——— FINANCIAL POLICY FORUM ———
In The News
· CNN, Lou Dobbs, December 16, 2004
also shown December 20 and 21st
· CNN, Lou Dobbs Tonight, October 14, 2004
also shown October 15th
· CBS MarketWatch, October 12, 2004
also in AFX wireservice
· Marketplace, September 24, 2004
· Barron’s, September 27, 2004
National Post (
· Dow Jones Newswire, September 22, 2004
· Marketplace, July 15, 2004
· Reuters, July 9, 2004
· Boston Globe, July 6, 2004
· CBS MarketWatch, June 29, 2004 – Derivatives
also in Investors Business Daily
· CBS MarketWatch, June 29, 2004 – Fed Rate Hike
also in Investors Business Daily
· Insight In The News, May 24, 2004
· The Topeka Capital Journal, April 26, 2004
· Washington Post, April 24, 2004
· Insight In The News, May 24, 2004
· CNNfn, March 30, 2004
· Fort Worth Star-Telegram, February 23, 2004
· Reuters, March 4, 2004
December 16, 2004
SYLVESTER: So why should the average American
care? Because it can hit them right in their pocketbook.
RANDALL DODD, FINANCIAL POLICY FORUM: If foreigners no longer want to invest in the
SYLVESTER: And it will make it more expensive to finance the government's growing budget deficit.
October 14, 2004
SYLVESTER: But the budget deficit is
not the only concern. Economists are also worried about a growing trade
As Americans have stopped buying
RANDALL DODD, FINANCIAL POLICY FORUM: If we continue along the pace we are now, it's unsustainable and there will have to be some day of reckoning.
October 12, 2004
Banks' derivative use jumps 23% in
Financial Policy Forum calls for more regulation of market
Barr, CBS MarketWatch
Last Update: 4:02 PM ET Oct. 12, 2004
Banks used $81 trillion worth of
derivatives in the second quarter, up from $65.8 trillion a year earlier,
according to a report by the Office of Comptroller of the Currency, a
government agency that compiles reports from lenders operating in the
A derivative is a contract that gains its value from other securities. The market for these instruments has boomed: In 1991, there were about $7 trillion worth of contracts outstanding. At $81 trillion, the market now dwarfs equity markets such as the New York Stock Exchange, which lists companies with a market capitalization of less than $12 trillion.
"This market has been growing rapidly for years and the over-the-counter part of it is devoid of regulation," said Randall Dodd, director of the Financial Policy Forum, a Washington, D.C.-based think tank funded by the Ford Foundation.
Ninety percent of outstanding derivatives were traded over the counter in the second quarter, with the remaining 10 percent traded on exchanges, the OCC said.
Dodd, a former economist at the Commodity Futures Trading Commission, thinks there should be rules for posting collateral to back up derivatives trades, like in other markets.
"Interruptions in the collateral chain can spark systemic risks in the financial markets," Dodd warned.
The value of swaps outstanding surged 31 percent to $49.7 trillion in the second quarter from a year earlier, the OCC said. Options use grew 23 percent to $17.6 trillion, while the value of outstanding credit derivatives jumped more than 80 percent to $1.5 trillion, the OCC reported.
The use of futures and forward contracts slid slightly to $12.2 trillion, the OCC added.
While 637 banks operating in the
Those banks retain large credit exposures thanks to their derivatives holdings, the OCC said.
Credit risk exposure as a percent of risk-based capital for J.P. Morgan Chase (JPM: news, chart, profile) remains the highest of any lender at 768 percent, the OCC said. That's down from 890 percent in the first quarter of 2004.
Risk exposure for HSBC (HBC: news, chart, profile), Citigroup (C: news, chart, profile) and Bank of America (BAC: news, chart, profile) stands above 200 percent of their risk-based capital, the OCC added.
September 24, 2004
Potential top-level management shuffle at Fannie Mae
ANCHORS: DAVID BROWN
REPORTERS: AMY SCOTT
DAVID BROWN, anchor:
You know, we could be looking at a top-level management shuffle over at Fannie Mae; this on the heels of a report outlining massive accounting problems at the mortgage finance company. Regulators are calling for some serious housecleaning. In response, Fannie Mae says it's revised its top three officers' contracts to make it easier to drop them. In fact, as MARKETPLACE's Amy Scott tells us, it appears Fannie Mae didn't have much of a choice.
AMY SCOTT reporting:
This week Fannie Mae's board got a
letter from the company's regulator. It read something like this: `You've got a
serious problem in the highest levels of your company, and if you don't fix it,
we will.' Tim Riddiough teaches at the
Mr. TIM RIDDIOUGH (
SCOTT: That safety and soundness are important because, together, Fannie Mae and Freddie Mac own or guarantee three out of every four home loans. Last year Freddie Mac got into trouble for smoothing out its earnings to hide volatility. OFHEO now says Fannie Mae has done the same kind of thing. Randall Dodd with the Financial Policy Forum says more troubling is that in at least one case, executives allegedly inflated earnings to qualify for company bonuses.
Mr. RANDALL DODD (Financial Policy Forum): That's exactly the kind of activities that we saw with Enron: executive compensation linked very closely to current earnings. And it provides these guys with huge incentives to misbehave.
SCOTT: As to whether the top executives
will be fired, neither OFHEO, nor Fannie Mae would comment, saying they're
negotiating the next step. In
BROWN: Fannie Mae is an underwriter of this program.
September 27, 2004
When regulators become hedge-fund advisers
By LEAH MCGRATH GOODMAN
ON THE LAST MONDAY IN AUGUST, Scott Parsons was the Commodity Futures Trading Commission's chief operating officer. Tuesday, he started work at a hedge-fund industry group, helping the firms he was charged to regulate a day before.
move drew little notice, but serves as the latest flashpoint in the debate over
whether the defection of CFTC officials to organizations once under their
purview is good for the burgeoning
Industry observers, including former commission officials, are of two minds. But critics say the pattern reveals a dangerous courtship between the commodities industry and CFTC officials looking for better-paying jobs.
debate has cropped up before, but has special urgency now. Energy prices are
soaring, and so is participation in
"If you're looking at the job with
an eye toward making more money when you get out, you don't want to get a
reputation for being anti-industry, or they're not going to hire you,"
says Randall Dodd, head of the
Dodd served as an economic-policy analyst at the CFTC from 1996 to 2000.
The CFTC is directly responsible for regulating commodities trade on futures exchanges, but also has the power under the Commodity Exchange Act to bring charges of wrongdoing against traders in the over-the-counter markets.
Average daily trading volume on the New
York Mercantile Exchange has leapt nearly 20% this year. Notional values
(underlying asset values) of global over-the-counter derivatives, where
importance of the CFTC's role may grow, as the
government wrangles with questions of how to beef up its scrutiny of hedge
funds, many of which are heavily invested in commodities. But such
responsibilities also provide good background for industry jobs. "Working
at the CFTC is like getting your training for the major leagues," says
Philip McBride Johnson, CFTC chairman from 1981-1983. "But I haven't seen
anybody prostituting themselves in order to enamor themselves of other
jobs." Johnson left the CFTC to work for
"If the industry didn't hire us, that would mean it didn't value our talent," Parsons said. His new employer, the Managed Funds Association, aims to work with CFTC and other government officials to ease "excessive regulation" yet many others say this market is too thinly supervised.
Parsons' leap came just weeks after a much-debated move by James Newsome -- formerly CFTC chairman and Parsons' boss -- who in early August became president of the Nymex, the world's largest energy-futures marketplace.
The lure of such posts, and the higher salaries they command, can be irresistible to CFTC civil servants on a government payroll, many say. In his new job at the Nymex, Newsome's salary swelled to around $1 million, nearly seven times what he made at the commission.
In July, the Industrial Energy
Consumers of America wrote a letter to members of Congress, stating: "As
consumers, we not only request but demand that government officials not be
placed in a position of temptation by the prospect of moving quickly into a
high-paying position with the organizations they are to monitor and
Unquestionably, the past year and a half has been a fruitful one for CFTC enforcement actions. In the energy market alone, the agency has levied about $250 million in penalties, mostly for alleged abuses in the over-the-counter markets. But privately, former CFTC officials say that until the 500-strong agency receives more funding, staff and resources, it will continue to sidestep bigger challenges in the industry -- and, by extension, tangling with the financial firms that control it.
LEAH McGRATH GOODMAN is a reporter for Dow Jones Newswires.
September 22, 2004
DOW JONES NEWSWIRES
September 22, 2004 9:29 a.m.
The move drew little notice, but serves
as the latest flashpoint in the debate over whether the defection of CFTC
officials to organizations once under their purview is good for the burgeoning
Industry observers, including former commission officials, are of two minds on the subject. But critics say the pattern reveals a dangerous courtship between the commodities industry and CFTC officials looking for better-paying jobs that blurs the lines of authority.
The debate has cropped up before, but
has special urgency now. Energy prices are soaring, and participation in
"If you're looking at the job with an eye toward making more money when you get out, you don't want to get a reputation for being anti-industry, or they're not going to hire you," said Randall Dodd, head of the Financial Policy Forum, a Washington think tank. "So regulators' behavior is going to be affected even when they're at the commission."
Dodd served as an economic policy analyst at the CFTC from 1996 to 2000.
The CFTC is directly responsible for regulating commodities trade on futures exchanges, but also has the power under the Commodity Exchange Act to bring charges of wrongdoing against traders in the over-the-counter markets. The importance of the CFTC's role may grow, as the government wrangles with questions of how to beef up its scrutiny of hedge funds, many of which are heavily invested in commodities and, CFTC acting Chairwoman Sharon Brown-Hruska says, already registered with the commission.
Those responsibilities provide a good background for industry jobs, former officials say.
"Working at the CFTC is like getting your training for the major leagues," said Philip McBride Johnson, who served as CFTC chairman from 1981 to 1983. "But I haven't seen anybody prostituting themselves in order to enamor themselves of other jobs."
Johnson left the CFTC to work for
"I think the hiring is exciting and beneficial to the CFTC and a signal to everyone that the CFTC is a good training ground," former Chief Operating Officer Parsons said. "If the industry didn't hire us, that would mean it didn't value our talent."
Parsons wasn't sure what his first projects would be at the Managed Funds Association, where he took a job as executive vice president of strategic and government affairs. But the MFA's mission is to work with CFTC and other government officials to ease "excessive regulation" of a market some already say is poorly supervised.
Parsons' leap came just weeks after a much-debated move by James Newsome - formerly CFTC chairman and Parsons' boss - who in early August became president of the New York Mercantile Exchange, the world's largest energy futures marketplace.
The lure of such posts, and the higher salaries they command, can be irresistible to CFTC civil servants on a government payroll, many say.
Newsome's new job at the Nymex saw his salary swell to around $1 million, nearly seven times what he made at the commission. Parsons declined to comment on the details of his compensation.
Just before leaving for the Nymex, Newsome made the case that his move demonstrated the industry's interest in regulatory compliance and working with the government.
"Now, more than ever, relationships between exchanges and government are increasingly important, particularly with the current volatility of energy markets," he said.
But some argued hiring former officials creates the wrong incentives.
"As consumers, we not only request but demand that government officials not be placed in a position of temptation by the prospect of moving quickly into a high-paying position with the organizations they are to monitor and regulate," the Industrial Energy Consumers of America wrote in a letter to members of Congress in July.
While CFTC staffers have long left their contracts early as Newsome did to take cushier industry jobs, Newsome's appointment signified the seriousness of the problem, said IECA Executive Director Paul Cicio.
"We don't need increased uncertainty in the market in having to worry about the integrity of enforcement officials," he said. "There's enough uncertainty out there about market manipulation without that."
In the balance is an exploding
Average daily trading volume on the Nymex has leapt nearly 20% this year. Notional values of
global over-the-counter derivatives, where
A handful of former CFTC officials fault the agency's close industry ties for robbing it of the one chance it had to regulate the ballooning over-the-counter derivatives market.
While the CFTC has the power to regulate exchange-based trade, the Commodity Futures Modernization Act of 2000 left the over-the-counter market exempt from its oversight - though subject to its enforcement power.
The legislation effectively freed energy
and metals derivatives from regulation and directly benefited online trading
platforms, sponsored by some of the world's largest financial institutions.
Some critics say those platforms facilitated market manipulation in the months
"The premise of the CFMA seemed to be `the bigger you are, the lighter you fall,"' said former CFTC chairman Johnson. "I kind of have a problem with going along with that."
The potential fallout of another derivatives scandal like the one involving Enron Corp. (ENRNQ) could be devastating, Johnson said.
"I'm not trying to sic the whole government on them, but this needs to be monitored," he said.
The Financial Policy Forum's Dodd, who worked at the CFTC at the time the Commodity Futures Modernization Act was being considered, said the influence of industry heavy-hitters on the commission was enormous. In particular, officials worried the CFTC would lose support from the financial sector and Congress, which approves the agency's budget, if it didn't play along.
"The CFTC failed to make its point, and they caved," he said. "As an organization, it was a big disappointment."
But despite the limits on its authority, the past year and a half has been a fruitful one for CFTC enforcement actions. In the energy market alone, the agency has levied about $250 million in penalties, the bulk of them for alleged abuses in the over-the-counter markets.
Arguably, those violations show the need for greater preventative regulation of over-the-counter markets.
"You can have a philosophical debate over whether it's better to have more oversight or prosecute after the fact," CFTC director of enforcement Gregory Mocek said.
Privately, former CFTC officials say that until the 500-strong agency receives more funding, staff and resources, it will continue to sidestep bigger challenges within the industry - and, by extension, tangling with the financial firms that control it.
"A lot of people think we're talking about a niche market here, but it's not a niche market," Dodd said. "It's every bit as important to our economy as banking and securities."
By Leah McGrath Goodman, Dow Jones Newswires
July 15, 2004
SEC hears proposal that would require
hedge fund managers to register with the government and open their books to
ANCHORS: CHERYL GLASER
REPORTERS: AMY SCOTT
CHERYL GLASER, anchor:
The Securities and Exchange Commission gave the go-ahead yesterday to a proposal that would require hedge fund managers to register with the government and open their books to examiners. SEC Chair William Donaldson takes the case for greater hedge fund regulation to Congress today. MARKETPLACE's Amy Scott has more.
AMY SCOTT reporting:
First things first. What exactly is a hedge fund?
Mr. RANDALL DODD (Financial Policy Forum): It's like a mutual fund for the very wealthy.
SCOTT: Randall Dodd directs the Financial Policy Forum. He says hedge funds use more sophisticated investment tools than mutual funds, like short selling and derivatives trading. He says more than $800 billion are now invested in hedge funds with almost no supervision.
Mr. DODD: It's not only wealthy individuals that are moving into the hedge fund market but also our endowments at our universities, hospitals, our pension funds, and now people think they're playing a particularly significant role in the trading volume on Wall Street.
SCOTT: A hedge fund industry group called mandatory registration burdensome and unnecessary. It plans to lobby against the proposal until the SEC votes on a final version later this year.
July 9, 2004
By Chris Baltimore and Tom Doggett
July 9 (Reuters) - James Newsome, the top U.S. futures regulator who oversaw a
high-profile investigation into bogus energy trading, said Friday he would
resign to head the New York Mercantile Exchange, the world's largest energy
futures market. Newsome, the chairman of
the U.S. Commodity Futures Trading Commission, will leave his post on July 23
and become president of NYMEX on Aug. 2, the exchange said. He would be the first CFTC chairman to leave
and immediately head an exchange regulated by the agency. Newsome, a Republican, has served on the
commission since August 1998 and has been chairman since January 2001. The CFTC regulates the NYMEX, the Chicago
Board of Trade, the Chicago Mercantile Exchange and other
Newsome walks into a controversy between
NYMEX and its arch-rival, Atlanta-based IntercontinentalExchange,
known as ICE, over allegations that ICE improperly uses NYMEX prices to settle
its contracts. NYMEX has long sought a
merger with ICE, which bought NYMEX's
Despite the rules, Newsome's history as a
former regulator could present some ethical dilemmas, experts said. "It's certainly not common practice and
I don't think it's a good practice" for a CFTC head to move quickly into
industry, said Randall Dodd, director of the Financial Policy Forum, a
Washington-based nonprofit research group. "It's kind of a revolving door
that you don't want to see in
PROBED FAKE ENERGY TRADES
As CFTC chairman, Newsome oversaw an
investigation into fake trades reporting by several large
Rumors had circulated for weeks that Newsome was being courted by NYMEX to replace its president, J. Robert Collins Jr., whose contract expired June 30 and was not renewed.
Traders said they were not surprised that the CFTC's top regulator would leave the government to join the industry. "Of course Newsome took the job," said one Texas-based trader. "He's probably getting five times his salary at the CFTC. That's why people work in government." NYMEX is expected to pay Newsome around $1 million, according to one industry source. That would be much higher than his present government pay of about $145,600 a year. An exchange spokeswoman would not comment on Newsome's pay, but Collins had a yearly salary of $1.2 million when he left.
An acting CFTC chairman will be chosen from among the two remaining commissioners, Republicans Walter Lukken and Sharon Brown-Hruska, a CFTC official said. The agency normally has five members, but two seats are open. President George W. Bush must nominate a new chairman, who has to be confirmed by the U.S. Senate.
July 6, 2004
-- John Deere & Co., the
It wanted to own a bank.
spring, John Deere, Target department stores,
Now, as the fate of industrial banks sits in the hands of a Congress eager for deregulation, the push to mix banking with unrelated companies has alarmed some lawmakers and financial officials, who say the mix blurs the line between commerce and industry and could destabilize the country's financial system.
''It is my concern that these institutions may not be sufficiently supervised or regulated," wrote Representative Jim Leach, Republican of Iowa, in a March request to the General Accounting Office for a review of industrial banks.
While federal agencies would be able to monitor the standards of lending, they wouldn't be able to supervise the overall health of the parent company. Opponents like Leach worry that if the whole corporation went under, it could expose the federal government to billions of dollars in liability.
banks are backed by an alliance of manufacturing companies like John Deere and
retail giants such as Wal-Mart Stores and Target that want credit agencies to
help consumers buy their products. They have won the support of representatives
from the seven states that already allow local versions of the banks:
Opponents, however, say granting national charters to industrial banks could seed the next generation of Enron-like financial crises.
''This is a
very dangerous thing," said Randall Dodd, director of the Financial Policy
The current dispute stems from a 1987 exemption to federal law that allows the seven states to issue banking charters to nonfinancial companies. In March, the House of Representatives approved a bill that placed restrictions on the banks' ability to open branches nationwide while requiring that any company wishing to own such a bank be primarily financial in nature. That would exclude corporate giants such as Target and John Deere.
The restrictions were part of a compromise forged out of concerns that a company like Wal-Mart could install credit windows in its stores and devastate community banks the way it has some local retailers.
restrictions have gone nowhere in the Senate, according to some lawmakers,
because Senator Robert Bennett of
Bennett did not return calls for comment.
''Bennett is holding it up because he wants to tamper with the compromise," said US Representative Barney Frank, a Newton Democrat. Frank and Representative Paul E. Gillmor, Republican of Ohio, worked on the restrictions.
A spokesperson for John Deere said the company withdrew its bid to open an industrial bank after concluding that such an operation ''did not fit with our long-term plans," although some congressional aides say the withdrawal was in response to the restrictions.
supervisor of industrial banks at
Although funds invested in industrial banks represent a fraction of the country's total bank-deposit base, they are growing fast. Since 1995, the deposits owned by nonfinancial companies have grown from $2.9 billion to an estimated $120 billion today. The owners of the banks range from the auto manufacturers BMW and Volvo to a firm that finances taxi companies.
Proponents of the banks say they offer niche products that larger, more diversified commercial banks have no interest in providing. ''If you look at what [industrial banks] do" -- loans, credit cards -- ''they don't compete with community banks, but with other captive banks," said Thomas Billings, who represents a number of industrial banks as an attorney at Van Cott, Bagley, Cornwall & McCarthy, a Salt Lake City law firm.
Take EnerBank, a Salt Lake City-based industrial bank that is
owned by CMS Energy, an electrical power company based in
While EnerBank is supervised by state and federal banking
authorities, companies like CMS Energy are not. That's the kind of blind spot,
some lawmakers say, that could prevent regulators from
detecting balance-sheet manipulation. Federal officials, including the FDIC's
inspector general, have suggested such discrepancies may have led to the
collapse last year of Southern Pacific Bank, a
In a letter to the House of Representatives' Financial Services Committee a year ago, Federal Reserve Chairman Alan Greenspan made clear his opposition to industrial banks. In particular, he warned against any move to allowing existing industrial banks to set up branches nationwide, which would effectively repeal the separation of commerce and industry as established by the Bank Holding Company Act of 1956.
''History demonstrates that financial trouble in one part of a business organization can spread rapidly to other parts of the organization," Greenspan wrote. ''This is particularly true if the parent holding company has weak financial or capital resources because the parent may well seek, or be required, to divert financial resources from a healthy subsidiary to aid either the parent or an ailing subsidiary."
The FDIC disagrees.
Its chairman, Donald Powell, the chief executive officer of the First National Bank of Armarillo, Texas, before he was brought to Washington by President Bush, said in March that industrial banks ''can provide efficient combinations of banking and commerce that deliver results for the consumer."
George French, the FDIC's deputy director of supervision, told reporters late last month that he resented the suggestion that the agency was ill-equipped to properly supervise industrial banks.
''We find that as something of a slight, to be honest," French said at a press breakfast.
Susan Milligan of the Globe staff contributed to this report. Stephen J. Glain can be reached at email@example.com
June 29, 2004
By Tom Bemis
Last Updated: 6/29/2004 7:05:40 PM
understood financial instruments have been at the center of most of the
financial debacles of the past decade -- Barings,
They've been called financial "weapons of mass destruction" by no less an investment sage than Warren Buffett.
Moreover, a huge portion of these financial transactions exist in a netherworld of little or no regulation, making them the polar opposite of what is meant by open and transparent markets.
Yet their use grows by an estimated 30 percent a year from already stunning levels.
reckless way to regulate them and there's a good way to regulate them. And
right now we're definitely on the reckless side," said Randall Dodd,
executive director of the Financial Policy Forum, a think tank in
What troubles Dodd, among others, is the possibility that one of the major banks or broker-dealers at the heart of the derivatives trade could run into a problem that cascades into a full-fledged global financial crisis.
"Those dealers are central to the market and they're also a central part of our financial system," Dodd said. "So if some big bank like Citigroup or Bank of America fails, then the whole payments and settlements system in the economy is arrested."
Central bankers take the matter seriously, given the potent mix of conditions: Derivative instruments have no reporting requirements, and global hedge funds make abundant use of them. On Monday, Bank of England officials warned that hedge funds pose a threat to financial stability as they continue to seek higher yields with enormous amounts of money in play. See related story.
Options contracts are the most familiar type of derivative because their use is so widespread. In a classic example, an option can be used to hedge against the decline in value of an asset can't be sold at the moment -- soy beans or corn growing in a field, for example.
As interest rates remained low and debt underwriting jumped, brokerage firms made millions of dollars selling specialized derivative products to protect debt issuers from things like swings in interest rates or fluctuating currencies.
In a rising rate environment, however, at some point underwriting volumes will decline, and the derivatives business may not be as profitable. See full story.
While so-called exchange-traded derivatives are well understood, the over-the-counter market for derivatives exists without any significant oversight or regulation.
It's this market that has grown so exponentially over the past 15 years. When Bill Clinton entered office, "the over-the-counter derivatives market was just $3 trillion," Dodd said. "Today it's $140 trillion," he said.
It's hardly surprising. Trading in derivatives has proved enormously profitable for many of the world's largest banks and broker dealers. See related story.
And it's that
very profitability that fuels opposition to regulation. "The big dealers
are all the major banks in
As Robert Fuller, principal and founder of Capital Markets Management, pointed out, trading firms worry the machine they created could be dismantled.
"They like doing these things sub-rosa. As markets become transparent it's very easy for people to come in and reverse engineer. So they'll resist as long as they can."
To be sure, there are many responsible uses for derivative contracts. For one, they make it much easier for companies to have access to funds without having to go to the expense of bond offerings. And they give banks a tool to overcome the inherent bias toward "being long" in their business of borrowing short-term deposits and lending the money out long term.
"Fannie Mae and Freddie Mac couldn't operate if they couldn't hedge with derivatives," Dodd said. "They couldn't do what they do. And our home mortgages would be much more expensive."
similar to efforts made in the 1930s to reign in banking and broker dealers
could make the
© 1997-2004 MarketWatch.com, Inc
June 29, 2004
By Kathie O'Donnell
Last Updated: 6/29/2004 6:57:19 PM
Fed officials have done a good job of signaling their intentions, the observers noted.
Hedge funds have been among the major beneficiaries of the trade, according to John Mauldin, president of Millennium Wave Investments, an Arlington, Texas-based independent advisory firm.
The carry trade entails borrowing at ultra-low short-term rates and investing in longer-term instruments with higher rates. For instance, a hedge fund manager might borrow at the London Interbank Offered Rate (LIBOR) plus 50 basis points, and invest the money in longer-dated U.S. Treasuries, emerging markets debt, derivatives or other investments that produce higher returns, Mauldin said.
Rising short-term rates narrow the spread and ultimately make the trade less profitable.
"When people put the carry trade on, they all knew that it had a finite life," said Mauldin, adding that investors knew the Fed wouldn't keep short-term rates low forever. "We don't get the government giving you that many profit opportunities in a lifetime, so you have to take it when you get it."
The U.S. Federal Reserve is widely expected to raise the federal funds rate, the rate banks charge each other for overnight loans, by 25 basis points on Wednesday to 1.25 percent from 1 percent. Federal Reserve Chairman Alan Greenspan in late March began sending "clear" signals that rates would rise, Mauldin said, adding that investors began unwinding the trade almost immediately.
"The way you know the carry trade was being taken off is by looking at the profits of the hedge funds, which have suffered since mid-March," he said.
Mauldin expects the Fed funds rate to be at 2 percent by year end.
The Fed has
been "afraid of that kind of activity getting into trouble when they jack
up rates, said Randall Dodd, executive director of the Financial Policy Forum
Wrong-way bets by market participants can lead to a stampede to get out of unprofitable investments and create market dislocations, Dodd says. See related story.
Other experts said the Fed's efforts to telegraph its plans should prevent investors from trying to exit the trade all at once.
"Anyone that gets caught long so to speak in this environment shouldn't be managing money," said Robert MacIntosh, chief economist and a portfolio manager overseeing $1.5 billion in debt at Eaton Vance Management, a unit of Eaton Vance Corp.(EV)
Tony Crescenzi, chief bond market strategist at Miller Tabak & Co., said while the Fed's preparation means risks to the financial markets from blow ups are low, the risk looks high on the surface because it appears that little of the big increase in carry trades has been unwound to date.
"The evidence to show that there has been a big increase in this carry trade is in the repo market, the market for repurchase agreements," Crescenzi said, adding that the amount of repurchase agreements outstanding for the week ended June 16 was $2.975 trillion, an all-time high.
In a repo transaction, a holder of Treasuries lends out the securities and receives money in return, he said. For example, a pension fund that owns $100 million of 10-year notes may decide to make money by lending them out. In exchange, the borrower gives the pension fund $100 million in collateral, which the fund then pays interest on at a rate roughly equal to the Fed funds rate. The pension fund then takes the cash and re-invests it, possibly in two-year notes earning about 2.75 percent.
"It looks dangerous on the surface because there are all of these repurchase agreements outstanding, indicating there's a tremendous amount of carry trades on," Crescenzi said. "But there are other indicators that suggest it's not so much to worry about."
He cited the "tremendous cushion" between short-dated Treasuries and the Fed funds rate. If the two-year note is at 2.75 percent, it's 1.75 percent over the funds rate currently. If that shrinks to 1.5 percent as a result of Fed tightening it's still a "significant amount of positive carry," and investors make money on the trade, the strategist said.
"The biggest argument against an implosion is the fact that there's such a large cushion between short-term rates on market-based instruments and the Fed funds rate, making it highly unlikely that investors will be forced out en masse," said Crescenzi, who expects the Fed funds rate to be at 2.25 percent by year end.
Mark Kiesel, an executive vice president and portfolio manager at Pacific Investment Management Co. LLC (PIMCO), said the carry trade has been an easy way for investors to make money for a long while.
"The party has been going on for a long time because this yield curve has been incredibly steep," Kiesel said, adding that the spread between two-year and 10-year Treasuries has been more than 200 basis points for about two years.
The manager, who helps run $400 billion for Newport Beach, Calif.-based PIMCO, expects the Fed to lift the Fed funds rate to 2.0 percent by year end, and then wait to see its effect. Market rates are likely to reflect Fed moves more quickly than in past tightening cycles because consumers and the U.S. government have so much debt outstanding making them much more sensitive, he said.
While Kiesel also expects the unwinding to be orderly, a surprise spike in inflation that forces the Fed to act more aggressively could cause a rush for the doors, elevating the likelihood of blowups, he said.
Even if that doesn't happen, and most investors heed the Fed's warnings, the history of Fed tightening cycles likely means somebody, somewhere will be caught off guard, Kiesel said.
"I can't tell you where it's going to come from," he said. "But I can tell you that there is an enormous amount of money in these levered hedge funds, and there's bound to be an accident."
That's not enough to worry others, however.
"Prices would likely fall very sharply of course," Crescenzi said. "But because it would create opportunities for other investors, there would be tremendous value apparent to investors who were unharmed by the sell off."
© 1997-2004 MarketWatch.com, Inc.
May 24, 2004, Monday
Fed Wizard's Policies Not Economic
By Christopher Whalen, SPECIAL TO INSIGHT
In February testimony before the U.S. Senate Banking Committee, Alan Greenspan said "the Federal Reserve is concerned about the growth and scale" of the swelling mortgage portfolios of Fannie Mae and Freddie Mac. Created by Congress in 1938 and 1970, respectively, Fannie and Freddie are privately held corporations that facilitate mortgage lending in the
"Unlike many well-capitalized savings and loans and commercial banks, Fannie and Freddie have chosen not to manage risk by holding greater capital," Greenspan warned, and raised the possibility that a financial hiccup by one or both of these highly leveraged entities could pose a "systemic risk" to the global financial system. He explained in a nationally televised appearance that government supports for such government-sponsored enterprises [GSEs] as Fannie Mae and Freddie Mac are the equivalent of subsidies which might be leading investors to underestimate the risk of dealing in their securities. Indeed, in the third week in April, Greenspan confirmed that the European Central Bank in July 2003 responded to an unfolding accounting scandal at Freddie Mac by planning to shed holdings of all Fannie Mae and Freddie Mac debt.
Echoing Greenspan's warning, U.S. Treasury Secretary John Snow said on April 22 that continued growth of the giant government-sponsored enterprises Fannie Mae and Freddie Mac could pose a threat to financial markets. "There are clear systemic risks in the continued growth of entities this large relative to the whole financial system," Snow said at a meeting of the Bond Market Association.
Though the most recent warnings of Greenspan are welcome and indeed overdue, it is worth noting that the Fed under his leadership has encouraged the creation of gigantic institutions that pose just as great a "systemic risk" to the
Of the 575 U.S. bank holding companies and single-unit institutions active in the derivatives market in the fall of 2003, 138 held notional value positions in excess of their weighted risk-based capital [RBCW], as reported to the Federal Deposit Insurance Corp [FDIC]. At the top of the pile was J.P. Morgan Chase [JPM] with $34.3 trillion in notional contracts outstanding, some 49.8 percent of total positions held by banking institutions. JPM is also the least profitable a relatively small realized loss in the notional position, a mere 15 basis points, would create a loss equivalent to JPM's entire RBCW. Significantly, the Top 20 institutions represent 97.6 percent of the notional contracts held by banks involved in derivatives, some $67.2 trillion out of the total $68.8 trillion reported by domestic banks.
JPM is said to have in excess of 800 derivatives traders, a tribute to a business that for a decade grew several times faster than the economy or even the cash markets. There is an inverse relationship between the size of the derivatives business and profitability. The apparent margin in basis points reported by the banks to the FDIC reminds us of financial author Martin Mayer, who observed that 1] there are no economies of scale in banking and 2] the derivatives market is about shifting the risk to the dumbest guy in the room.
Now half the total market, JPM seems to fit that pair of shoes. Credit Greenspan and the mandarins at the Federal Reserve Board for encouraging the formation of a single bank that is effectively counterparty to every derivative contract traded on Wall Street. It is not that JPM controls the derivatives market; rather, the trillion-dollar total asset institution is the derivatives market. Because of the poor profitability of many large banks, mergers are the only way for them to show revenue and earnings growth. JPM currently is set to merge with Banc One of Ohio, creating a gigantic financial company that hopes to rival market leader Citigroup.
The latest data on global derivatives markets from the Bank for International Settlements indicates that total contracts reached $170 trillion by mid-2003, up from $127.5 trillion a year before and $142 trillion six months ago. That represents a 43 percent annual rate of growth during the last six months and 33 percent during the last year. This figure, together with the $38 trillion in outstanding positions in exchange-traded futures and options, brings the total size of global derivatives markets to $208 trillion.
Randall Dodd, proprietor of the
It may be that Greenspan's legacy to the U.S. economy will not be growth and low inflation but a financial system where risk is highly concentrated among a handful of large banks that rely on gambling via derivatives trading to generate the appearance of profitability. Like the statist economies of Europe, the
Christopher Whalen is a contributing writer for Insight.
Monday, April 26, 2004
The mistake would be to allow
The IMF is a highly visible international institution thanks to the critical role it plays in providing oversight of the global economy and coordinating economic rescue policies in response to economic crises.
In the past decade, the IMF has
assembled bailout plans for
Wheeling and dealing over the next IMF
chief is being done behind closed doors -- and only a small percentage of the
world's population is represented in the room. European governments are engaged
in round after round of backroom horse-trading to make their selection. The top
candidate appears to be Rodrigo Rato, the former
finance minister of
Meanwhile, 11 IMF regional directors -- representing 126 developing countries, or over two-thirds of all members -- are demanding a fair and transparent selection process. They want all members to be involved in the selection of the managing director. They also want an end to the discrimination against developing countries.
Excluding non-Europeans from the search for the IMF's top official is discriminatory.
In addition to maintaining control of
the top position,
These control almost 30 percent of the total voting power.
Nations defined as having developing or transition economies account for 85 percent of the world's population, and have a gross domestic product more than double that of the European Union -- yet they have only 38 percent of total votes. Looked at individually, Denmark has more voting power than Korea, and Belgium has 52 percent more voting power than Brazil and 74 percent more than Mexico, despite their larger populations, economic output and volume of international trade.
It's time to restore the balance of power in this important economic institution in order to reflect how the world has changed since it was created 60 years ago.
Defenders of the status quo cite the Europeans' unique institutional knowledge and expertise that qualify them for the managing director post. But there are many highly qualified candidates from developing countries as well. If they are dismissed, it would be a cruel irony that the people most affected by the IMF and its policies have no voice in the selection of its chief executive.
The IMF Executive Board -- including
Randall Dodd is director of the
Financial Policy Forum, a
April 24, 2004 Saturday
SECTION: Editorial; A20
HEADLINE: A Voice for Developing Countries
The April 13 editorial "The IMF's Next Leader" strongly supported a process that will select the ninth consecutive European as head of the International Monetary Fund despite the disapproval of more than two-thirds of the IMF member countries. Developing countries are demanding a fair and transparent selection process whereby all member countries are involved in the nomination and selection.
Also, The Post should know that a country cannot raise its own contribution or "quota." Quotas, like voting shares, are decided by a majority of votes, and these are in the hands of Europe, the
Financial Policy Forum
SHOW: MONEY & MARKETS 04:00 PM Eastern Standard Time
March 30, 2004 Tuesday
HEADLINE: SEC Probing Timing of
Option Grants for Execs., CNNfn
GUESTS: Randall Dodd
BYLINE: David Haffenreffer
DAVID HAFFENREFFER, CNNfn ANCHOR, MONEY & MARKETS: The SEC is reportedly looking into whether companies have been strategically handing out options to executives before the release of positive corporate news. The "Wall Street Journal" says a government probe is under way.
The SEC told CNNfn that it had no comment. Joining us with his thoughts on whether some companies may be timing their options handouts, Randall Dodd, Director of the Financial Policy Forum. He joins us today from
RANDALL DODD, FINANCIAL POLICY FORUM: Hi, David. Thanks for inviting me in.
HAFFENREFFER: Sure. What did you make of that story out of the journal today? They cited a number of options. Most of them -- a number of different cases here that they're looking at. Among them, Cisco systems, Amazon, Siebel Systems, again, all high tech. Your thoughts overall on the story itself?
DODD: First of all, I think we're going to have to add another chapter in the book we're writing on financial misconduct and corporate fraud. I think one of the particular anecdotes you mention is Cisco, they've been one of the most outspoken, most visible and quick to fund the effort to block the new FASB rule that's coming down that will require firms to expense their employee stock options.
HAFFENREFFER: Yes. That proposal is expected, I believe, tomorrow? Is that right?
HAFFENREFFER: From the FASB. And, really what they're getting at here in this article is, if you were an executive at a corporation, that the board of directors would give you these options. The next day some wonderful great news would come out. The stock would go much higher. But your compensation is only calculated based on the price that was set when you got the options themselves. Is that what we're talking about?
DODD: That's correct. David, basically what's happening here is, if you went out, and you were an executive and you bought 140 million shares of your company today, tomorrow we release some absolutely great earnings news, then that would be reported because it would be a Securities transaction. And I suspect you would be enforced against for insider trading.
You can do the exact same thing however with employee stock options, and apparently there is no strict prohibition (ph) against it. I think it's sort of showing us that we just simply need to update our Securities laws to take into consideration all the innovations that are occurring in our financial markets.
HAFFENREFFER: But the executives in question here -- at the companies in question I guess, and again, the SEC had no comment on the story to us earlier today, is that the executives can't go out and sell the stock that next day. They have to hold these options for a certain period of time before they can exercise them. So why does it matter necessarily that the stock jumps the day after the options are awarded?
DODD: Sure, David. Sure. The law requires for the firm to issue what are called qualified employee stock options, and they must be written at the market. That means the stock options must be granted at the current market price of the stock.
So you would rather have them granted the day before when the stock is 3 percent lower than tomorrow when the stock is 3 percent higher. And three percent is not trivial. Particularly if it sets it on a good trajectory for growing much further over the coming years. If you had the choice, you'd rather have one than the other.
HAFFENREFFER: Yes, but certainly -- and I know a lot of companies, when you get options, you have to hold them for at least a year, and you begin to sort of get them on a percentage basis with every passing anniversary. Doesn't that sort of limit, I guess, how much the stock can stay up because of a single news event?
DODD: Well, it certainly -- it's different than being able to cash out the next day. However, I should recommend two things to be aware of. One, it still makes a big difference in terms of the value of the options. And you just look at how the options are traded in the Chicago Board Options Exchange. And a $3 change in price of the underlying stock makes as huge difference to those guys that are trading equity options every day. Don't try to convince them it doesn't matter, because the option doesn't expire three more months.
The other thing, there are some unfortunately, some instances in which executives have turned around and gone out into over the counter equity derivatives market, and sold their employee stock options to certain brokerage firms. So that also is another way in which they could potentially capture short-term gains from these moves in stock prices.
I think in general, though, it just seems like there's nothing good about what we're observing here. And as the "Wall Street Journal article mentioned, there is a study of 527 instances of firms issuing employee stock. And it turns out that the two most common days of issuing employee stock options are the day before an earnings announcement and the day of. And presumably, it's earlier that day.
HAFFENREFFER: Whenever we get stock options, the stock goes immediately down. I don't know why Randall, but I suspect we'll hear a lot more about this story in the days and weeks to come. Randall Dodd thanks for being with us. He's from the Financial Policy Forum, joining us today from
Fort Worth Star-Telegram
February 23, 2004, Monday
Regulatory Critics Worry about
Next-Generation Underground Energy Trading
By Dan Piller
Last week's arrest of former Enron Chief Executive Jeffrey Skilling continued the high-profile perp walks of corporate executives accused of fraud and other malfeasance.
But along with Enron luminaries such as Andrew Fastow, Richard Causey and Skilling have been a second-string of names on federal and state case files, names such as Gordon, Furst and Brown.
They are veterans of the energy trading business who have been fired or fined or both in connection with bogus trading practices during the California energy crisis of late 2000 and 2001, perhaps the first wave of corporate fraud uncovered in recent years.
While the big names have gotten the media attention, regulators have made progress in researching the way the energy markets were manipulated for personal and company gain -- and who did it.
Since California's electricity crisis, much of the energy trading business has quietly moved from the financially crippled energy companies in Texas and elsewhere to the quiet back rooms of the nations' largest banks.
Critics worry that the wholesale electricity market has essentially gone underground with little oversight or transparency. The energy bill now under revival in Congress would do little to address electricity market changes, other than to ban "round trip," or sham, trading. Such bans have been imposed by state regulators and the Federal Energy Regulatory Commission.
"There is no hard data on what the new traders are doing," said Randall Dodd, a graduate of
What the other generation of traders did is slowly becoming clear.
But the mix of regulatory bodies taking action makes it difficult to gauge the overall number of fines and penalties assessed to various companies.
Enron is in a class by itself. Four of its traders have been sentenced or fined for their roles in the
FERC and other agencies have announced settlements with several companies totaling millions of dollars.
Five of those found to be manipulating the market were
Beyond the Texas-based companies,
In a related case, Reliant Energy has paid $ 18 million to settle charges of false reporting and wash trade allegations in a case filed with the Commodity Futures Trading Commission. Reliant neither admitted nor denied the allegations but agreed to cease-and-desist orders. Additionally, three Reliant executives were dismissed in 2002 for their role in the
In another CFTC case, Dynegy agreed to pay $ 5 million to settle charges by regulators that its traders provided false prices. Dynegy neither admitted nor denied the allegations.
The irony is that the traders who have been in the docket, or who are awaiting their turn there, represent a breed now long dead.
Energy companies do very little speculative trading in derivatives for the market, returning themselves to their traditional roles of trading their own oil, gas and electricity.
FERC and the Public Utilities Commission of Texas have imposed strict rules that essentially ban all the bad behavior of the Enron-era trading. The proposed energy bill in Congress also would specifically prohibit wash trades.
But what hasn't happened yet is the establishment of a new national market for electricity, expanding beyond the current jerry-built system of trading within the major zones overseen by reliability councils.
Electricity generators and providers in other states, such as
That problem was highlighted last August when millions of people from
That would seem to be tacit approval of a substantial switch in the electricity trading market, which, after Enron's collapse, moved from Houston's Energy Alley, along Louisiana Street downtown, to the back rooms of mega-financial institutions such as UBS Warburg (which bought the old Enron trading operation), Bank of America, Citigroup, J.P. Morgan Chase and a number of other financial players.
The Federal Reserve has blessed the new bank trading players by giving them permission to hold and trade energy assets.
Opinions range on the wisdom and long-term viability of this switch.
TXU Corp. chairman Erle Nye a new set of trading rules that would ban the various malfeasance that occurred in
But electricity, unlike stocks and bonds and corn and wheat, can't move across the country. Even if
Sen. John Cornyn, R-Texas, noted that the energy bill in Congress doesn't affect
"That's the way I like it," Cornyn said of the omission of the Electric Reliability Council of Texas from the energy bill.
Mark Baxter, director of the McGuire Energy Institute at Southern Methodist University, also laments the lack of disclosure in the trading business. But he thinks the eventual development of electricity trading instruments on the New York Mercantile Exchange, similar to those for oil and natural gas, will hasten the arrival of a more open market.
McGuire and others point to the Northeast blackout in August as an example that, whatever technical problems may have arisen, evidence of California-style market manipulation didn't surface.
"The system seemed to prove itself in the Northeast last year," Baxter said. "The problem there was entirely technical."
Reuters, March 4, 2004
By Eric Burroughs and Dan Wilchins
NEW YORK, March 4 (Reuters) - Warren Buffett's broadside against the opaque world of derivatives provided a prominent voice to critics who fear these securities could bring Armageddon to the global financial system and have crowed for regulation over the vast market.
Buffett branded derivatives as "financial weapons of mass destruction" in a letter to Berkshire Hathaway shareholders, but the colossal $127 trillion market has garnered praise from regulators like Federal Reserve Chairman Alan Greenspan for reducing risks.
By widely spreading the risks from a stock market plunge and massive bankruptcies like WorldCom and Enron, the little-understood market is seen as having helped soften the blow from the late-1990s bubble exploding.
While the world's second-wealthiest man and chairman of Berkshire is not above using derivatives for the company's portfolio, Buffett gravely warned the financial system was at "mega-catastrophic risk" from the intricate links derivatives weave between global banks, insurance companies and the like.
The likelihood of such a "domino effect" was cast in stark light by the near collapse of the huge hedge fund Long-Term Capital Management, whose bad trades threatened to bring the financial system to its knees in late-1998. That prompted the Fed to help organize a rescue and cut interest rates to restore confidence.
derivatives do pose a danger to our financial markets and the economy as a
whole. They need special attention," said Randall Dodd, a former economist
at the Commodity Futures Trading Commission and head of the Financial Markets
Derivatives are contracts based on underlying cash securities or things, ranging the gamut from interest rates and currencies to energy and weather. They allow investors to both buy protection against various risks and also make big leveraged bets.
Some derivatives like futures for oil, cattle and U.S. Treasuries are traded on exchanges and regulated. But the vast majority of derivatives are traded directly between parties in the over-the-counter market.
Because of their complexity, derivatives have spooked some commentators who talk about them as the toxic concoction of nefarious bankers that could bring today's entwined global markets crashing down,
Buffett bemoaned how hard it is to find out the derivatives risks banks have in their reports, and fretted about the concentration of derivatives among major banks.
"These problems have been brewing for years, and we've been lucky to dodge the bullets so far," said Frank Partnoy, author of "FIASCO," an autobiography of his experience as a derivatives salesman on Wall Street, and now a professor at the University of San Diego School of Law.
"He's right on target, and is in a perfect position to know and comment on these things," he said about Buffett. "There needs to be more disclosure here, so investors can know about the derivatives positions of companies they invest in," he said.
demise and manipulation of electricity prices in
Derivatives backers, particularly the International Swaps and Derivatives Association (ISDA), the industry's trade group, contend the contracts are used primarily to disperse risks widely and by doing so cut down the odds of the financial system suffering from a major shock.
The fact Enron's collapse did not cause major disruptions, even with its huge derivatives portfolio, was a testament to the market's maturity -- even as it roiled energy derivative markets that have yet to fully recover.
evidence from our academic colleagues is that the effect of shocks to the
market is smaller if there are derivatives in the market, because the risk is
spread among more parties," said Charles Smithson, a partner at Rutter Associates, a risk management consulting company in
And following the crises that have hit, from LTCM and Enron, major banks and users of derivatives have learned their lessons and become more savvy at gauging potential risks from other counterparties in derivative contracts.
"Firms have gotten pretty sophisticated about protecting against exposures," said Robert Pickel, chief executive of ISDA.
Buffett's own charges come from frustrations in winding down the portfolio of a derivatives boutique, General Re Securities, he bought along with reinsuer General Re in 2000 for Berkshire Hathaway Inc. Buffett said the process would take a "great many years."
"The reinsurance and derivatives businesses are similar: Like Hell, both are easy to enter and almost impossible to exit," he said in his annual letter to investors, first published in Fortune.
Ironically, Buffett was happy to have General Re Securities. In a press release in May 2000, General Re quoted Buffett as saying he was "unequivocally" against selling or spinning off the derivatives unit.
So far Congress and various administrations have shown little inclination to regulate derivatives. And Fed chief Greenspan has been one of the most outspoken in defending the market from regulation.
"Regulation is not only unnecessary in these markets, it is potentially damaging, because regulation presupposes disclosure and forced disclosure of proprietary information can undercut innovations in financial markets," he said in a speech last year on regulation, innovation and wealth creation.
But as Dodd responded, "Alan Greenspan has never seen a government regulation he's liked in his life."