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Two Financial Must-Reads

[Guest post by Noam Scheiber:]

First, if you missed this Wall Street Journal op-ed by CFTC Chairman Gary Gensler this week, you should really check it out. It's one of the most lucid cases for regulating derivatives that I've read this last year or so. (The CFTC is the primary federal regulator overseeing derivatives--at least, the minority of derivatives that are actually regulated today. Which is the whole problem...). Here's the key passage:

Derivatives themselves are not new: They have existed since the Civil War, when farmers and grain merchants began using them to hedge against future changes in the price of corn and wheat. So they entered into derivatives contracts with other parties to lock in the price of corn or wheat for harvest time.
These first derivatives—called futures—have been comprehensively regulated since the 1930s.
Futures markets functioned largely without incident during the 2008 financial crisis in part because these contracts are cleared by regulated clearinghouses. Clearinghouses act as middlemen between the buyer and the seller of a futures contract, guaranteeing the obligations of both parties. They value positions on a daily basis and require both parties to post collateral to ensure that there is sufficient cushion in the event that any party defaults. And they minimize the risk and interconnectedness brought about by derivatives transactions.
But in 1981 a new type of derivative was developed to allow corporations to hedge risks outside of the regulated futures markets. These unregulated derivatives—commonly referred to as over-the-counter derivatives—are not yet required to be cleared by clearinghouses. This has created a system where financial institutions are deeply interconnected. If a derivatives dealer fails today it can have severe economic implications across the entire financial system.
A key measure included in the financial reform bill currently being debated in the Senate would require standard over-the-counter derivatives to be cleared by central clearinghouses. This will greatly reduce risk, interconnectedness and the need for future bailouts. Financial institutions would be freer to fail with limited effects on the broader economy. ...
Roughly 90% of over-the-counter derivatives transactions are between two financial entities such as banks, hedge funds, finance companies, pension plans and insurance companies. As long as financial entities remain interconnected through their derivatives, one entity's failure could mean a run on another financial entity and a difficult decision for a future Treasury secretary.

Second, if you're at all interested in the SEC case against Goldman Sachs over a deal it set up for hedge fund titan John Paulson, you really should read this terrific investigative piece by Jesse Eissenger and Jake Bernstein at ProPublica from two weeks ago. It's about a hedge fund called Magnetar, which did Goldman-Paulson style deals on a massive, massive scale as the housing boom turned into a bust. In doing so, it injected money into the mortgage market that arguably kept the boom going for significantly longer than it otherwise would have, which of course made the bust much more painful. Eissenger and Bernstein have pieced together a long, fascinating narrative, which I'd encourage you to read in its entirety. But here's the gist of what Magnetar was up to:

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.
Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.  ...
An independent analysis commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. ...
Magnetar wasn't the only market player to come up with clever ways to bet against housing. ... Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.
Magnetar's approach had the opposite effect -- by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn't alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.