Full Disclosure

By Thomas Brom
     
      No Worries
      If you listen carefully to the soundtrack of the documentary Enron: The Smartest Guys in the Room, you can hear the refrain from a Tom Waits song: "What's he building in there? What the hell is he building in there?"
      For the filmmakers, the context was Enron CFO Andy Fastow's manipulation of arcane investment products inside off-the-books special-purpose entities. Fastow, who pleaded guilty to two counts of wire and securities fraud, could never really explain very well what he actually did.
      California has had some unhappy experiences with structured finance?think Orange County's bankruptcy in 1994 following bad bets on interest-rate fluctuations, and Irvine-based New Century Financial Corporation's recent bankruptcy when creditors demanded their money back on collateralized loan obligations.
      But the market for over-the-counter credit derivatives has never been hotter. The most widely used instruments are credit default swaps (CDSs) and collateralized debt obligations (CDOs) that transfer the risk exposure of fixed-income products between parties. It is entirely a private market, based primarily in New York and London. Under provisions of the Commodity Futures Modernization Act of 2000 (7 U.S.C. §§ 1 and following), the Commodity Futures Trading Commission is prohibited from exercising regulatory authority with respect to a covered swap agreement offered, entered into, or provided by a broad group of "eligible contract participants." That refers essentially to institutional and commercial traders, futures commission merchants, banks, and broker-dealers.
      According to the Bank of International Settlements, in 2006 the face value of credit default swaps more than doubled from the previous year to $29 trillion, a nearly unimaginable number. Investors in collateralized debt obligations may now participate in CDOs squared?a CDO that invests in other CDOs?or even CDOs cubed. "Financial products are evolving at a very fast pace," says Thomas V. D'Ambrosio, a partner in the business and finance practice of Morgan Lewis in New York. "Parties trading in the OTC derivatives market are sophisticated-they have selected this market in order to individually negotiate the terms of their transactions."
      The worry here?and people do worry?is that OTC contracts are so complicated, and the amount of financial exposure so large, that a default or bankruptcy affecting underlying securities could produce a global crash. In a recent paper, professors Frank Partnoy of the University of San Diego School of Law and David A. Skeel Jr. of the University of Pennsylvania Law School concluded, "Given the size of the market?the ten largest U.S. banks alone have $600 billion at stake?a crisis involving credit derivatives would cause convulsions throughout the international financial markets." (U. Penn. Law School, Paper 125, 2006.)
      The OTC derivatives market is governed by protocols devised by the private International Swaps and Derivatives Association (ISDA). Until recently, contracts were made by phone and confirmed by fax. But starting in 2003 a huge increase in trading volume created enormous paperwork backlogs.
      In September 2005 the Federal Reserve Bank of New York called in representatives of the "14 Families"?14 of the major broker-dealers on Wall Street?to address backlogs of 30 days or more, as well as the common practice of regularly "assigning" part of a trade to another firm, without notifying the counterparty on the original trade.
      "Tim Geithner, president of the New York Fed, said, 'Let's get the backlog down,' " says Ernest T. Patrikis, a partner in the New York office of Pillsbury Winthrop Shaw Pittman. "Geithner doesn't need regulatory authority?he has a moral position. When he speaks, the market follows."
      And it did. "The vast percentage of trades are now processed electronically," says Paul N. Watterson Jr., a partner in the structured products and derivatives group of Schulte Roth & Zabel in New York. According to the ISDA, large firms have reduced the backlog to the equivalent of 5.5 business days.
      John Williams, a partner in the New York office of Allen & Overy, says the ISDA still needs a protocol for the cash settlement of contracts following a "credit event"?a bankruptcy, default, or restructuring. But Williams isn't overly concerned. "A lot of people with a lot at stake make sure the market functions properly," he says.
      Not everyone is so sanguine. "Risk does not stay in the bank," says the University of San Diego's Partnoy. "It's passed along like a hot potato, and it may end up anywhere. The big fear is that the buyers of these instruments-the pension funds and insurance companies?won't know about losses until it's too late. That's what happened with Enron."
      Partnoy concedes that Congress and the Fed aren't really interested in expanding oversight of the derivatives market. In May, for example, Fed Chairman Ben S. Bernanke opened the Federal Reserve Bank of Atlanta's financial markets conference with an endorsement of a "principles-based" policy on credit derivatives adopted by the Financial Services Authority, which regulates financial markets in the United Kingdom. "Derivatives in general," Bernanke said, "are not necessarily more complex than some types of structured securities."
      Still, Partnoy says he has two major concerns. "One, are the sophisticated folks running their shops well enough? That's where the Fed is involved. And two, is there an asymmetry between a sophisticated seller of these products and an unsophisticated buyer? That could lead to much bigger market failures."
      Jane D'Arista, an economist and the director of programs at the Financial Markets Center located in Howardsville, Virginia, says she worries about the derivatives market's lack of transparency. "It isn't monitored by anyone, even by the private sector itself," she says. "The buyers of risk don't lay off a bet?they make another bet to offset that risk. That generates another bet, and another. No one knows how many. But the dealers are all so smug?they always claim that critics do not understand."
      No worries, Bernanke said again in May. "If transparency about risk-bearing is important, then consistency seems to imply that full transparency should be required of credit markets broadly, not just of credit derivatives," he told the financial markets conference. "And why stop with credit markets? Do we know exactly who is bearing the risk in equity markets or foreign-exchange markets, for example?"
      Well no, Ben, we don't. But like Tom Waits, we still want to know, "What's he building in there? He's hiding something from the rest of us."
     
     

---