The WSJ reports, “Regulators are making it harder for J.P. Morgan to enter new markets or introduce new products, and they are preparing to hit the bank with more enforcement actions highlighting past missteps in the bank’s consumer operations. The bank is scrambling to keep up with the demands, putting some 60 new projects on hold within its consumer unit.”

In addition to the OCC and the Fed in respect of risk management and money-laundering controls, even FERC has gotten in on the action, according to the WSJ, “accusing the bank of misrepresenting prices of electricity contracts with California and Michigan that resulted in overpayments.”

The WSJ goes on to say, “Hundreds of employees have been redeployed to deal with the mounting regulatory demands . . . [the number] will likely double by the end of the year . . . [and] it will take years to work through these problems and regain the trust of regulators.”

Aliens must have kidnapped the real Jamie Dimon who the journal quotes as saying, “‘These problems were our fault and it is our job to fix them.’”  A far cry from the pre-whale “tempest in the teapot Dimon.”  So, what does this have to do with derivatives?  Well, everything and nothing.  Everything in the sense that it is proof positive of the regulatory backlash that has haunted the industry post-crisis and exacerbated by the whale scandal.  Nothing in the sense that even without the whale scandal it is has been clear to anyone who has been paying attention that regulators are on a rampage.  It’s as if they are under the misapprehension that years of no regulation and the ensuing crisis can somehow be ameliorated by over regulation post-crisis.  One can only hope they come to their senses before they regulate the industry out of business.

With the advent of Truex as Bill Hodgson skillfully blogs about here and the publication by ISDA and SIFMA of MAC (or “market agreed coupon”) IRS forms, are we moving even further away from a world in which bespoke derivatives play an essential role?  If we assume some role will always need to be fulfilled by bespoke derivatives how small can that role shrink to be before it becomes untenable to function in such an environment and everything simply becomes standardized or falls away?  I’m curious to hear your thoughts.

Perhaps the most amusing thing about post-crisis financial reform (ok, it’s not that amusing, but then remember there is little amusing about regulatory reform), the Dodd-Frank Act and the CFTC is that no one has yet found a way to keep CFTC Commissioner Bart Chilton (a/k/a “Crazy” Bart on this blog ) from engaging in what can, at its very best, be described as rhetorical geriatrics (which is a new phrase I have just invented to describe Chilton’s old and tired attempts at rhetoric, but which have all the elegance of an ill fitting suit from another era rife with mind alterting substances, lava lamps, large lapels and big collars) and at its worst, well, at its worst, it leaves even me at a loss for words…

In a recent speech, entitled “KISS”, to the Federal Reserve Bank of St. Louis, “Crazy” Bart sounds off in a Jim Cramer style lighting round, except even more random, about various things that are bothering him at present.  These topics range from the unfairness of uneven wealth distribution to the Volcker Rule, but the gem of the speech, in my opinion, is this beauty: 

But it isn’t just the CFTC. All the federal financial regulators, as a group, have slowed significantly. To some, we might seem like slackers. I’m afraid we have lost our way.  We’re certainly in a heck of a jam.  All of the Dodd-Frank agencies went from 31 percent last July to only 37 percent (148 out of 398 rules) now!  That’s just a 6 percent improvement.  It’s been a long time since we rock n’ rolled. A lonely, lonely, lonely, lonely, lonely time. WAH, WAH, WAH.

Of course, this one is pretty good too:

However, before we move on, let’s spend a little more time on this one—Dodd-Frank—because it’s a big deal that we have lost our way.  When I say “we” I mean the federal government regulators working on these rules.  While I certainly can’t speak for other regulators, I can say that I’ve had private conversations with some of my colleagues in government, and I’m not the only one who has the view that all is not going so tremendously. Plus, those percentages speak for themselves and they say, “Ugh!”

And, there you have it folks, the understament of the millenium, ”Crazy” Bart and his fellow regulators have lost their way.  And, it’s a big deal. 

If nothing else, I’m sure we can all agree with “Crazy” Bart on one thing, “Ugh” is an appropriate response to the current state of play.

BUT, hey, at least they’re not blaming derivatives!  You have to read this story to believe it, but there is apparently a Professor named “Nutt” seriously advocating Wall Street cocaine abuse caused the financial crisis.  Carney’s piece is a bit tongue in cheek, but it must be a damn slow news week.  Check it out here.  Oh, and Mr. Carney, if you’re reading this, how about reporting on the regulatory roadblock out of DC and the fact that notwithstanding imposing compliance deadlines on market participants the regulators are years behind where they are supposed to be?

It’s still Sunday, but I’ve finished my morning projects so I thought I’d take a quick break and grace you with a second post today before diving back into the mounds of paper staring at me. 

The WSJ recently reported that U.S. regulators are warning about a marked increase in volume of leveraged loans and especially the cov-lite variety.  Their concern, to state it bluntly, is that banks are making increasinlgy higher volumes of (what the regulators consider to be) risky loans ($78b in Feb 2013 compared to the pre-crisis record of $71b in Feb 2007) and may not be prepared for the consequences in stress-case scenarios (especially since, in the case of cov-lite loans, convenants may not serve as early warnings of problems).  

The WSJ quotes Jeremy Stein (Fed governor) as saying, “the Fed is ‘seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit.’”  Is it me, or do regulators just not get it?  After years of whining about not enough lending and frozen credit markets we’re seeing massive activitiy in this space.  Why?  Well, gee, shockingly enough it has to do with investors seeking yield and banks, wait for it, wait for it, wait for it….willing to extend credit in exchnage for being paid those higher yields….   Borrowers are willing to pay these rates becuase they need the money, lenders and their backers are willing to provide the money for those returns.  Of course, the regulators are worried about the risk….and banks making bad decisions… 

This part cracks me up.  Lenders are in the business of making loans.  They make judgments about the risk of default versus the return on the extension of credit.  If the return justifies the risk in their view they make the loan.  If not, then they do not.  Same thing with the folks they sell portions of these assets to in the secondary market. 

So, in one sense, there are no incorrect credit decisions, just poorly priced ones–at least from a free market perspective…  Put on your regulator hat, however, and all of a sudden, a bank making loans at high interest rates in exchange for taking on high risks is all of a sudden a potential problem, especially when the banks hold portions of these things and then sell chunks into the secondary markets to, according to the WSJ, wait for it, “pension funds, asset managers and other financial firms . . . .”

So, here we have a traditional type of banking activity that poses all sorts of risks to banks as well as to the secondary markets and regulators somehow think, again per the WSJ, that all of those risks are addressed by expecting “banks to only make loans they would be willing to hold in their own portfolios.”  Sort of like all the CDO paper the banks were willing to hold on their own books?  Personally, I’ve got no problem with these activities except that any secondary market player buying this stuff deserves whatever they get if they didn’t learn their lesson over the past few years. 

Ok, so why did I write all of this crap about leveraged loans on my derivatives blog…?  Well, it’s because the example illustrates the fundamental misconception on which the Volcker Rule is founded (i.e., that somehow precluding banks from engaging in prop trading, but allowing them to engage in traditional lending will somehow make them safer).  It further illustrates that in whatever activities banks are engaged in they are fundamentally making credit decisions resulting in their exposure (be it in the form of a derivative or a leveraged loan).  As such, what it ultimately reflects is that the line the regulators and others would like to draw between traditional extensions of credit and derivatives and other structured products is a big honkin’ lie.  A credit decsion is a credit decision and whether on or the other is fully funded or not does not change the fundamental nature of the decisions that must be made. 

It’s a few minutes before 9am Sunday morning here in NYC and I’m about to dive back into a client project, which I promised for Monday open in another time zone…  In any event, I thought I would take a moment to do a post since it has been such a long time since the last one.  Sorry about that folks, but as those of you in the know know, the run-up to Cat 1 mandatory clearing was a bit frenzied and although that frenzy has a slowed a bit, I find myself extremely busy of late, with little time for anything but the bare essentials beyond dealing with my professional obligations and occasionally trying to get a decent night’s sleep.  Don’t get me wrong, being busy in this market and this climate is a wonderful thing, but it also means I have less time to rant and rave about some of the more interesting developments in the derivatives space.

For example, since my last post, the first bit of mandatory clearing has commenced…and lo and behold the world didn’t end…  Of course, although we have ATSs (sort of) we still don’t have real SEFs or final rules as to what real SEFs will look like….  Shockingly To the surprise of no one, since my last post, the SEC has basically done nothing in terms of Dodd-Frank rulemaking…while the CFTC hasn’t done much more than release a few no-action letters.  As for when a new Volcker Rule proposal will come out, well let’s just say Congress and the President might actually agree a compromise budget before that happens…and in other news, flying pigs discovered  Even Occupy Wall Street has had enough with the delay and has brought suit seeking to force the regulators to adopt final rules–pretty stupid, but, hey they’re right about one thing–the delay is absurd.  Of course, in addition to that, we’re all still waiting for a real U.S. person definition and final extraterritorial guidance for Title VII purposes, but at this rate, Chris Christie or Andrew Cuomo might be President of the United States before that happens…

JPM continues to take heat over the whole London whale thing…  It’s kind of like Ahab caught Moby Dick, made scrimshaw and lamp oil out of him, and post-mortem still wants to prosceute persecute the whale, his whale forbearers and anyone else who might be made an example of for the sake of optics.  One would have thought by this point that the press and regulators would have found something else to be pursued aimlessly excited about…

For example, on an anecdotally related note, and an item which got far less media coverage than it should have, Bloomberg reports that the swap data being reported under the Dodd-Frank rules would not have enabled the Government to detect events similar to the “JPM London Whale” occurrence, quoting O’Malia, “’The problem is so bad that staff have indicated that they currently cannot find the London Whale in the current data files.’”  They can’t even find it!!!

This comes as no great surprise when one considers that the SEC received written notice of the whole Madoff thing and still didn’t notice it…but the Dodd-Frank rules were magically supposed to make everything transparent and better…as if we needed more proof that it was poorly conceived….  The Bloomberg piece goes on to say, again quoting O’Malia, “The CFTC’s computer systems are failing to handle the incoming data. ‘None of our computer programs load this data without crashing . . .’”  So, they cant find Moby Dick’s remains and every time they try their systems crash….

Just one question:  who exactly is supposed to be vanguard in the battle to ward off the next financial crisis (let alone the next MF Global or Peregrine)?

This piece in Bloomberg almost made me choke on my coffee this morning.

Sell someone an interest rate swap that goes bad and you were at fault because the buyer miraculously didn’t understand that derivatives can result in losses as well as gains . . . that is . . . until they suffered losses . . . seriously?  What horsesh!t!  That’s like penalizing Dunkin Donuts for customers who get fat from eating donuts or a liquor store for selling booze to someone that drinks too much.

I am so tired of 5+ years of sob stories.  Everyone from municipalities to school districts to small businesses whining that their derivatives plays didn’t work out the way they expected–enough already!  Same geniuses that bought CDO paper without understanding what it was or how it worked and then sued the banks–enough already!  Instead of penalizing the banks wouldn’t it be nice if these “victims” took some responsibility for making bad decisions?

If you’re a small business owner, or a school district or a municipality or anyone else for that matter and you don’t understand how derivatives work . . . don’t buy them!  If you are any of the aforementioned and you didn’t hire expert counsel or financial advisers independent of the people selling you the derivatives, what on earth were you thinking?  Why would anyone assume that buying complex financial products without understanding them or having their own expert that does review them is a good idea?

Hey regulators–enough already!  I’ve got no problem with you going on a crusade against the folks that manipulated LIBOR. Likewise, no objections to you chasing those folks that took out fraudulent mortgages that then got securitized (screwing the economy at large not by virtue of the securitization but by virtue of the bad assets being included in those securitizations) or those that aided and abetted the culprits.  And, no issue with you hunting down the Madoffs and Wassendorf’s of the world, BUT, I have a huge problem with you starting an inquisition over allegedly improper derivatives sales!  So, enough already!

What does “improper derivatives sale” even mean?  What makes it an “improper” sale?  Why penalize the sellers?  Shouldn’t their be some baseline of competence and reasonableness assumed about someone that chooses to buy a derivative? There’s a great quote from a regulator in the Bloomberg article (mentioned above), “If small businesses can show ‘the break costs weren’t clearly stated or understated or there was a mismatch with the size of the loan,’ there would be a case for compensation.”  Wait, I’m sorry, shouldn’t someone buying a cap or a collar or even a more simple variant be able to figure out if there was a mismatch to the size of the loan?

I’m envisioning unsophisticated bumpkin looking at the swap confirmation and thinking, “Gee, I just borrowed X, but this hedge thing shows X + 100K . . . I guess that’s ok.”  Seriously?  I find this baffling. Same idea about break costs—isn’t it common sense to ask when entering into a contract in respect of a loan how much it will cost to unwind it . . . seems to go hand in hand with asking, how much it will cost to prepay the loan or whether there will be any penalty for doing so . . .

Don’t get me wrong, I’m all for slapping down (hard) those people that really fraudulently sold things or lied about what they were selling.  BUT, there is a huge divide between lying or committing fraud and selling something complex to someone who is either unwilling or incapable of doing the work to understand what they are buying.  The fraudsters and the liars should be punished (severely), but this notion of suitability or “improper” derivatives sales is a bit dopey (and, yes, I know . . . that goes completely against the current evolution of thinking by regulators who seem to be on a quest to implement suitability requirements around the world). 

So—I say, enough already!  Onwards and upwards, the banks have been tortured enough.  It is time for a new era of personal accountability on the part of market participants.  If you dont understand it, dont buy it.  Pretty simple.

Reuters reports that Wassendorf has been sentenced to 50 years in jail, which is apparently the maximum sentence for his nearly 20 years of fraud. 

I have just three questions:

(1) How the hell did Peregrine’s DSRO miss 20 years of fraud? 

(2) How the hell did the CFTC miss 20 years of fraud? 

(3) Does anyone really believe it was an absence of regulation that allowed this to occur?

I did not always agree with Sommers’ views or the inflection points at which she chose to make certain stands, but I was always glad to know that there was at least one champion for a sensible approach to cross-border derivatives regulation at the CFTC.  With Sommers’ resignation, only O’Malia stands as a voice of reason with respect to reigning in the Gensler’s delusions of a U.S. regulated global derivatives market.  That concerns me greatly, but with any luck continued pressure from foreign regulators will force the CFTC to take a reasonable final view on issues of extraterritorial application under Title VII of Dodd-Frank. 

I will also miss all of the amusing remarks Sommers would make in response to the absurdity of many of Gensler’s shenanigans.  Of course, since the CFTC has basically started doing everything by seriatim there has been a lot less of that of late (so much for Obama’s emphasis on transparency with respect to rulemaking and process).  As a practical matter, I think Sommers’ resignation will mean that the CFTC’s rulemaking process will experience further delays, but Obama will likely appoint a replacement who is much more like Gensler than Sommers.  The net result is that ultimately we may see an even more aggressive approach being taken by the CFTC throughout the remainder of the Dodd-Frank rulemaking process.

With respect to the SEC, I have no doubt that Mary Jo White will be successfully confirmed and I am extremely hopeful that with that appointment the SEC will actually start fulfilling its statutory obligations to write rules.  Ms. White has been on both sides of the fence and will undoubtedly bring significant experience to the process.  One can only hope that her experiences in the real world will bring a discipline to the SEC that has heretofore been lacking not only in terms of process, but also in terms of approach, scope and implementation.  So, while I think it is probably a net long-term positive, I do also think that in the short-term it will result in delays pending her confirmation and however long thereafter it takes for her to really grab the reins and go to work.

What do you think?

On January 21^st, The Wall Street Journal published an article describing a new investment strategy for pension funds, which involves using derivatives to leverage bond exposure so as to take advantage of the inverse movement of stock and bond prices—the theory being that absent the leverage the return on the bond portions of these portfolios when stock prices drop will not be sufficient to make-up the losses on the stock portions.  Now, I have no problem whatsoever with this use of derivatives as a tool to achieve leverage.  So, why bother blogging about it?

Well, the reason it’s worth writing about is that these same individuals lauding this strategy will later look to derivatives as a scapegoat if it doesn’t work out as they intended much like all of those municipalities and school districts did as soon as their interest rate trades moved against them.  As I have written many times before, derivatives are just a tool and leverage can be achieved in many ways, but mark my words, the first time this strategy results in a problem, some pension fund manager with a CFA and a PHD jackass will come forward and proclaim that derivatives are evil.  And, further, that he or she didn’t understand that leverage magnifies losses, etc… 

So yield-starved pension fund managers, by all means, go forth and earn your fees.  But, please, if it all goes wrong, remember, you knew what you were doing.  Don’t blame the derivatives later if it turns out that this isn’t a good strategy.  Indeed, the piece in The Wall Street Journal quotes the chief investment officer of a pension fund with 10% of its assets invested in this strategy as saying, “the fund ‘is aware of the leverage being utilized in their risk-parity strategies and has no misgivings.’”  One can only hope that nothing goes wrong for them and if it does that they remember to blame themselves and not derivatives.