, includingderivatives markets, are being regulated by private parties, he said.

There is nothing involved in federal regulation per se which makes it superior to market regulation.Mr. Greenspan warned that derivatives could amplify crises because they tied together the fortunes ofmany seemingly independent institutions. The very efficiency that is involved here means that if acrisis were to occur, that that crisis is transmitted at a far faster pace and with some greater virulence,he said. But he called that possibility extremely remote, adding that risk is part of life.Later that year, Mr. Markey introduced a bill requiring greater derivatives regulation. It never passed.

Resistance to Warnings

In 1997, the Commodity Futures Trading Commission, a federal agency that regulates options andfutures trading, began exploring derivatives regulation. The commission, then led by a lawyer namedBrooksley E. Born, invited comments about how best to oversee certain derivatives.

Ms. Born was concerned that unfettered, opaque trading could threaten our regulated markets or,indeed, our economy without any federal agency knowing about it, she said in Congressionaltestimony. She called for greater disclosure of trades and reserves to cushion against losses.Ms. Borns views incited fierce opposition from Mr. Greenspan and Robert E. Rubin, the Treasurysecretary then. Treasury lawyers concluded that merely discussing new rules threatened the derivativesmarket. Mr. Greenspan warned that too many rules would damage Wall Street, prompting traders to taketheir business overseas.Greenspan told Brooksley that she essentially didnt know what she was doing and shed cause afinancial crisis, said Michael Greenberger, who was a senior director at the commission. Brooksleywas this woman who was not playing tennis with these guys and not having lunch with these guys.There was a little bit of the feeling that this woman was not of Wall Street.Ms. Born declined to comment. Mr. Rubin, now a senior executive at the banking giant Citigroup, saysthat he favored regulating derivatives particularly increasing potential loss reserves but that hesaw no way of doing so while he was running the Treasury.All of the forces in the system were arrayed against it, he said. The industry certainly didnt want anyincrease in these requirements. There was no potential for mobilizing public opinion.Mr. Greenberger asserts that the political climate would have been different had Mr. Rubin called forregulation.In early 1998, Mr. Rubins deputy, Lawrence H. Summers, called Ms. Born and chastised her for takingsteps he said would lead to a financial crisis, according to Mr. Greenberger. Mr. Summers said he couldnot recall the conversation but agreed with Mr. Greenspan and Mr. Rubin that Ms. Borns proposal was

highly problematic.On April 21, 1998, senior federal financial regulators convened in a wood-paneled conference room atthe Treasury to discuss Ms. Borns proposal. Mr. Rubin and Mr. Greenspan implored her to reconsider,according to both Mr. Greenberger and Mr. Levitt.Ms. Born pushed ahead. On June 5, 1998, Mr. Greenspan, Mr. Rubin and Mr. Levitt called on Congressto prevent Ms. Born from acting until more senior regulators developed their own recommendations.Mr. Levitt says he now regrets that decision. Mr. Greenspan and Mr. Rubin were joined at the hip onthis, he said. They were certainly very fiercely opposed to this and persuaded me that this would causechaos.Ms. Born soon gained a potent example. In the fall of 1998, the hedge fund Long Term CapitalManagement nearly collapsed, dragged down by disastrous bets on, among other things, derivatives.

More than a dozen banks pooled $3.6 billion for a private rescue to prevent the fund from slipping intobankruptcy and endangering other firms. Despite that event, Congress froze the Commodity FuturesTrading Commissions regulatory authority for six months. The following year, Ms. Born departed.

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In November 1999, senior regulators including Mr. Greenspan and Mr. Rubin recommended thatCongress permanently strip the C.F.T.C. of regulatory authority over derivatives.Mr. Greenspan, according to lawmakers, then used his prestige to make sure Congress followed through.Alan was held in very high regard, said Jim Leach, an Iowa Republican who led the House Bankingand Financial Services Committee at the time. Youve got an area of judgment in which members ofCongress have nonexistent expertise.As the stock market roared forward on the heels of a historic bull market, the dominant view was that

the good times largely stemmed from Mr. Greenspans steady hand at the Fed.You will go down as the greatest chairman in the history of the Federal Reserve Bank, declaredSenatorPhil Gramm, the Texas Republican who was chairman of the Senate Banking Committee whenMr. Greenspan appeared there in February 1999.Mr. Greenspans credentials and confidence reinforced his reputation helping him to persuadeCongress to repeal Depression-era laws that separated commercial and investment banking in order toreduce overall risk in the financial system.He had a way of speaking that made you think he knew exactly what he was talking about at all times,said SenatorTom Harkin, a Democrat from Iowa. He was able to say things in a way that made peoplenot want to question him on anything, like he knew it all. He was the Oracle, and who were you toquestion him?

In 2000, Mr. Harkin asked what might happen if Congress weakened the C.F.T.C.s authority.If you have this exclusion and something unforeseen happens, who does something about it? he askedMr. Greenspan in a hearing. Mr. Greenspan said that Wall Street could be trusted. There is a veryfundamental trade-off of what type of economy you wish to have, he said. You can have hugeamounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either, hesaid. Later that year, at a Congressional hearing on the merger boom, he argued that Wall Street hadtamed risk.Arent you concerned with such a growing concentration of wealth that if one of these huge institutionsfails that it will have a horrendous impact on the national and global economy? asked RepresentativeBernard Sanders, an independent from Vermont.No, Im not, Mr. Greenspan replied. I believe that the general growth in large institutions haveoccurred in the context of an underlying structure of markets in which many of the larger risks aredramatically I should say, fully hedged.The House overwhelmingly passed the bill that kept derivatives clear of C.F.T.C. oversight. SenatorGramm attached a rider limiting the C.F.T.C.s authority to an 11,000-page appropriations bill. TheSenate passed it. President Clinton signed it into law.

Pressing Forward

Still, savvy investors like Mr. Buffett continued to raise alarms about derivatives, as he did in 2003, inhis annual letter to shareholders of his company,Berkshire Hathaway.

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively fewderivatives dealers, he wrote. The troubles of one could quickly infect the others.But business continued.And when Mr. Greenspan began to hear of a housing bubble, he dismissed the threat. Wall Street wasusing derivatives, he said in a 2004 speech, to share risks with other firms.Shared risk has since evolved from a source of comfort into a virus. As the housing crisis grew andmortgages went bad, derivatives actually magnified the downturn.The Wall Street debacle that swallowed firms like Bear StearnsandLehman Brothers, and imperiled theinsurance giant American International Group, has been driven by the fact that they and their customerswere linked to one another by derivatives.In recent months, as the financial crisis has gathered momentum, Mr. Greenspans public appearances

have become less frequent.His memoir was released in the middle of 2007, as the disaster was unfolding, and his book toursuddenly became a referendum on his policies. When the paperback version came out this year, Mr.Greenspan wrote an epilogue that offers a rebuttal of sorts.

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Risk management can never achieve perfection, he wrote. The villains, he wrote, were the bankerswhose self-interest he had once bet upon. They gambled that they could keep adding to their risky

positions and still sell them out before the deluge, he wrote. Most were wrong.No federal intervention was marshaled to try to stop them, but Mr. Greenspan has no regrets.Governments and central banks, he wrote, could not have altered the course of the boom.

May 27, 2009, 3:41 pmBill Clinton, on His Economic Legacy

ByDavid Leonhardthttp://economix.blogs.nytimes.com/2009/05/27/bill-clinton-on-his-economic-legacy/?scp=2&sq=derivatives&st=cseGiven the range of issues Peter Baker covers in his article about Bill Clinton for the coming New YorkTimes Magazine, there was not room for anything close to Mr. Clintons entire comments on hiseconomic record. And theyre fascinating (as is the article). So were going to post, below, the transcriptof that portion of the discussion between Mr. Clinton and Mr. Baker.In several places, I have annotated it, in italics. Id be interested in hearing the thoughts of readers and

other bloggers, too. (Update:Noam Scheiber,Mark Thoma and Matthew Yglesias weigh in.)NEW YORK TIMES: Speaking of banks and toxic assets, you know theres been this debate among alot of people about trying to figure out where did we get to this point, how did we get to this point. Youknow that Time magazine named you and said you should have done this, that or the other thing. Whatdo you say to that? Is there anything you would have done differently?Mr. CLINTON: Yes. Well, I dont know if I would have done anything different. First, I always ask. Ido not believe this would have happened in this way if I had been in office or if Al Gore had beenelected. I just dont. I think we would have caught the housing bubble and taken steps to stem it before itgot out of hand. And I know that having Arthur Levitt at the Securities and Exchange Commissionwould have made a huge difference.

ECONOMIX: This is a reasonable argument. But is there tangible evidence in its favor? Were thereinstances in which Mr. Levitt or other Clinton advisers, like Timothy Geithner, Robert Rubin, Gene

Sperling, Lawrence Summers and Laura Tyson put a stop to financial excesses in the 1990s? This

would add weight to the notion that they would have pricked the housing bubble in the current decadeand put a halt to the Wall Street excesses that depended on that bubble. There is a real counter-

argument that a Clinton or Gore administration might not have.Alan Greenspan would still have been at the Federal Reserve and, in all likelihood, still been influential

with the White House. Mr. Geithner, at the New York Fed during the Bush administration, did not stop

the buildup in Wall Street leverage that has turned out to be so damaging. Mr. Summers issuedwarnings about the financial crisis before many others, but he did not issue them, at least not very

loudly, in 2005, 2006 oreven into 2007.

Mr. CLINTON: Now, there basically have been three charges, if you will, laid at our doorstep, becauseeverybody recognizes that I vetoed the securities reform bill and that we had a very different economicphilosophy. But they the three charges are one, because I enforced the Community Reinvestment Actfor the first time and over 90 percent of all lending done under that law was done when I was president,$300 billion, that part of that was a lot of little banks made loans to people they had no business makingloans to to buy houses so they could check the box for the Community Reinvestment Act. Thats theright-wing argument.Then theres the argument from the left that I shouldnt have signed the bill that got rid of the Glass-Steagall law because that enabled banks and investment banks in effect to merge their functions.And then theres the argument that I make, which is that I should have raised more hell about derivatives

being unregulated. I believe the last one is by far the most valid

ECONOMIX: This seems impressively honest. Former presidents dont often engage in such self-criticism.Mr. CLINTON: although I dont think that the Congress would have permitted anything to be done

because Alan Greenspan was against it.

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So lets take them in reverse order. The argument against regulating derivatives, which Greenspan urged and this is one of the few things I think I think Bob Rubin and Larry Summers and those guyshave gotten a little bit of a bum rap on this lately, you know, something goes wrong and the whole last30 years were the same. Thats just not true.The economic consequences of what happened in our eight years were dramatically different than whathappened in the 12 years before or the eight years after. And the policies were different, including

policies for the poor, policies for working people. The economic policies were completely different. Its

just if youre against all trade, youre just all in. If you think the Democratic Party should have becomean anti-trade party, then you can say that. But otherwise, I think its just not accurate including the factthat we consistently argued for putting labor and environmental standards in the trade agreements andactually made real progress on that in the last few years I was in office and the Republicans undid it. SoI dont buy that.But I do believe on the derivatives they made the argument, the people who were against regulating it,that people like you werent buying derivatives. It wasnt like you were investing your 401(k) inderivatives. You were investing your 401(k) in mutual funds, which were subject at least under normaltimes to the jurisdiction of the S.E.C., which was supposed to be minding the store. And so because wehad a hostile Republican Congress which threatened not to fund I dont know if you remember this

but we had a huge knock-down fight when they threatened not to fund the S.E.C. because of what

Arthur Levitt was doing to try to protect the American economy from meltdowns. They said, Oh, hesinterfering with a free market and all that. This is what hes supposed to do.They argued that nobodys going to buy these derivatives, well do it without transparency, theyll getthe information they need. And it turned out to be just wrong; it just wasnt true. And once you got thatmassive amount of money invested in derivatives that people thought its like these credit defaultswaps, where people thought, the Lehman people talk about it, they thought, or the A.I.G. people, theythought it was 100 percent safe investment, they thought there would never be defaults on thesemortgage securities. So of course you wanted insurance there because you got the insurance premium,you make the profit and you couldnt possibly lose money, right? Well, it turned out to be all wrong.That rested on a lot of assumptions, including the fact that the ratings agencies would do a good job,which didnt happen, in evaluating risk. So I very much wish now that I had demanded that we putderivatives under the jurisdiction of the Securities and Exchange Commission and that transparencyrules had been observed and that we had done that. That I think is a legitimate criticism of what wedidnt do.On the Glass-Steagall, Ive really thought about that because No. 1, nonbank banking was already amajor part of American life at that time. Letting banks take investment positions I dont think had muchto do with this meltdown. And the more diversified institutions in general were better able to handlewhat happened.

ECONOMIX: President Obama has made a similar point. Perhaps the strongest piece of evidence in itsfavor is that the first institutions to collapse, like Lehman Brothers and Bear Stearns, had not combined

standard banking and investment banking. Some firms that did combine the two, especially J.P. Morgan

Chase, have weathered the crisis considerably better.Mr. CLINTON: And again, if I had known that the S.E.C. would have taken a rain check, would I havedone it? Probably not, but I wouldnt have done anything. In other words, I would have tried to reverseeverything if I had known we were going to have eight years where we wouldnt have an S.E.C. formost of the time. But I believe if you look at the blurring of the lines which already existed before that

bill was signed the bill arguably gave us a framework, at least, for which this process, which washappening anyway, could be regulated. So I dont think thats such a good criticism.I think actually, if you want to make a criticism on that, it would be an indirect one; you could say thatthe signing of that legislation sped up what was happening anyway and maybe led some of theseinstitutions to be bigger than they otherwise would have been and the very bigness of some of thesegroups caused some of this problem because the bigger something is and the newer it is the harder it is

to manage. And I do think there were some serious management problems which might not haveoccurred. Not all of these people were lazy or flagrant or blindly greedy. You know, some of this stuff, Ithink, was just people were trying to manage more than they could manage. That has a little leveragewith me but on the merits I dont think so.

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And the first argument, I think its totally without merit. If you look at the community banks in thiscountry actually I never believed Id cite her as an authority, but Arianna Huffington had a great

piece on the success of community banks yesterday in the Huffington Post. You ought to get it NEW YORK TIMES: Do you read the Huffington Post?Mr. CLINTON: A lot. I read a lot of the blogs. I try to keep up with what theyre saying. But the point isall she did was report that most of these community banks were in good shape, theyre loaning money. Italked to a friend of mine from Laredo the other day and he said as far as he knew there was no bank in

from San Antonio south of Texas that was in trouble unless it was a national affiliate of something, thatif they were community banks and loaning money to their depositors, they were going great. So thats

just a totally off the wall, crazy argument. It just doesnt have any merit. The banks that took care of thepeople even if they gave some of those faulty loans, even if they gave a few subprimes, they are notin trouble. They were not part of the problem here.The community reinvestment requirement is a good one. Its one of the reasons that we had the broad-

based economic growth we had and one of the reasons we were able to lift incomes and wealth levels forpeople who otherwise would have been left out of what happened in the 1990s because banks had toloan a certain percentage of their money back to their depositors in the community. Thats my take on it.The Time magazine thing, I thought, if you actually read what they said, they kind of hedged. They saidWell, here are some of the things people say. But if you ask me to write the indictment, Id say, I

wish Bill Clinton had said more about derivatives. The Republicans probably would have stopped himfrom doing it but at least he should have sounded the alarm bell.Because it was irrelevant that only one-tenth of one percent of the American people could ever invest inderivatives and a small percentage of people around the world. Because once you had that much volume,if they all failed anyway, they would impact everybody else.

NEW YORK TIMES: Who told you that? In other words, when you were thinking about this in the 90s,who were you listening to?Mr. CLINTON: Oh, I talked to a lot of people. I talked to actually Greenspan about this once. I said howcan we have all this money you remember we had one institution failed that the New York Fed had to

bail out. It had some derivative investments and it went down. Do you remember that?NEW YORK TIMES: I dont.Mr. CLINTON: What was the name of that? There was a bank that failed that the New York Fed bailedout an institution that had some derivative exposure? And so I talked with them.

NEW YORK TIMES: In 98-ish?Mr. CLINTON: Yeah. But you got to understand, again, we were living in a different world. We had alot of confidence in the S.E.C. We had a lot of confidence in the broad-based nature of our economicgrowth. We never dreamed thered be a time like in the first five years of this decade where literally thewhole growth of the country would be in the housing, finance and consumer spending because we hadno other investment strategy.

ECONOMIX: This is a bit of an oversimplification. Its true that economic growth in the 1990s was far

more broadly based and significantly faster than growth during George W. Bushs presidency. Mr.

Clintons policies deserve some credit for the 1990s growth. But so does an enormous stock-marketbubble. The popping of the bubble, starting in 2000, led to the recession of 2001. It was an accident of

history that Mr. Clinton left office before that recession began. The fact that the Clinton administrationdid nothing to stop the 1990s stock bubble is the main reason to be skeptical it would have done much to

stop the housing bubble.Mr. CLINTON: I think, you know, maybe you could say, well, you should have anticipated Al Gorewould lose the election and thered be nobody home at the S.E.C. I made the best call I could. But I dowish I always felt a little queasy about the derivative issue. Otherwise, I think we did a good job andI do not believe when anybody asks me that, I ask them, I look at them and ask them, Do you thinkthis would have happened if we had been there? Look me in the face and say yes. I havent found anytakers yet.

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http://www.nytimes.com/2009/05/14/business/14regs.html

White House Pushes Broad Rules for Derivatives

May 13, 2009, 3:08 pm

http://dealbook.blogs.nytimes.com/2009/05/13/white-house-to-offer-plan-to-regulate-derivatives/?

scp=5&sq=derivatives&st=cse

Update | 8:22 p.m. In its first detailed effort to overhaul financial regulation, the Obama administrationon Wednesday sought new authority over the complex financial instruments, known as derivatives, thatwere a major cause of the financial crisis and have gone largely unregulated for decades.The administration asked Congress to move quickly on legislation that would allow federal oversight ofmany kinds of exotic instruments, including credit default swaps, the insurance contracts that caused thenear-collapse of the American International Group, The New York Timess Stephen Labaton andJackie Calmes report.The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types ofderivatives to be traded on exchanges and backed by capital reserves, much like the capital cushions that

banks must set aside in case a borrower defaults on a loan.Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to

participate in the derivatives markets.The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them.This financial crisis was caused in large part by significant gaps in the oversight of the markets, Mr.Geithner said in a briefing. He said the proposal was intended to make the trading of derivatives moretransparent and give regulators the ability to limit the amount of derivatives that any company can sell,or that any institution can hold.The initiative was well received by senior Democrats in Congress with jurisdiction over the issue. The

proposal had been expected, but some lawmakers, impatient with the pace of the new administrationsefforts, had begun moving ahead themselves.Hinting at a lobbying campaign to come, Robert Pickel, the chief executive of the International Swapsand Derivatives Association, a trade group, said his organization looked forward to working with

policy makers to ensure these reforms help preserve the widespread availability of swaps and otherimportant risk management tools.But some in the financial industry say that regulation is inevitable. Nobody is in a just say no mode,said Steve Elmendorf, a former House Democratic leadership aide who represents several majorfinancial institutions and groups. Everybody understands that weve been through a financial crisis andthat change has to happen. And the only question is how the change happens.The administration is seeking the repeal of major portions of the Commodity Futures Modernization

Act, a law adopted in December 2000 that made sure that derivative instruments would remain largelyunregulated.The law came about after heavy lobbying from Wall Street and the financial industry, and was pushedhard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary,Lawrence H. Summers, who is now President Obamas top economic adviser.At the time, the derivatives market was relatively small. But it soon exploded, and the face value of allderivatives contracts a measure that counts the value of a derivatives underlying assets outstanding at the end of last year totaled more than $680 trillion, according to the Bank forInternational Settlements in Switzerland.The market for credit default swaps a form of insurance that protects debtholders against default stood around $38 trillion, according to the international swaps group. That represents the total amount of

insurance that has been written on various kinds of debt, but the amount that would have to be paid outif the debt went into default is considerably less.As the credit crisis has unfolded, trading in credit default swaps has cooled, market participants said.The collapse of A.I.G. took a huge player out of the market and banks, hobbled by loan losses, have

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curbed their activities in the market. Still, derivatives trading desks have been one of the few profitcenters at major banks recently.The biggest banks like JPMorgan Chase, Citigroup and Goldman Sachs, as well as big insurers, areall major players in derivatives.Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, eventhough they are one of Wall Streets biggest profit engines. They dont trade openly on public exchangesand financial services firms disclose few details about them. The new rules are meant to change most,

but not all, of that opacity.Used properly, they can reduce or transfer risk, limit the damage from market uncertainty, and makeglobal trade easier. Airlines, food companies, insurers, exporters and many other companies usederivatives to protect themselves from sudden and unpredictable changes in financial markets likeinterest rate or currency movements. Used poorly, derivatives can backfire and spread risk rather thancontain it.The administration plan would not require that custom-made derivative instruments those withunique characteristics negotiated between companies be traded on exchanges or throughclearinghouses, though standardized ones would. If approved, the plan would require the development oftimely reports of trades, similar to the system now used for corporate bonds.The letter suggested that the Commodity Futures Trading Commission would play a leading role in the

oversight of the market, although it would also leave important elements to the Securities and ExchangeCommission. Over the years, the turf battle between those agencies contributed to the neglect of thatmarket by government overseers.Some lawmakers in the House and Senate have already introduced measures to regulate derivatives. Buta number of members have pressed the administration to put out its own plan.Representative Barney Frank of Massachusetts, the chairman of the House Financial ServicesCommittee that oversees the S.E.C., and Representative Collin C. Peterson of Minnesota, chairman ofthe House Agriculture Committee with oversight of the C.F.T.C., on Wednesday released a jointstatement saying, we agree there must be strong, comprehensive and consistent regulation ofderivatives. We will work closely together to achieve that goal, they added.While derivatives regulation will be a focus of some market players, of equal concern to many in thefinancial industry are what the Obama administration and Congress might do to regulate compensationfor executives across the board, not just at institutions that have accepted federal bailout money.The Treasury is acting on two paths. First, it plans as soon as next week to announce revisedcompensation rules for companies getting assistance, to make those rules conform with a law Congress

passed in February that was more stringent than the Treasurys own earlier guidelines.Separately, Treasury officials have just begun discussing with the Federal Reserve and the S.E.C. whatthe government can do industrywide through incentives, restrictions or a mix of the two for corporate

boards to guard against eye-popping compensation that rewards excessive risk-taking of the sort thatcontributed to the current crisis.The fear among many in the industry and some in the administration is that whatever limits Mr.

Obama proposes, Congress will seek to add even more, in response to widespread public anger at WallStreet.In addition to the regulatory changes it is seeking, the administration is also continuing to expand its

bailout programs for various industries. Mr. Geithner announced on Wednesday that the administrationwould provide a new round of capital assistance to smaller community banks, and would increase theamount that they can borrow from the program.Beyond derivatives, he also said that the administration would be presenting a comprehensive proposalto overhaul the regulation of the financial system. He provided few specifics, but said a central goalwould be to eliminate the ability of companies to pick the least onerous regulator.We need a much simpler financial oversight structure, he said. Its not going to be comfortable foreverybody but its important to do.

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http://www.treasury.gov/press/releases/tg129.htm

May 13, 2009Regulatory Reform Over-The-Counter (OTC) Derivatives

The crisis of the past 20 months has exposed critical gaps and weaknesses in our financial regulatorysystem. As risks built up, internal risk management systems, rating agencies and regulators simply did

not understand or address critical behaviors until they had already resulted in catastrophic losses. Thosefailures have caused a dramatic loss of confidence in our financial institutions and have contributed to asevere recession.Last March, Secretary Geithner laid out new regulatory rules of the road to ensure we never face acrisis of this magnitude again. An essential element of reform is the establishment of a comprehensiveregulatory framework for over-the-counter derivatives, which under current law are largely excluded orexempted from regulation.

As the AIG situation has made clear, massive risks in derivatives markets have gone undetected by bothregulators and market participants. But even if those risks had been better known, regulators lacked the

proper authorities to mount an effective policy response.

Today, to address these concerns, the Obama Administration proposes a comprehensive regulatoryframework for all Over-The-Counter derivatives.Moving forward, the Administration will work with Congress to implement this framework and bringgreater transparency and needed regulation to these markets. The Administration will also continueworking with foreign authorities to promote the implementation of similar measures around the world toensure our objectives are not undermined by weaker standards abroad.Objectives of Regulatory Reform of OTC Derivatives Markets

Preventing Activities Within The OTC Markets From Posing Risk To The Financial System

Regulators must have the following authority to ensure that participants do not engage inpractices that put the financial system at risk:

The Commodity Exchange Act (CEA) and the securities laws should be amended to require

clearing of all standardized OTC derivatives through regulated central counterparties (CCP):o CCPs must impose robust margin requirements and other necessary risk controls and

ensure that customized OTC derivatives are not used solely as a means to avoid using aCCP.

o For example, if an OTC derivative is accepted for clearing by one or more fully regulated

CCPs, it should create a presumption that it is a standardized contract and thus required tobe cleared.

All OTC derivatives dealers and all other firms who create large exposures to counterpartiesshould be subject to a robust regime of prudential supervision and regulation, which will include:

Conservative capital requirements

Business conduct standards Reporting requirements Initial margin requirements with respect to bilateral credit exposures on both

standardized and customized contracts Promoting Efficiency And Transparency Within The OTC Markets -- To ensure regulators

would have comprehensive and timely information about the positions of each and everyparticipant in all OTC derivatives markets, this new framework includes:

Amending the CEA and securities laws to authorize the CFTC and the SEC to impose:

Recordkeeping and reporting requirements (including audit trails). Requirements for all trades not cleared by CCPs to be reported to a regulated

trade repository. CCPs and trade repositories must make aggregate data on open positions

and trading volumes available to the public.

CCPs and trade repositories must make data on individual counterparty'strades and positions available to federal regulators.

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The movement of standardized trades onto regulated exchanges and regulatedtransparent electronic trade execution systems.

The development of a system for the timely reporting of trades and promptdissemination of prices and other trade information.

The encouragement of regulated institutions to make greater use of regulatedexchange-traded derivatives.

Preventing Market Manipulation, Fraud, And Other Market Abuses The Commodity

Exchange Act (CEA) and securities laws should be amended to ensure that the CFTC and theSEC have:

o Clear and unimpeded authority for market regulators to police fraud, market

manipulation, and other market abuses.o Authority to set position limits on OTC derivatives that perform or affect a significant

price discovery function with respect to futures markets.o A complete picture of market information from CCPs, trade repositories, and market

participants to provide to market regulators. Ensuring That OTC Derivatives Are Not Marketed Inappropriately To Unsophisticated

Parties Current law seeks to protect unsophisticated parties from entering into inappropriatederivatives transactions by limiting the types of counterparties that could participate in thosemarkets. But the limits are not sufficiently stringent.

The CFTC and SEC are reviewing the participation limits in current law to recommend how theCEA and the securities laws should be amended to tighten the limits or to impose additionaldisclosure requirements or standards of care with respect to the marketing of derivatives to lesssophisticated counterparties such as small municipalities.

Regulators should be neither bubble poppers nor blowers

http://www.theaustralian.news.com.au/business/story/0,,25552776-31478,00.html

Alan Wood | May 29, 2009Article from:A COMMON view of the global financial crisis is that it is the outcome of the bursting of a huge

asset price bubble or bubbles.

The process is a complex story involving failures of market regulation, a remarkable expansion ofinvestors' and households appetite for risk and leverage, an ultimately destructive explosion in financialinnovation and a related failure of financial institutions to appreciate the extent of their exposure to risk,loose monetary policy and serious global financial imbalances leading to a global savings glut.But was it a bubble? Not according to the efficient markets hypothesis, the academic paradigm that hasruled in the era of increasingly deregulated financial markets. This maintains that asset prices reflect thecollective information and wisdom of traders in asset markets, where arbitrage quickly eliminates price

anomalies, speculation is stabilising and diversification and financial innovation greatly reduce risk.These markets are also self-correcting in the face of shocks. And as a former deputy governor of theReserve Bank of Australia, Stephen Grenville, remarked in a caustic attack on efficient market theory,efficient markets have no need for constraining rules or intrusive supervision. There was also a beliefthat self-interest would ensure banks and other financial institutions would protect the interests of theirshareholders.Another central banker, president of the Federal Reserve Bank of San Francisco, Janet Yellen, said in aspeech last month: "It seems to me that this argument is particularly difficult to defend in light of the

poor decisions and widespread dysfunction we have seen in many markets during the current (financial)turmoil".But the most spectacular retraction came from the best-known central banker of them all, Alan

Greenspan, who told a US congressional committee in October last year that the financial crisis had lefthim in a state of shocked disbelief. "This modern risk-management paradigm held sway for decades,"Greenspan said. "The whole intellectual edifice, however, collapsed in the summer of last year."

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Where does this lead? Well, not to the conclusion many on the Left have reached: much greatergovernment intervention in markets via extensive regulation. US economist Nouriel Roubini, whosereputation has been considerably enhanced by his perceptive analysis of the financial crisis, recentlysummed up his view this way: "I believe in market economics ... But I also believe that marketeconomies sometimes have market failures, and when these occur, there's a role for prudential, notexcessive, regulation of the financial system."The need for improved regulation is widely accepted. Controversy has arisen over the issue of whether

there is a need for central banks to act not only against inflation but also excessive rises in asset prices.Central bankers in the US and in Australia are increasingly asking themselves this question.In Australia, the most comprehensive case against such intervention has been put in a policy monographfor the Centre for Independent Studies by economist Stephen Kirchner, Bubble Poppers: MonetaryPolicy and the Myth of 'Bubbles' in Asset Prices.It is impossible to do justice to Kirchner's detailed arguments here, but a flavour of them is in the term

bubble poppers. It comes from US Federal Reserve chairman Ben Bernanke, an authority on theDepression.Bernanke concluded the cause of the Depression was not the one popularly believed, that the stockmarket became overvalued, crashed and caused the depression. Instead Bernanke found that monetary

policy tried to overzealously stop the rise in stock prices, which the Fed regarded as caused by a

speculative bubble. The Fed fell under the control of "a coterie of bubble poppers".The message is that the Depression is a powerful lesson in the dangers of central bankers concludingthat markets are in a bubble and intervening to pop it.In a speech two weeks ago an assistant governor of the RBA, Guy Debelle, argued that the costs interms of economic growth and unemployment of intervening to pop an asset bubble were too high.Instead central banks should stick to targeting inflation and look to other means, namely prudentialregulation, to address asset prices. This was a personal view, not the RBA's.Much of this debate casts the issue in too narrow a context and the argument about whether or not

bubbles exist is a distraction. Nobody denies asset price booms and busts exist, nor that some of theseepisodes, notably the current one, have been associated with financial crises and recessions.Central bankers have always taken asset prices into account in setting monetary policy and in Australia'scase successfully intervened in the housing market via both interest rates and jawboning by thengovernor Ian Macfarlane and head of Australian Prudential Regulation Authority, John Laker, a formerReserve banker, to cool off reckless lending and overheating in housing prices.Kirchner dismisses this episode as unsuccessful, and the Howard government certainly didn't like it. Butthe ratio of house prices to income fell markedly after 2003, when the RBA raised rates by 0.5

percentage points in two back-to-back hits. And Australia has so far not suffered anything like thehousing price collapses in the US and Britain.The debate is not about intervening in every asset price episode, but in those rare cases that havecharacteristics such as rapid credit growth, a rapidly rising leverage, very low margins for risk and,frequently, falling inflation because they have been triggered by supply side productivity-boosting

innovations. Such episodes, whether or not we call them bubbles, led to severe economic dislocations.The idea isn't to set targets for asset prices in the way central banks now have inflation targets, but to runmonetary policy in a way that avoids excessive credit creation and leverage, doesn't allow officialinterest rates to diverge significantly from a neutral level for extended periods and avoids mistakes likeexcessively lowering interest rates because inflation is low.There is also general agreement on the need for much better quality macro and micro prudentialregulation and other reforms of the sort now being discussed in the Group of 20, the InternationalFinancial Stability Board and other forums.As the Depression illustrates, we don't want a coterie of bubble poppers running central banks, but nordo we want central bankers captured by mistaken views on the wonders of unfettered financial markets.

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Comments:

Macro managing asset markets, easily said than don Now it is high time to have a debate on a macroapproach to asset prices, in the context of the great recession following the financial crisis that had itsdirect root of the bursting in the bubbles of asset markets, including housing and equity markets. Thecurrent recession has been characterised by some as balance sheet recession. Balance sheet, no matter itis for banks, firms, or households, is affected by asset market conditions and asset prices. Although thecurrent recession is a highly synchronised one, there have been these types of so called balance sheet

recessions before, such as Japan in the 1990s. In macroeconomics, there are goods, money, labourmarkets, but no other markets explicitly, such as housing and equity markets. The three markets in themacroeconomic framework jointly determine interest rate, output/employment, aggregate price(inflation). Without a workable macro framework which includes important asset markets, it will beextremely difficult to see what macro policies should be used and how they will work in dealing withany perceived or real problems in those markets. The current debate should and will prompt economiststo come up with some workable macroeconomic frameworks that can guide policy makers in managingthe economy more effectively than they have been. The great recession has presented economists with avery practical and urgent task in their research. They need to meet the challenges of our time.

It's interesting this topic has recived more airplay - particularly as the horse bolted some time ago andRBA member now resort to jawboning in most of their 2009 speeches. Australia has been no differentthan other western nations in that massive excess credit creation has set the scene for a massive bust. Ifthe central bank took more action in 1999 when consumer debt to GDP exceeded 100%, or when M3exceeded 10% yoy in 2001, we, and our banks, would not be in the potentail calamity we face. (To befair on the RBA, government policy and lax bank lending standards played it's role in bubble inflation aswell). Questions? If our banks were such pillars of soundness, why has the govt stepped in with theguarantee, why has the govt. gone with such measures to prop up house prices?, and why has the RBAgone so big with repos from the big banks???? Could it be because foreign investors - half of bankfunding - were going to pull the pin?? Our residential housing bubble, and by extension the big bank

balance sheets, has grown too big too fail - evidenced by Rudd price propping grant and expectedincentives for investors comign in the Henry tax tinker, sorry, review.

Central bankers are responsable for the low interest rates that fueled the political move that allowedpeople who could not afford to pay off a mortage to buy homes . to say that banks should be moredissmissive of intervention is one thing but to my mind they were forced to act according to politicalymanufactured errors of judgement, the bill clinton initiated mortage problems and then the bush lowinterest rates that helped fuel the first error, certainly banks are NOT the innocent party here, and amongthemselves they created another money cow from the same crises,the other issue on allowing marketcorrections to fully correct on their on terms rather than central bank intervention, can you imagine the

outcry of business when they realized they were were not going to get assistence-read welfare- fromgovt and or banks.now that I would love to see, rod qld

You should have mentioned, as did Debelle, the concept of "macro-prudential stabilisers". The conceptcan be understood better in prudential regulation based on Basel I, with a simple capital adequacy ratio

based on risk-weighting of certain asset classes and amount of capital required to fundthe portfolio. Insuch a system the risk assessment of an asset class could be increased automatically if the prices of theassets are increasing "too quickly" (as assessed against the overall price level). This becomes more

problematic in a Basel II type world, where ultimately the "risk" of assets was determined by ratingsagencies. One of the many problems we've encountered was the way ratings agencies dealt with

increasing house prices - they assumed this made lending more secure as a potential defaulter woul havean asset worth more than the original purchase. This, of course, is a great theory so long as the price pathcontinues. However, it works disasterously when, as it did with sub-prime mortgages, it feeds themachine that offers increasingly risky loans. Apart from building rules into risk assessment that should

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discount the value of assets undergoing excessive aset-specific inflation, another very simple policyinstrument is consumer credit laws as apply in Australia. In Australia a lender canot make a loan merelyon the basis that the loan is "secure", the lender also needs to be satisfied that the borrower canadequately service the loan (and not by refinancing, which was the other under-pinning assumption withsome sub-prime loans). Monetary policy is definitely not a good mechanism for popping bubbles - as

bubbles are by definition increases in the price of one asset class out of sink with the price level ingeneral. Monetary policy can only work on the overall price level. That does not mean that we don't

need to take regulatory action globally to ensure improvement in risk assessment of assets undergoingexcessive price growth, and some "duty of care" legislation on lenders. Finally, the other lesson welearnt in the process is that the assumption that corporate finance markets need less direct supervisionthan consumer markets on the assumption that the lenders and borrowers are better able to "protect andinform" themselves is complete and utter nonsense.

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Economists Stuck in 1930s Need a Decade Update: Caroline Baum

Commentary by Caroline BaumMay 20 (Bloomberg) -- Depression avoided. Another recession to follow? That seems to be a concernfor some academics, including Princeton economist Alan Blinder.Writing in the Sunday New York Times, Blinder says a combination of expansionary monetary andfiscal policies prevented 2009 from turning into 1930.Mission accomplished it isnt. Premature withdrawal of the stimulus could turn 2010 into 1936, when aseries of missteps -- the Federal Reserve raised reserve requirements while FDR balanced the federal

budget -- sent the recovering economy down for Part II, according to Blinder.To avoid a replay of the policy disasters of 1936-1937, both the Fed and our elected officials must staythe course, he writes.

While the current recession is the worst in the last 50 years, the issues facing policy makers are thesame: How do they know when enough is enough?Policy makers arent exactly sequestered. They have lots of information, both quantitative (economicdata) and qualitative (surveys of businesses and consumers), at their fingertips to help them decide whenthe time is right to wean the patient from life support. They have econometric models, whose flaws aregenerally exposed after the fact. And they have (hopefully) the experience, wisdom, good judgment andfortitude to do what may be politically unpopular in the short run but vital in the long run for the healthof the economy.

Leaders Lead

Lets start with monetary policy and see what the seven men and women in Washington and 12 acrossthe country could use as a guide. Business cycle economists are forever testing indicators to see what

leads, whats concurrent with and what lags the economys ebb and flow. (Ive never understood thevalue of the laggards.) The Conference Board maintains an Index of Leading Economic Indicators,which peaked in March 2006, moved sideways for more than a year and came within 0.1 point of the

peak in July 2007 before heading down.

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The LEI is widely ignored in the best of times and dismissed when it doesnt agree with the forecast.The 10 components, most of which are known by the time the index is released, get the same treatment.The April LEI, due tomorrow, is expected to show a 0.8 percent increase, according to the averageforecast of 56 economists surveyed by Bloomberg News. That would be the first increase since June,with stock prices, the spread between the federal funds rate and 10-year Treasury note yield, andconsumer expectations contributing to the expected increase.

Sensitive Nomenclature

One month does not make a trend. Nor does it reverse the gloomy message reflected in the six-monthannualized change in the LEI and the six-month diffusion index, measures preferred by ConferenceBoard economists to the monthly change. Then theres the possibility historical revisions will change theleaders outlook: Januarys 0.4 percent initial increase became a 0.2 percent decline with subsequentrevisions.For the moment, the financial, or intangible, indicators -- the interest-rate spread, the stock market andreal M2, which probably didnt show an April increase but has soared since September -- are showinghopeful signs. And they typically lead more concrete measures, such as jobless claims, building permitsand orders for capital goods. Raw materials prices are sending a similar message. The CRB Spot RawIndustrial Price Index, which excludes oil, bottomed in December and went nowhere for three months

before heading higher. Theres a reason theyre called sensitive materials prices: They respond to

slight changes in demand. Manufacturers can step up their purchases of copper and steel scrap fasterthan raw materials suppliers can increase output. Prices rise as a result.Touchy Feely Rejection

Intangibles and price signals arent enough for the Fed, which is why monetary policy tends to overstayits welcome. Blinder can rest easy on that score.When it comes to the possibility of fiscal restraint, the only possible reason to worry is the Obamaadministrations expressed desire to tax the rich and unexpressed need to tax everyone else to pay for the

proposed spending.Congress enacted a $787 billion fiscal stimulus bill in February (only 11 percent has been spent so far)and a $3.55 trillion budget last month. The projected deficit for the current fiscal year is $1.84 trillionand $1.26 trillion for fiscal 2010.And thats before the dream of universal health care is realized. The idea that Congress can revamp one-sixth of the U.S. economy before the August recess is either folly or hubris. Either way, its frightening.

Decade Identification

President Barack Obamahas said current deficits are unsustainable, but that will be for foreigners todecide and us to find out. At some point, they will demand higher returns on their dollars or return theirdollars. That would be a sure sign the government waited too long to tighten fiscal policy.If that coincides with monetary policy that has overstayed its welcome, fanning inflation expectationsand actual inflation down the road, it might not be long before Blinder starts worrying about a replay ofthe 1970s, not the 1930s.(Caroline Baum, author of Just What I Said, is a Bloomberg News columnist. The opinions expressed

are her own.) Last Updated: May 20, 2009 00:01 EDT

http://www.bloomberg.com/apps/news?pid=20601039&sid=ae5Y7Lc6IrTw#

Curve Watching Beats Room Full of Forecasters: Caroline Baum

Commentary by Caroline BaumMay 12 (Bloomberg) -- Like clockwork, the alarm bells are going off as long-term Treasury yields starttheir inevitable climb.Rising Government Bond Yields Frustrate Central Banks, trumpets yesterdays Wall Street Journal.

Rising bond yields present fresh Fed challenge, according to the April 29 edition of the FinancialTimes.

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http://search.bloomberg.com/search?q=Barack+Obama&site=wnews&client=wnews&proxystylesheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1http://search.bloomberg.com/search?q=Barack+Obama&site=wnews&client=wnews&proxystylesheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1http://search.bloomberg.com/search?q=Caroline+Baum&site=wnews&client=wnews&proxystylesheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1http://www.bloomberg.com/apps/news?pid=20601039&sid=ae5Y7Lc6IrTw#http://search.bloomberg.com/search?q=Barack+Obama&site=wnews&client=wnews&proxystylesheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1http://search.bloomberg.com/search?q=Caroline+Baum&site=wnews&client=wnews&proxystylesheet=wnews&output=xml_no_dtd&ie=UTF-8&oe=UTF-8&filter=p&getfields=wnnis&sort=date:D:S:d1http://www.bloomberg.com/apps/news?pid=20601039&sid=ae5Y7Lc6IrTw#


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Its a funny thing about long-term interest rates. Theyre pro-cyclical. They tend to rise when theeconomy is doing well, when demand for credit is strong. They fall when the economy is in the tank,and the private sector isnt much interested in investing and spending.If theres a way to accommodate the increased demand for credit that goes hand in hand with recoverywithout pushing up the price, no one has figured it out just yet.For a time, the federal governments increased borrowing needs, both current and expected, were beingmet by more-than- willing lenders. The flight-to-quality into Treasuries drove yields to historic lows,

with the benchmark10-year note bottoming at 2.04 percent in December.Last Friday, the 10-year yield touched 3.38 percent as a proliferation of green shoots calmed investorfears of an endless dark winter. Thats not good news for the Treasury, which has to pay interest on therapidly expanding debt. For the F

derivatives regulation

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