" In practice, however, swaps and derivatives are often used for less lofty purposes. "

Via Yves Smith, I came upon this post by Rick Bookstaber:

"I was recently asked to testify in a Senate hearing "to explore the role of financial derivatives in the current financial crisis, the current system for regulating them and recommendations for modifying the regulatory system".

This hearing was by the Committee on Agriculture, Nutrition, and Forestry, chaired by Senator Harkin of Iowa. That might seem like an unusual place to deal with the regulation of esoteric financial products, but this committee has oversight for the CFTC, because the first futures contracts were agricultural, and the CFTC has oversight on swaps and derivatives, because they have characteristics similar to futures.

I was not able to accept the invitation to testify at the hearing, but it was still worth it, because in his letter, Senator Harkin explained that "You were strongly recommended for your knowledge and insights on this subject by Warren Buffett in a conversation I had with him yesterday". That alone makes the letter worth framing. But although I could not testify, I exercised my first-amendment right to send along off-the-record comments (you can do it too). I will give excerpts from these comments here:"

The CFTC actually makes sense.

"In academic theory, derivatives and swaps are intended to help "span the state space"; that is, they are intended to allow investors to efficiently hedge their specific risks, to more precisely meet contingencies of the market, and to mold their returns to meet investment objectives."

Derivatives are used for:
1) Hedging risks
2) Plan for market fluctuations
3) For specific purposes in aiding other investments

Pretty generic and sensible, I'd say.

"In practice, however, swaps and derivatives are often used for less lofty purposes. They are used to: avoid taxes (for example, total return swaps are used to take positions in UK stocks in order to avoid transactions-based taxes); take exposures that are not permitted in a particular investment charter (for example, index amortizing swaps were used by insurance companies to take mortgage risk); speculate (for example, the main use of CDSs is to allow traders to take short positions on corporate bonds); lever beyond an allowed level; and take risk off-balance sheet, where it is not as readily observed and monitored."

In fact, they are used for:
1) Avoiding taxes ( Yes )
2) Switch one investment to another ( Yes )
3) Speculate ( Short, bet on going down, certain Corporate Bonds ) ( Yes )
4) Avoid capital requirements ( Yes )
5) Escape regulation ( Yes )

He's got the entire playbook.

I would add:
6) Increase fees
7) Magnify profits

"The more complex swaps and derivatives not only find ready demand by serving these functions, there are strong profit incentives for the investment banks to supply them. The more complex the instrument, the greater the chance the investment bank can price it to make profit, for the simple reason that investors will not be able to readily determine its fair value. And if they create a product that is exclusive to them, they can also charge a higher spread when an investor wants to trade out of it."

They can:
1) Obscure the value to the client ( Yes)
2) Increase fees ( See 6 above )

"Viewed in an uncharitable light, derivatives and swaps can be thought of as vehicles for gambling; they are, after all, side bets on the market. But unlike the more common modes of gambling, these side bets can pose risks that extend beyond losses to the person making the bet. There are a number of ways the swaps and derivatives end up affecting the market: "

This was my argument on Derivative Dribble:

"Those who create these products need to hedge in the market, so their creation leads to a direct affect on the market. ( Yes )

Those who buy these instruments have other market exposures, so that if they are adversely affected by the swaps or derivatives, they might be forced to liquidate other positions, thereby transmitting a dislocation into other markets. ( Yes )

The value of some derivatives can have real effects for a company. For example, the credit default swaps are used as the basis for triggering debt covenants, so if the swap spread rises above a critical level, it can have an adverse effect on the company. ( Yes, big problem )

The use of derivatives and swaps can pull capital away from other productive uses. Because these are side bets, capital employed in these markets does not find an end-user. ( This is what I argued on Derivative Dribble )

Those who are writing the derivatives are in effect providing insurance to the buyers, but without any regulatory requirements. Often those writing these instruments are not in a well-capitalized position to pay out in the event that the option goes into the money. ( Yes. AIG )

All good points.

"In terms of regulation, here are some points to consider:

The regulators must know who owes what to whom in these markets. Right now there is no way to ascertain the effect on the swap and derivatives markets of a firm failing, because regulators do not know the web of counterparties to these instruments. ( I will call them Examiners)

We should consider standardization of instruments and make the instruments simpler. As I point out in my book, complexity of financial instruments is one of the sources of market crisis. ( True. But very hard to do. Not sure. Truthfully, I think I disagree here )

We should consider having swaps and derivatives move as much as possible away from party-to-party into a clearing house. This would improve monitoring and provide for a lower risk of default. ( Yes )

There should be stronger oversight on the use of these instruments. Who is buying and selling them,and for what purpose. Perhaps require participants to specify if the instrument is being used for speculation or hedging. Regulators should also ascertain if the use is reasonable; are these instruments simply being used to move risk off-balance sheet or to take on positions that would have been prohibited if they were executed in another way. ( I like Examiners )

A very interesting post indeed. Thanks to Yves.

"There are still some municipalities getting involved in swaps and derivatives, judging from rating-company reports"

This is disturbing. From Joe Mysak in the FT:

"Nov. 28 (Bloomberg) -- Swaps live.

Yes, states and localities across the nation are paying millions of dollars to get out of the interest-rate swaps and other derivatives that they engaged in during the past decade.

Yes, Jefferson County, Alabama, has been toying with the idea of bankruptcy, its finances in ruins because of an infatuation with variable-rate debt and interest-rate swaps.

Yes, the federal government is looking into the whole reinvestment-of-bond-proceeds business, which includes guaranteed investment contracts, swaps and derivatives. “Looking into” is probably too mild a term for the high- profile investigation.

And yes, JPMorgan Chase & Co., once one of the biggest purveyors of swaps and derivatives in public finance, said on Sept. 3 that it was getting out of the business. It seems the risks of selling these things to local governments are greater than the rewards.

Well, I have news for you. Don’t bury swaps. They’re not dead yet.

What? Is this possible?

There are still some municipalities getting involved in swaps and derivatives, judging from rating-company reports. Most seem to be planning or executing exit strategies. Some are deciding what to do about contracts they entered into years ago. Still, that any municipalities are even contemplating their use, at all, is amazing and appalling."

Now, I can't tell if he means that they're still buying them, or trying to get out of them, with as much money back as possible. So, I'm not sure what to say. Let's read on.

"Can’t you folks just say no?

I’m sure your bankers are coming in and saying, “Hey, you know what, we can put together a transaction that makes a lot of economic sense right now.”

And there are probably some financial advisers who are even saying how much money you can make today by selling an option for a swap to be entered into at some point in the future.

Does the experience of the last nine months or a year mean nothing? Doesn’t it at least give you pause? Shouldn’t you get in touch and talk it over with some of your fellow government finance officers, who have had to unwind their nightmarish involvement in the swaps and derivatives market?

Terminating their runaway swaps is costing cities, towns and school districts millions of dollars right now. Many of the public officials involved are ashamed and are trying to keep a lid on it all, I realize, especially because everything about the swaps market is supposed to be a big secret. Surely some of them will talk about it, especially the ones filing lawsuits."

If this is happening, it's certainly very troubling. I also expect a deluge of litigation, rightly, in this situation, to be unleashed.

"I like to read new-issue ratings reports (it’s an acquired taste) from the companies that grade municipal bonds.

I was especially taken with what Moody’s Investors Service said in its analysis of a Pennsylvania school district’s rating earlier this month.

This particular district was refinancing some debt and retaining two interest-rate swaps with Royal Bank of Canada.

In 2003, the state of Pennsylvania gave its municipalities the power to use swaps as long as they hired an independent financial adviser to help them figure out the deals. A 2008 story in Bloomberg Markets magazine showed that this was like letting the fox loose in the henhouse.

It seems that most of the school districts that were examined paid far too much for their swaps."

Joe, I am troubled, deeply troubled, by your taste in literature. But let's move on from that now, if we can after so jarring a revelation.

If you read my blog, you'll understand why they overpaid, since, in my opinion, that's part of the fox's incentive for entering the hen house in the first place. Does that make sense?

"That’s easy if you don’t really know what you are doing, and most municipalities don’t, when it comes to these kinds of transactions. The story’s conclusions were so alarming that I suggested the state prepare a comprehensive study detailing just how the state’s school districts have fared with their use of swaps and derivatives since passage of the 2003 law.

Not very well, I suspect. Moody’s nevertheless said in its rating report that it “expects these tools to become common for Pennsylvania school districts for asset and liability management,” adding that there was “little state supervision” of their use.

Moody’s continued: “The use of swaps will require credit monitoring given the increasingly complex nature of these instruments. Moody’s will also continue to base its analysis on the amount of exposure and our assessment of district management’s understanding of the complexities and additional risks involved in swaps.”

That’s nice. Moody’s thinks school districts’ use of swaps will become “common.”

This is too funny to be a tragedy, too sad to be a farce."

Moody's, you say? Fox in the henhouse, you say? Apparently there's more than one fox. I think that Joe is spot on. These local governments need a serious review of their investing practices and knowledge before entering the "Swap" meet.

"This is too funny to be a tragedy, too sad to be a farce."

Joe, that's not bad for a man whose prose style is derived from reading new-issue rating reports. But, do me a favor, Joe. Leave out the amusing lines so that I can add them on my blog. I really would have liked to have said, "This is too funny to be a tragedy, too sad to be a farce."

Joe, I'll tell you what. If you'll say that the line above was mine, I won't tell anyone about your peculiar reading habits. Is it a deal?

"nervous investors sought sanctuary from the turbulence in equities and other asset classes."

Here's more evidence of the Flight From Risk going on in the FT:

"The spectre of looming deflation drove government bond yields on both sides of the Atlantic to historic lows on Thursday as nervous investors sought sanctuary from the turbulence in equities and other asset classes.

Some US Treasury bills were quoted at 0 per cent, while the two-year note and the 30-year bond recorded their lowest yields since they were first regularly issued in the 1970s. The five-year note was at its lowest since 1954, based on historical data from the Federal Reserve. In the UK, the two-year gilt yield dropped to its lowest level since since the second world war."

So, people are buying bonds with no interest in order to buy a government guarantee that their money is safe. Does this even make sense?

"Buying government bonds as a safe haven investment has dominated flows in recent months. The latest moves come as increasingly worrying economic data point to rising unemployment and plunging inflation.

“Given the recent deflationary data, not just in the US but globally, the world is starting to build in a Japan-style deflationary scenario,” said Jim Caron, head of interest rate strategy at Morgan Stanley."

It can make sense in a time of Deflation, since your money is essentially appreciating in value because you can now buy more with it at cheaper prices. Is Deflation even realistic given the Fed?

"Recently, the Federal Reserve’s effective Fed funds rate has traded at around the 0.25 percentage point level, well below the target rate of 1 per cent. Meanwhile, Treasury inflation securities have moved to price in deflation for the next nine years.

Bill O’Donnell, strategist at UBS, said the bond market was reacting to the very low effective Fed funds rate and the possible start of a deflationary period. “The mood is ‘give me Treasuries at the expense of all other asset classes’ as spreads blow out and stocks slump,” said Mr O’Donnell.

Tom di Galoma, head of Treasury trading at Jefferies & Co said: “There is no place to hide but in US Treasuries. You cannot hide in corporate or mortgage bonds.”

So, investors are buying US Treasuries because they're the safest bet, and are willing to get almost nothing for that. It's hurting investment because investors are avoiding corporate and mortgage bonds, read loans. TIPS see deflation for 9 nine years. Is this even realistic?

"Deflation fears drove the 30-year swap rate to more than 50bp below that of the 30-year bond yield. Some investors are using swaps rather than buying bonds to keep their cash reserves intact as they seek greater exposure to long-term rates.

“If you already have a portfolio, using swaps allows you to increase duration without liquidating cash bonds,” said Jay Mueller, portfolio manager at Wells Capital Management."

So there's a rush into Swaps to maintain liquidity to be able to purchase long term rates, read more interest.

"The demand for long-term debt pushed the 30-year bond yield to a new record low of 3.71 per cent on Thursday; the two-year note traded as low as 0.96 per cent."

That shift to government backed long term bonds have driven their interest rate down. Supply and Demand. There's a large supply of fear, and a demand for less risk. But is this rational?

“This is about the collapse of inflation from official numbers this week and the very real spectre of disinflation in the UK,” said Moyeen Islam, fixed income strategist at Barclays Capital. “We expect yields will go lower as inflation is likely to be negative between May and October next year.”

The yields on the two-year German Schatz fell to levels not seen since September 2005. Yield spreads between Germany, the most liquid and deepest bond market in Europe, and other eurozone countries, also widened as it continued to outperform."

Since I don't fear deflation, as opposed to a drop in prices for a short period of time, and always fear inflation, I consider this behavior to basically panic behavior, based on the more unlikely scenarios going forward. Time will tell if I'm being foolish. But, given my beliefs, you can see why I believe that the Fear and Aversion to Risk at the expense of ignoring fundamentals and the most likely outcomes is our main problem now, and we need to attack these fears with incentives and moves to encourage risk.

More On Credit Default Swaps

Via Crunch Con, the transcript to 60 Minutes on Credit Default Swaps:

"Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. "A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails," he explains.

"It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated," Greenberger adds.

"So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?" Kroft asks.

"A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument," Greenberger says.

But he says there was a big problem. "The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side."

"Now, who was selling these credit default swaps?" Kroft asks.

"Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them," Greenberger says."

Read the whole thing.