The budget deal,underpriced risk, and financial market instability

December 12th, 2014 at 1:56 pm

Just a quick note on an aspect of this budget deal that’s in progress—a point I haven’t seen adequately fleshed out, i.e., the connection between what’s happening in real time and future financial instability.

First, an update: The House narrowly passed the CRomnibus (Cramnibus?) despite the fact that it had a number of provisions to which many House D’s objected. I wrote about one of these a couple of days ago—defunding the IRS. But this note is about the section that deregulates the way certain derivatives are traded by repealing a part of Dodd-Frank financial reform.

The bill is now in the Senate where, despite similar opposition, it will very likely garner the needed 60 votes. The President will then sign it and we’ll have a budget in place until the end of this fiscal year on Sept 30, 2015.

Mike Konczal provides the details of the proposed “fin reg” change, which is the elimination of section 716 of Dodd-Frank:

Section 716 of Dodd-Frank says that institutions that receive federal insurance through FDIC and the Federal Reserve can’t be dealers in the specialized derivatives market. Banks must instead “push out” these dealers into separate subsidiaries with their own capital that don’t benefit from the government backstop. They can still trade in many standardized derivatives and hedge their own risks, however. This was done because having banks act as exotic swap dealers put taxpayers at risk in the event of a sudden collapse. That’s it.

This change should be understood in a larger context, one I’d call “never bet against Minsky.”

That’s Hyman Minsky, who recognized that as economic recoveries accelerate, financial markets begin to systemically underprice risk, often through the proliferation of “innovative” ways to borrow and bet.

And one of the ways this happened in the run-up to the Great Recession was precisely through the process that this part of Dodd-Frank was designed to block. The problem was that risky trades involving large sums were taking place in banks with government backstops, typically through federal deposit insurance (the FDIC). That meant the taxpayer was on the hook if the deal went south.

Now, absent the backstop, the risks embedded in these deals would make them more expensive. But because they’re insured by Uncle Sam, they’re cheaper, and so such trading activity grows to an unstable magnitude. As Konczal puts it (my bold):

Keeping derivatives in FDIC-insured entities lowers their costs: creditors charge lower rates, as FDIC accounts are seen as having the backing of the federal government. And these FDIC accounts typically have higher credit ratings, which is why, in 2011, Bank of America moved derivatives from its Merrill Lynch subsidiary, which had just suffered a downgrade, into its FDIC-insured subsidiary, much to the chagrin of the FDIC.

As Peter Eavis writes in The New York Times, this directly helps Citigroup, who lobbied for and wrote the change [the one in the budget deal], as they own a lot of CDS: “With some $3 trillion of exposure, the bank is one of biggest default swap dealers in the United States. Those swaps right now live inside an entity called Citibank N.A. that enjoys federal deposit insurance. Nearly $2 trillion of those swaps are based on companies or other entities with a junk credit rating.”

Those sounds you hear are a) Minsky laughing, and b) the next financial bubble inflating, right on schedule.

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5 comments in reply to "The budget deal,underpriced risk, and financial market instability"

  1. Dausuul says:

    Repealing this provision is nothing more nor less than a bailout-in-advance. If you ever want to know what Republican elected officials *really* think about bailing out the financial industry, here’s your answer. Tea Party, are you listening?

    (Didn’t think so.)


  2. Larry Signor says:

    Dose anyone think the average American understands this point of view or really cares? Where are the jobs?


  3. Ebenezer Scrooge says:

    Nope.
    And here’s why.
    Dodd-Frank changed the model of large bank insolvency. The “single point of entry” approach authorized by Dodd-Frank and being implemented by the FDIC puts the risk of insolvency on parent bondholders of large banks. As a consequence, it really doesn’t make much difference where risks are placed inside the large banking organization. The insolvency proceeding works at a consolidated level, not at the level of a particular subsidiary entity, such as a bank. Pushing an activity out of the bank and into a cross-stream affiliate is merely rearranging the deck chairs. FDIC insurance doesn’t mean much for large banking entities–the parent bondholders provide the first line of defense. FDIC insurance is, at most, a second line of defense. And I don’t think that the market price for an 8-sigma event is all that different than that for a 9-sigma event. Sigmas don’t mean all that much that far out on the tail.
    Contrast this with the Volcker rule, which pushes the proscribed activity out of the entire enterprise, not just an entity. The Volcker rule will actually change the business. Section 716 merely imposes transition and transaction costs.


    • Jared Bernstein says:

      Nope. The gov’t backstop lowers the risk premium. That’s the target of the pushout.


      • Ebenezer Scrooge says:

        If financial markets can distinguish 8-sigma events from 9-sigma events, you’re correct, albeit very much on the margin. I don’t think that financial markets can distinguish 4-sigma events from 5-sigma events. We’ll agree to disagree.


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