The WSJ report suggests how dangerously exposed the financial system is. The huge market lacks both a modern clearing system to process trades as well as tranparency. There is a big backload of unconfirmed and legally unenforcable transactions, and borrowers "routinely turn over obligations to a third party" without the lending counterparty reportedly knowing about it. "The danger is that with no firm certain who owes what to whom, a minor hiccup might become a financial calamity with repercussions for the whole economy." - MG ------------------------------------------------ By DAVID WESSEL WSJ Wall Street Is Cleaning Derivatives Mess February 16, 2006; Page A2
In September 1998, the Federal Reserve Bank of New York gathered the biggest names on Wall Street to organize a rescue of Long Term Capital Management, a big investment fund whose "abrupt and disorderly" demise, as the New York Fed's then-president put it, posed "unacceptable risks to the American economy." The session sparked headlines and congressional hearings about a bondholder bailout.
Today, representatives of Wall Street firms, dubbing themselves the "Fourteen Families," gather again at the New York Fed. There will be few headlines, and little controversy. This time, they're acting to prevent a crisis, rather than respond to one.
It's a case study in effective, efficient intervention by regulators to get major players to fix a problem that several see, but none can fix individually. "These are the types of efforts where the return is almost never quantifiable, for the payoff comes in the avoidance of crisis," says Timothy Geithner, the current New York Fed president.
The problem: The market for financial deals called credit derivatives, particularly a strain known as credit-default swaps, which allow banks and others to buy insurance against a borrower going bust, has grown so fast that it has overwhelmed the legal, technological and paperwork-handling infrastructure. The danger is that with no firm certain who owes what to whom, a minor hiccup might become a financial calamity with repercussions for the whole economy.
Derivatives allow banks, companies and investors to transfer financial risk, much as homeowners buy insurance to shift the risk of repairing fire damage to an insurer. In the simplest form, Joe's Manufacturing Inc. borrows $5 million at an interest rate that moves up and down with market rates, and then cuts a deal with Frank's Investment Bank in which Joe promises to pay a fixed rate and Frank pays the variable rate.
The subspecies known as credit-default swaps allow banks that have lent money to, say, General Motors Corp. to shift risk of default to a risk-loving investor for a fee. As the market has evolved and drawn speculators, as well as banks looking to lay off risk, investors now place bets not only on individual firms, but on baskets of credits and on risks sliced and diced in increasingly complex ways.
You would think that Wall Street would have computerized this when the market started taking off a few years ago. But deals were, and often still are, done by telephone and fax. Detailed confirmations, important in avoiding nettlesome disputes later, weren't completed. One firm confessed in June that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than 90 days. It wasn't unusual.
That's not all. One party to a two-party deal was routinely turning obligations over to a third party without telling the first one. It was as if you lent money to your brother-in-law and later learned that he had passed the debt to his deadbeat cousin without so much as an email. "When I realized how widespread that was, I was horrified," says Gerald Corrigan, a former New York Fed president now at Goldman Sachs. "What it meant was that if you and I did a trade, and you assigned it without my knowing it, I thought you were my counterparty -- but you weren't."
In LTCM's case, each player knew the dimensions of its exposure; no one realized how exposed other firms were and how fragile LTCM's strategy was. In the case of credit derivatives, the problem has been worse: Record-keeping, documentation and other practices have been so sloppy that no firm could be sure how much risk it was taking or with whom it had a deal. That's a particularly embarrassing problem for an industry that has resisted regulation of derivatives by arguing that big firms would police each other.
Stocks, bonds and options traded on exchanges go through clearinghouses, which pick up the pieces when something goes awry with a trade. In this market, there's no clearinghouse yet. Until recently, dealers didn't even enter most credit-default-swap trades into a computer database to be sure both sides agreed on the terms.
Mr. Geithner, the Paul Revere of this story, began shouting about all of this before the end of his first year on the job. In an October 2004 speech, he noted that inadequate financial plumbing was "a potential source of uncertainty that can complicate how counterparties and markets respond in conditions of stress." That's central-bank speak for: The car is careening down the highway at 85 miles an hour and the lug nuts aren't tight. If we hit a pothole, look out!
With Mr. Geithner's encouragement, Mr. Corrigan in January 2005 reconvened an industry group, one he had chaired after LTCM, to ponder the problem. In April, Mr. Geithner publicly called for "stronger collective commitment by the principal dealers." In May, then-Fed Chairman Alan Greenspan, while stridently arguing that credit derivatives are key to the resiliency of the U.S. economy, cautioned that the inadequate infrastructure was "a significant problem."
In July, Mr. Corrigan's group issued a voluminous report with 47 recommendations. In August, with Mr. Corrigan's report in hand, Mr. Geithner invited the Fourteen Families, which handle the bulk of credit-derivatives trading, to a Sept. 15 summit. There, the New York Fed and other bank and securities regulators from the U.S. and abroad delivered a message: Tell us how you're going to fix these problems. Be ambitious. Let's agree on a way to measure progress.
It worked. "Solutions forced on the industry by the regulators are invariably going to create problems, costs and inefficiencies," says Michael Alix, chief risk officer of Bear Stearns, one of the Fourteen Families. "You have people with different ideas. You need to get them together and focus them on what needs to be done. You need to force progress and promote self-discipline. That global supervisors are watching helps move things along."
The firms subsequently agreed to enforce an industrywide protocol that requires notice before any party to a trade hands it off to another. Initially, hedge funds and some other big customers resisted demands that they notify dealers within a day when assigning a position to someone else, worried about sharing their secrets and about dealer efficiency. But they relented.
The Fourteen Families also agreed to reduce the number of trade confirmations outstanding for more than 30 days -- which stood at 97,000 as of Sept. 30 -- by 50% by April 30. At today's meeting, the Fourteen Families will report that the number of trade confirmations outstanding was down to 45,000 at the end of January.
"The government was incredibly important," says Thomas Russo, vice chairman and chief legal officer of Lehman Brothers, also one of the Fourteen Families. "We were all aware that they were observers and we knew that we'd better straighten this out because if we didn't, they would."
The problems aren't solved. There is a backlog of thousands of unconfirmed trades. About 40% of new trades still aren't matched electronically. There's no centralized utility to process credit-derivative trades. But the industry and its regulators are on the way to replacing the pipes before they burst -- without cumbersome rule making or humiliating any one firm to make a point, or waiting for a crisis to force action.