Congress' New Clearinghouses

A Wall Street Journal editorial earlier this week exposed some inconvenient truths regarding proposed Congressional so-called 'reform' of derivatives trading. The topic is clearinghouses.

Personally, I find the notion of establishing clearinghouses for derivatives to be progress, if it prevents the valuation panics attendant upon derivatives due to counterparty risk, and the consequent panic over the valuation of the holders of said derivatives.

If, rather than having daisy chains of derivatives existing among various institutions, the bulk of the instruments are traded via an exchange, perhaps counterparty risk will be reduced, thus improving confidence in the risks of potential losses to the various parties.

However, the evolving, awful Dodd bill doesn't seem to have so much confidence in the proposed exchanges for derivatives.

The Journal editorial notes that the fine print of Dodd's effort gives said clearinghouses Fed discount window borrowing privleges.

Pretty scary, eh?

Because that blows the argument about 'no more bailouts' out of the water.

In fact, this provision makes clear that Dodd & Co. fear precisely that even a derivative exchange can't be sufficiently well-capitalized to cover losses, and, thus, needs access to...you guessed it....our taxpayer money.

The editorial points out,

"Also most clearinghouses that operate today set margins based on historic volatility. Everything works well as long as patterns continue as they have in the past, but as we have so painfully learned the worst crises involve assets long considered very safe that turn out to be risky. We now know that regulators at the Treasury's Office of Thrift Supervision signed off on AIG's credit-default swaps because they backed AAA-rated mortgage assets. And everyone knew housing had been rock-solid for decades."

Once again, we are reminded that regulators who are, frankly, less smart than industry practitioners will cause taxpayers losses every time. In the last crisis, our federal regulators proved unable or unwilling to challenge rating agency opinions and/or think for themselves about high ratings on securities backed by whole new mortgage instruments (subprime and Alt-A).

So any Congressional creation that depends upon regulators to get the basics right, such as, oh, say, the derivatives exchange collateral levels, is bound to be wrong.

And that means, as the Journal piece concludes, that this legislation won't do much more for derivatives risk than, first, concentrate it into an exchange, then pass any uncovered risk/losses to taxpayers, via the Fed window.

Makes you want to cry, doesn't it?