Tuesday, September 23, 2008

Daily Recap of Emerging Trends - 9/23/08

The State of New York wishes to regulate credit default swaps as “insurance” instruments, limiting their distribution to authorized insurance companies. This would be a horrible mistake and is typical of the misguided political overreaction that emerges from crises. The New York Federal Reserve has been working with banks to develop a clearinghouse structure, similar to that used for financial futures, that would virtually eliminate counterparty risk, diminish the systematic risk of bank failures, and create a more standardized and transparent market for these valuable derivative instruments. It would be wise for the Governor of New York to avoid front-running more sensible reforms that will inevitably emerge as banks and regulators work towards a solution.

House Democrats have dropped their opposition to offshore drilling as they have finally come to the realization that public opinion DOES matter. Sarcasm aside, their sudden change of heart is likely a gamble on an Obama Presidency and the inevitable reinstitution of the ban. In exchange, they have secured a $25 billion bailout for Detroit as the automakers have demanded low interest loans to develop more fuel efficient cars. There is nothing like rewarding those that spent millions lobbying against greater fuel economy and reforms that may have prevented the need for taxpayer funded life support.

On a final note, the Senate testimony and interrogation of Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson confirm that most Senators, even those on the Finance Committee, possess little more than an elementary knowledge of capital markets and securities. With the fate of the global economy resting upon the intellectual equivalent of a teenager, one can only hope that their individual ignorance subordinated to the guidance of more informed advisors. Properly structured, the $700 billion bailout package could provide opportunities to inject much needed liquidity into the financial system while exposing taxpayers to little risk. Legislators must demand that competitive “bidding” in the reverse auction process be conducted such that the lowest market clearing price is obtained. If the Treasury provides pricing guidance based on overly optimistic projections of mortgage defaults and prepayments, we will be repeating the mistakes that brought about the credit crisis in the first place. Additionally, attempting to mandate that mortgages are written down or “re-worked” will debase the collateral that support’s the taxpayer’s securities. In both cases, the outcome will be little more than income redistribution from taxpayers to the banks and homeowners that both entered into risky gambles with other people’s money. The potential for a sensible outcome, however, seems bleak.