Obama and Boeing - From The Economist

The White House and American business
Don't bully Boeing, Barack
Want to prove you are “pro-business”? Condemn a loony-left complaint against America’s biggest exporter

May 19th 2011 | from the print edition

IF YOU book a holiday and the flight is cancelled, you may decide to use a different airline the next time. Airlines know this, which is why Sir Richard Branson, the boss of Virgin Group, was so angry when Boeing failed to deliver the planes he needed to ferry thousands of passengers to sunny climes one Christmas. He blamed a strike by Boeing workers in Washington state. “If union leaders and management can’t get their act together to avoid strikes, we’re not going to come back here again,” he told reporters. “We’re already thinking: ‘Would we ever risk putting another order with Boeing?’”

No one disputes a traveller’s right to switch airlines, or an airline’s right to switch suppliers. But woe betide an aircraft-maker that tries to shift production from a strike-plagued American state to a more business-friendly one; at least, if the National Labour Relations Board (NLRB) gets its way. Under President Barack Obama, the federal agency charged with policing interactions between firms and employees has started to interpret old laws in new and troubling ways.

Its case against Boeing goes like this. Since 1995 Boeing has suffered three strikes at its unionised factories near Seattle. The longest stoppage, in 2008, lasted for eight weeks, cost the firm $2 billion and prompted customers such as Sir Richard to use phrases like “absolutely and utterly ghastly”. Oddly enough, when deciding where to expand production, Boeing took this into account. In 2009 it announced that it would build a new factory to assemble 787 Dreamliner jumbos in South Carolina. That, the NLRB’s general counsel claims, was an illegal act of “retaliation” against strikers in Washington, aimed at intimidating them into not striking in the future. Its proposed remedy is for Boeing to move the work to Washington. What would become of the $1 billion it has already invested in the new factory, and the 1,000 South Carolinians it has hired, is anyone’s guess. The case will be heard next month (see article).

Be careful what you wish for

The 1935 National Labour Relations Act has never been construed so broadly. Boeing is not actually reducing the amount of work it does in Washington. Quite the opposite: it increased its workforce there by 2,000. It is not closing the factories where the strikes occurred, nor is it sacking the strikers. It is merely choosing to add capacity in a state where labour relations are more cordial. In Washington, once workers at a company vote to unionise, every employee can be forced to join (and pay dues to) the union. In South Carolina they cannot. It is one of 22 “right to work” states where such compulsion is illegal (and to which millions of jobs have migrated).

Labour unions hate right-to-work laws, and are hoping that the NLRB will undermine them. They should be careful what they wish for. The NLRB’s line of reasoning would make it potentially illegal to build a new factory in a right-to-work state if you already operate one in a heavily unionised state—creating a powerful incentive never to do business in a heavily unionised state in the first place. It would be safer to make things only in places like South Carolina, or perhaps south China.

The NLRB is an autonomous body, but its board members are appointed by the president. Under a Democratic president, American businesses expect a more pro-union line, but the agency’s recent militancy is shocking, reminiscent of “loony-left” posturing in Britain in the 1970s. Not only does the agency in effect claim the power to tell firms where they may build factories. It is also suing two states (Arizona and South Dakota) where voters have decided that workers should be guaranteed a secret-ballot election before their workplace is unionised. Mr Obama has so far said nothing about any of these cases. The president claims he understands business. Condemning the NLRB would be a good way to prove it.

http://www.economist.com/node/18714050?story_id=18714050&CFID=164728604&CFTOKEN=32815208

http://www.economist.com/node/18714050?story_id=18714050&CFID=164728604&CFTOKEN=32815208

From the Wall Street Journal

The Case For Birthright Citizenship

Since the abolition of slavery, we have never denied citizenship to any group of children born in the U.S. Why change now?

By LINDA CHAVEZ

Republican leaders in Congress are now flirting with changing portions of the 14th Amendment—which grants citizenship to "all persons born or naturalized in the United States and subject to the jurisdiction thereof"—to deny citizenship to children born here to illegal immigrants.

The idea of modifying birthright citizenship has been around for decades but was previously relegated to the fringes of the immigration restriction movement. Yet in recent days, Sens. John McCain, Lindsey Graham and Jon Kyl have embraced the idea; Senate and House GOP leaders Mitch McConnell and John Boehner have proposed hearings.

Repealing birthright citizenship is a terrible idea. It will unquestionably jeopardize the electoral future of the GOP by alienating Hispanics—the largest minority and fastest-growing segment of the U.S. population. More importantly, ending birthright citizenship would fundamentally change what it means to be an American.

Proponents of repeal argue that the 14th Amendment was passed after the Civil War to guarantee citizenship to freed slaves, and that it was never intended to grant rights to the offspring of illegal aliens. But this argument is a non sequitur. At the time of the adoption of the amendment, there was no category of "illegal alien" because immigration was unrestricted and unregulated. If you secured passage to the United States, or simply walked across the open border with Mexico or Canada, you could stay permanently as a resident alien or apply to be naturalized after a certain number of years. And if you happened to give birth while still an alien, your child was automatically a citizen—a right dating back to English common law.

The most serious challenge to birthright citizenship for the children of aliens came in 1898, and it involved a class of aliens who were every bit as unpopular as present-day illegal immigrants: the Chinese. Like most illegal immigrants today, the Chinese came here to work as common laborers, eagerly recruited by employers but often deeply resented by the workers with whom they competed. This popular resentment, coupled with racial prejudice, led to America's first immigration restriction law, the Chinese Exclusion Act of 1882. It was followed by successively more restrictive federal and state laws that denied Chinese aliens—and, later, other Asians—the right to own property, to marry, to return to the U.S. if they left, or to become American citizens.

With anti-Chinese alien sentiment still high, the Supreme Court took up the case U.S. v. Wong Kim Ark in 1898. Born in San Francisco to alien parents who later returned to China, Wong travelled to his parents' homeland for a visit and was denied re-entry on his return in 1895. The government argued that Wong had no right to birthright citizenship under the 14th Amendment because his parents remained "subjects of the emperor of China" not subject to U.S. jurisdiction, even while residing in California at the time of his birth. In a 7-2 vote, the Supreme Court ruled otherwise.

The court found that the only persons Congress intended to exclude from birthright citizenship under the 14th Amendment were children born to diplomats—an ancient, universally recognized exception even under common law; Indians, who by treaty were considered members of sovereign nations; and children of an occupying enemy. "The amendment, in clear words and in manifest intent, includes the children born within the territory of the United States of all other persons, of whatever race or color, domiciled within the United States," wrote Justice Horace Gray for the majority. To hold otherwise, he noted, would be to deny citizenship to the descendants of English, Irish, Germans and other aliens who had always been considered citizens even if their parents were citizens of other countries. For more than a 100 years, the court has consistently upheld this analysis.

Our history has been largely one of continuously expanding the community of people regarded as Americans, from native-born whites to freed slaves to Indians to naturalized citizens of all races and ethnicities. Since the abolition of slavery, we have never denied citizenship to any group of children born in the U.S.—even when we denied citizenship to their parents, as we did Asian immigrants from 1882 to 1943. This expansive view of who is an American has been critical to our successful assimilation of millions of newcomers.

Conservatives should not betray these values based on a misreading of American history and legal precedent. Instead of amending the Constitution to eliminate "anchor babies"—the ugly term opponents of birthright citizenship use to describe these U.S. citizens—Republicans should be helping them become good Americans.

Ms. Chavez is chairman of the Center for Equal Opportunity in Falls Church, Va. and was director of public liaison in the Reagan White House.

Build that Mosque

From the current issue of The Economist

Lexington

Build that mosque

The campaign against the proposed Cordoba centre in New York is unjust and dangerous

Aug 5th 2010

WHAT makes a Muslim in Britain or America wake up and decide that he is no longer a Briton or American but an Islamic “soldier” fighting a holy war against the infidel? Part of it must be pull: the lure of jihadism. Part is presumably push: a feeling that he no longer belongs to the place where he lives. Either way, the results can be lethal. A chilling feature of the suicide video left by Mohammad Sidique Khan, the leader of the band that killed more than 50 people in London in July, 2005, was the homely Yorkshire accent in which he told his countrymen that “your” government is at war with “my people”.

For a while America seemed less vulnerable than Europe to home-grown jihadism. The Pew Research Centre reported three years ago that most Muslim Americans were “largely assimilated, happy with their lives… and decidedly American in their outlook, values and attitudes.” Since then it has become clear that American Muslims can be converted to terrorism too. Nidal Malik Hassan, born in America and an army major, killed 13 of his comrades in a shooting spree at Fort Hood. Faisal Shahzad, a legal immigrant, tried to set off a car bomb in Times Square. But something about America—the fact that it is a nation of immigrants, perhaps, or its greater religiosity, or the separation of church and state, or the opportunities to rise—still seems to make it an easier place than Europe for Muslims to feel accepted and at home.

It was in part to preserve this feeling that George Bush repeated like a scratched gramophone record that Americans were at war with the terrorists who had attacked them on 9/11, not at war with Islam. Barack Obama has followed suit: the White House national security strategy published in May says that one way to guard against radicalisation at home is to stress that “diversity is part of our strength—not a source of division or insecurity.” This is hardly rocket science. America is plainly safer if its Muslims feel part of “us” and not, like Mohammad Sidique Khan, part of “them”. And that means reminding Americans of the difference—a real one, by the way, not one fabricated for the purposes of political correctness—between Islam, a religion with a billion adherents, and al-Qaeda, a terrorist outfit that claims to speak in Islam’s name but has absolutely no right or mandate to do so.

Why would any responsible American politician want to erase that vital distinction? Good question. Ask Sarah Palin, or Newt Gingrich, or the many others who have lately clambered aboard the offensive campaign to stop Cordoba House, a proposed community centre and mosque, from being built in New York two blocks from the site of the twin towers. Every single argument put forward for blocking this project leans in some way on the misconceived notion that all Muslims, and Islam itself, share the responsibility for, or are tainted by, the atrocities of 9/11.

In a tweet last month from Alaska, Ms Palin called on “peaceful Muslims” to “refudiate” the “ground-zero mosque” because it would “stab” American hearts. But why should it? Cordoba House is not being built by al-Qaeda. To the contrary, it is the brainchild of Imam Feisal Abdul Rauf, a well-meaning American cleric who has spent years trying to promote interfaith understanding, not an apostle of religious war like Osama bin Laden. He is modelling his project on New York’s 92nd Street Y, a Jewish community centre that reaches out to other religions. The site was selected in part precisely so that it might heal some of the wounds opened by the felling of the twin towers and all that followed. True, some relatives of 9/11 victims are hurt by the idea of a mosque going up near the site. But that feeling of hurt makes sense only if they too buy the false idea that Muslims in general were perpetrators of the crime. Besides, what about the feelings, and for that matter the rights, of America’s Muslims—some of whom also perished in the atrocity?

Ms Palin’s argument does at least have one mitigating virtue: it concentrates on the impact the centre might have, without impugning the motives of those who want to build it. The same half-defence can be made of the Anti-Defamation League, a venerable Jewish organisation created to fight anti-Semitism and other forms of bigotry. To the dismay of many liberal Jews, the ADL has also urged the centre’s backers to seek another site in order to spare the feelings of families of the 9/11 victims. But at least it concedes that they have every right to build at this site—and that they might (only might, since the ADL hints at vague concerns about their ideology and finances) genuinely have chosen it in order to send a positive message about Islam.

The Saudi non-sequitur

No such plea of mitigation can be entered on behalf of Mr Gingrich. The former Republican speaker of the House of Representatives may or may not have presidential pretensions, but he certainly has intellectual ones. That makes it impossible to excuse the mean spirit and scrambled logic of his assertion that “there should be no mosque near ground zero so long as there are no churches or synagogues in Saudi Arabia”. Come again? Why hold the rights of Americans who happen to be Muslim hostage to the policy of a foreign country that happens also to be Muslim? To Mr Gingrich, it seems, an American Muslim is a Muslim first and an American second. Al-Qaeda would doubtless concur.

Mr Gingrich also objects to the centre’s name. Imam Feisal says he chose “Cordoba” in recollection of a time when the rest of Europe had sunk into the Dark Ages but Muslims, Jews and Christians created an oasis of art, culture and science. Mr Gingrich sees only a “deliberate insult”, a reminder of a period when Muslim conquerors ruled Spain. Like Mr bin Laden, Mr Gingrich is apparently still relitigating the victories and defeats of religious wars fought in Europe and the Middle East centuries ago. He should rejoin the modern world, before he does real harm.

Over the counter, out of sight

Derivatives

Over the counter, out of sight

Nov 12th 2009
From The Economist print edition

Derivatives are extraordinarily useful—as well as complex, dangerous if misused and implicitly subsidised. No wonder regulators are taking a close look

Illustration by Otto Dettmer

IN 1958 American onion farmers, blaming speculators for the volatility of their crops’ prices, lobbied a congressman from Michigan named Gerald Ford to ban trading in onion futures. Supported by the president-to-be, they got their way. Onion futures have been prohibited ever since.

Futures are agreements to trade something at a set price at a given date. They are perhaps the simplest example of a derivative, a contract whose value is “derived” from the price of a commodity or another asset. Derivatives continue to be vilified, usually when someone loses a lot of money. Orange County and Procter & Gamble lost fortunes on them in the 1990s. They were at the core of Enron’s failure. And in September 2008 they brought American International Group (AIG), a mighty insurer, to its knees. Its fetish for credit default swaps (CDSs), a type of derivative that insures lenders against borrowers’ going bust, led it to guarantee at least $400 billion-worth of other companies’ loans—including those of Lehman Brothers. The American government forked out $180 billion to save AIG from collapse.

Every catastrophe brings calls for restrictions on derivatives. This year Joseph Stiglitz, a Nobel economics laureate, has said that their use by the world’s largest banks should be outlawed. But derivatives have defenders too. Used carefully, they are an excellent—some would say indispensable—tool of risk-management. Myron Scholes, another Nobel prize-winner, says a ban would be a “Luddite response that takes financial markets back decades.”

Because of the mayhem of the past year or so, lawmakers in America and Europe are on the point of giving derivatives markets their biggest shake-up since the 1970s. For the world’s biggest banks, billions of dollars are at stake. For taxpayers, the stakes are just as high.

Derivatives come in many shapes. Besides futures, there are options (the right, but not the obligation, to buy or sell at a given price), forwards (cousins of futures, not traded on exchanges) and swaps (exchanging one lot of obligations for another, such as variable for fixed interest payments). They can be based on pretty much anything, as long as two parties are willing to trade risks and can agree on a price: commodities, currencies, shares or bonds. Derivatives create leverage too. Contracts are sealed with initial payments that are a small fraction of the potential gain or loss.

In the main, businesses use derivatives to shift risks to other firms, chiefly banks, that are willing to bear them. An airline worried about fuel prices can limit or fix its bills. A bank concerned about its credit exposure to the airline can pass some of its default risk to other banks without selling the underlying loans. About 95% of the world’s 500 biggest companies use derivatives. A lack of them can be costly. “The absence of derivatives in iron-ore markets makes negotiations between Australian suppliers and Chinese buyers very confrontational,” says Philip Killicoat of Credit Suisse. Earlier this year Rio Tinto’s chief negotiator, Stern Hu, was arrested in China during hard bargaining over prices. And the futures ban has not stopped the price of onions from going up and down.

Derivatives have a long history, stretching back thousands of years. In the 17th century the Japanese traded simple rice futures in Osaka and the Dutch bought and sold derivatives in Amsterdam. But trading in financial derivatives really took off only in the 1970s. The fluctuations in currencies and interest rates after the collapse of the Bretton Woods system gave a push to demand. The option-pricing formula developed by Fischer Black and Mr Scholes, plus advances in computing power, made valuing derivatives much easier. Regulators encouraged them, too. Thrift Bulletin 13, issued by the Federal Home Loan Bank System in 1989, obliged American thrifts to hedge their interest-rate risk.

Derivatives are bought and sold in two ways. Contracts with standardised terms are traded on exchanges. Tailored varieties are bought “over the counter” (OTC) from big “dealer” banks. These banks support the OTC market by hedging their clients’ risks with each other or on an exchange.

The OTC market dwarfs exchange trading (see chart 1). Estimating its size, however, demands caution. In figures published this week the Bank for International Settlements, the central bankers’ central bank, puts its “notional” value at $604.6 trillion. But “those numbers don’t appear on anyone’s balance sheet,” says Barry Epstein, an accountant who specialises in derivatives. For example, the notional value of the CDS market is $36 trillion, says the BIS. But that counts all guaranteed debt—the equivalent, in home insurance, of the value of houses covered rather than premiums paid.

For interest-rate contracts, notional values are even more misleading because they are based on principal amounts; actual obligations depend on interest payments. “Gross market values”, which show how much money would change hands if derivative contracts were sold on the reporting date at prevailing prices, are a better guide. But even they are an overstatement. Once banks’ claims on each other are stripped out, the residual (“gross credit exposure”) is $3.7 trillion, well under 1% of the notional total (see chart 2).

Even so, $3.7 trillion is a large sum. And although derivatives did not cause the financial crisis, they (or their misuse) made it worse. They concentrated risk as much as they spread it, and amplified bad judgments. Their leverage magnified losses on underlying assets like mortgages and crippled even the biggest firms.

Size is not the only reason for regulators’ interest. Another is a practice called “close-out netting”. Traders of OTC derivatives record their net obligations to each other. On any day, each trader’s thousands of bilateral contracts boil down to a single net position owed to or by its counterparties. Netting agreements ensure that if a trader goes bankrupt its position is settled at once, with no need to wait for a court.

“Counterparties to derivative contracts effectively get a super-senior claim to each other’s assets,” says Craig Pirrong, a finance professor at the University of Houston. For example, in 2008 Goldman Sachs extended credit to CIT, a troubled American lender, but in the form of a “total return swap”, a type of derivative, rather than a conventional loan. Now that CIT has filed for bankruptcy, close-out netting puts Goldman up the queue for repayment.

Another problem is that governments implicitly subsidise derivative markets. Dealer banks are so important to the financial system that they cannot be allowed to fail. This government guarantee lowers their cost of borrowing and allows them to provide derivatives more cheaply than they otherwise could. “Even if dealers keep much of the benefit for themselves, everyone is getting derivatives more cheaply at the expense of the taxpayer,” says Edward Kane, a professor of finance at Boston College. About one-third of OTC trades require no margin or collateral requirements at all. In effect, firms can get leverage for nothing. On exchanges, traders must put up margin or collateral.

Complexity is a further worry. Richard Bookstaber, who headed market-risk management at Morgan Stanley, says that “complexity cloaks catastrophe”. Clients—even supposedly sophisticated ones—do not always understand the risks they are taking on. That’s their lookout, you might say, so long as traders do not defraud them and so long as bankrupted clients do not have to be bailed out by the state.

But regulators do have an interest in complexity. It makes valuation difficult: dealers often allocate different values to the same contract. This in turn makes financial accounts more opaque. (Remember Enron.) And the popularity of arcane derivatives has been sustained by “less than lofty purposes”, says Mr Bookstaber. For example, under the Basel capital-adequacy rules, when a bank makes a loan to an ordinary company it has to set aside 8% of the loan’s value as capital. But for loans to other banks the charge is only 1.6%, because the rules assume banks are more creditworthy. The less they must put aside, the more banks can lend and the more money they can make. This is where CDSs come in handy. A bank overexposed to airlines can use CDSs to share credit risk with other banks and slash the cost of holding the loan. Buying a CDS from AIG, which had a high credit rating, gave banks a similar deal. No wonder they were so eager.

Time to clear up

Regulators have a two-part answer to these problems. First, they want more OTC contracts to be cleared by central counterparties (CCPs). A central banker in Europe thinks this will offer “a clear point of entry for authorities to rescue the financial system next time, rather than rummaging through a mire of interlocking obligations.” Second, they want more of them to be shifted to exchanges.

The American Treasury has made specific proposals. The European Commission is a couple of steps behind, but promises to “ensure global consistency”. To prod derivative markets towards clearing, and ideally trading on exchanges, OTC trades that are not cleared will face a higher capital charge than contracts that are. This may ruin the habitat of more exotic OTC species. Regulators think this is a cost society can bear.

In America supervision would remain split between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC would regulate derivatives tied to individual securities and the CFTC much of the rest. For instance, the SEC would oversee CDSs for a single company, whereas the CFTC would regulate those for an index with more than ten names.

CCPs have been around since 1925, when the Chicago Board of Trade Clearing Corporation became the legal counterparty to buyers and sellers of derivative contracts. CCPs take margin and collateral according to the size of trades, so that if a trader defaults, the clearing house should see his counterparty right. They also allow traders to net their positions across all their counterparties, reducing the margin and collateral required.

A sizeable proportion of CCPs are likely to be owned by banks, even though a cap of 20% on their stakes is being mooted in Congress. This year at least three new CCPs have been given approval to clear credit derivatives. Two of them failed to attract significant volume. The other, ICE Trust, is backed by leading dealer banks. In October LCH. Clearnet, an established clearing house, underwent a €330m ($489m) share buyback that happened to boost banks’ shareholdings.

To calculate margins, CCPs need to compute a derivative contract’s volatility, but for a lot of customised OTC contracts the necessary historical price data do not exist. So the proposed rules require only that “standardised” derivatives be cleared. Clearing CDSs presents another difficulty: because a firm is either bankrupt or not, it is difficult for CCPs to demand margins or collateral that vary smoothly with the risk of the loans insured. The world’s largest banks have promised the Federal Reserve they will clear more than 90% of “eligible” interest-rate and credit derivatives by the end of the year. But this includes only derivatives now accepted for clearing.

Deciding what else should be cleared will be fraught. Some argue that regulators should choose, others that CCPs themselves should: if they can clear it, then it must be cleared. Different CCPs may have different motives. Independent clearing houses may overreach themselves in the hope of scooping up more business. CCPs owned by dealer banks might be more reluctant to clear because their owners might find it more profitable to keep trades purely two-way and charge bespoke prices.

CCPs are lauded for their safety and efficiency. When Lehman Brothers defaulted, LCH.Clearnet, the largest clearer of interest-rate swaps, processed its $9 trillion of OTC interest-rate derivatives seamlessly. Even so, regulators may be creating another set of institutions that are too important to fail. CCPs are supposed to have enough money in hand to withstand the default of one member under “extreme but plausible” conditions—whatever that means. As Ben Bernanke, the Fed’s chairman, has noted, CCPs’ margin and collateral will never be enough to protect them from a financial earthquake. Taxpayers will have to back them.

Exchange of views

Reforms will accelerate a shift to CCP clearing that was already under way, but proposals to push standardised and cleared derivatives onto exchanges are new, and more contentious. Critics believe large dealers “have a strong incentive to steer clients towards complex OTC rather than exchange-traded derivatives, because the margins are so much greater,” says Frank Partnoy, a professor of law and finance at the University of San Diego.

Indeed, commercial banks in America have pocketed $115 billion from cash and derivatives trading in the past ten years, according to the Office of the Comptroller of the Currency, a regulator. “Banks lump their trading revenue together but the significant majority of it comes from derivatives,” says Kevin McPartland of TABB Group, a research firm. The market is concentrated, too. In America the leading five dealer banks account for about 95% of all banks’ derivative contracts by value. This year trading has been especially lucrative. In the first six months of 2009 American banks earned $15 billion (see chart 3). Market insiders at an inter-dealer broker believe that derivative revenues at the biggest European banks are at least as large.

Robert Pickel, chief executive of the International Swaps and Derivatives Association, a trade group, dismisses accusations of profiteering. He says that users can always phone different dealers to get the best price. And dealer banks are rewarded for risks they assume.

Even so, exchanges would eat into banks’ trading profitability by making prices more widely available to buyers of OTC derivatives. But getting OTC derivative markets to use trading platforms is harder than getting them to clear: anything traded on an exchange can be cleared, but the converse is not true.

A simple OTC contract with an obscure maturity date is easy to value and margin. But it would not elicit enough interest from buyers or sellers to justify listing on an exchange. And OTC derivative trades are usually big. On an exchange, a single order could move the market price, creating uncertainty for traders. Mr McPartland likens this to buying a book on Amazon instead of eBay: you often pay more at Amazon, but at least you know the price in advance.

Regulators will permit use of a “swap execution facility” in place of an exchange. But that term remains undefined. It could mean simply allowing broking over the telephone to continue. Or it could mean an electronic trading system provided by a third party. ICAP, the biggest inter-dealer broker, has two such platforms ready to go.

Watchdogs are also expected to establish data repositories, which will give them unfettered access to dealers’ trades. BME, the Spanish stock exchange, launched a new one this month. These should alleviate uncertainty about inter-bank exposures. But Darrell Duffie, a finance professor at Stanford University, worries the reforms will not go far enough. “Any derivatives that are cleared should have the prices made public, regardless of whether they are put through an exchange,” he says.

Non-financial firms that use derivatives are keen to escape the new rules. They have no wish to be forced into joining a clearing house and thus into more demanding margin calls. Nor do they like the idea of capital charges. More than 170 of these “end users” wrote to Congress last month arguing that they needed derivatives but would not be able to afford them under the new rules. So far the proposals leave them out. But Mr Duffie asks: “What sort of firm is General Electric?” (it has a big financial division). Regulators fear that hedge funds, which are not strictly financial institutions, will wriggle out, too.

Some argue that those who use derivatives should face the economic cost whatever their legal status. Easier standards for end-users could encourage them to trade even more. Mr Partnoy thinks they are already predisposed to trade too much: “Making $10m profit here and there irresistibly snowballs into a bigger trading operation.” Their risk-management, he adds, is not as savvy. Josh Rosner, managing director of Graham Fisher, a financial-research firm, says banks will game the rules: “Dealers like Goldman Sachs could reach agreements with exempted firms like Cargill [a food trader] and funnel their derivative trades through them.”

Some companies are acting already. Paul Chrispin of Principal Search, a recruitment firm, reckons that physical trading firms like Noble and Vitol have been on a recruitment drive among banks’ derivative traders. “Traders are worried about their future compensation at banks; and the freer regulatory environment at non-financials makes them an attractive place to work right now,” he observes.

The ingenuity of derivatives traders in adapting to both market forces and regulations may well send supervisors back to the drawing board in a decade or so. For now, a higher capital charge for OTC contracts is a sensible step. Doing away with derivatives altogether is neither wise nor likely. As Mr Scholes says: “Cars cause accidents but we don’t ban them.” But the state does insist on seat belts.

Options have a future

Derivatives

Options have a future

Nov 12th 2009
From The Economist print edition

Economies need derivatives, but reform is justified

KING HAMMURABI of Mesopotamia regulated the use of derivatives almost 4,000 years ago. The Japanese have been trading rice futures since around 1650. That contracts based on the price of some commodity or asset have been around for about as long as mankind has been trading indicates that they are pretty useful.

Derivatives enable individuals and companies to insure themselves against risk. Just as they fear the destruction of their belongings by fire or theft, businesses may also be concerned that exchange- or interest-rate movements may turn a good idea into a lossmaker. Derivatives allow them to lessen that risk. But someone needs to take the other side of the bargain, and that usually requires a speculator. Some of those speculators will go bust. Those who insure against fire and theft can set premiums on the basis of decades of experience; financial markets are inherently less predictable.

In the latest crisis, the problem was that investors erroneously believed property prices were quite predictable and built a whole edifice of derivatives on the back of the American housing market. To make matters worse, regulators wrongly believed that the use of derivatives, and the bundling of property loans into securities, had spread risk evenly throughout the system. They accordingly allowed banks to gear up their balance-sheets to a greater extent than before. In fact, much of the risk of a property crash still resided in the banks, and the complex nature of derivatives made their exposure very hard to calculate, leading to a loss of confidence in almost all of them.

Derivatives’ tendency to magnify problems has led to calls for regulators to ban some types. Their economic usefulness, it is argued, is far outweighed by their capacity to create systemic risk. Similar arguments were advanced two decades ago, when equity futures may have contributed to the Black Monday crash of 1987 and British local councils lost money in the obscure world of interest-rate swaps.

But after a few modest reforms, equity and interest-rate futures traded without incident, even through the latest crisis. And the same could be true of the more complex stuff. Even the much-maligned credit default swaps have their uses; by allowing investors to separate default risk from the other risks involved in buying bonds, they potentially reduce the cost of capital for business. Nor is a ban likely to achieve its aims. Congress banned onion futures in the 1950s on the ground that speculators were driving the price of the vegetable. The initiative ended in tears: onion prices since have been no less volatile than they were before.

Clearing and present danger

More modest reform, however, is needed (see article). Proposed legislation to encourage the trading of more derivatives on exchanges or through central counterparties deserves support, for it would make it easier to monitor what market participants were doing. Capital requirements need to be increased, so derivatives cannot be used as an easy way for banks to get around restrictions on gearing.

The trickiest issue concerns exemptions for end-users, such as manufacturers. Allowing companies to hedge their risks is the whole point of the instrument. But if the rules favour them over financial companies, trading will tend to migrate towards them, and away from banks. AIG, once the world’s biggest insurer, thought it was making “easy money” by using its strong credit rating to sell protection against credit defaults; in fact, it was digging its own grave.

These reforms may raise the price of using derivatives, but that would not necessarily be a bad thing. When fire and theft premiums rise, those who really need insurance still pay up.

The Fatal Conceit

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October 27, 2009

Op-Ed Columnist

By DAVID BROOKS

Humans are overconfident creatures. Ninety-four percent of college professors believe they are above average teachers, and 90 percent of drivers believe they are above average behind the wheel. Researchers Paul J.H. Schoemaker and J. Edward Russo gave computer executives quizzes on their industry. Afterward, the executives estimated that they had gotten 5 percent of the answers wrong. In fact, they had gotten 80 percent of the answers wrong.

Fortunately, for those who study the human comedy, the epicenter of overconfidence moves from year to year. Up until recently, people in the financial world bathed in the warm glow of their own self-approval. Hubris in that world always takes the same form: The geniuses there come to believe that they have mastered risk. The future is an algorithm and they’ve cracked the code.

Over the past year, the bonfire of overconfidence has shifted to Washington. Since the masters of finance have been exposed as idiots, the masters of government have concluded (somewhat illogically) that they must be really smart.

Overconfidence in government also has a characteristic form: that of highly rational Olympians who attempt to stand above problems and solve them in a finely tuned and impartial manner. In moments of government overconfidence, officials come to see society not as a dynamic and complex organism, but as a machine, which can be rebuilt. In such moments, governance and engineering merge into one.

Examples of this overconfidence abound. But let us pick just one: the effort to cap financial compensation.

Back in the days of Wall Street overconfidence, the financial titans believed that they deserved to give each other G.D.P.-level pay packages, even though there is no evidence that such packages improve performance. Now in disgrace, Wall Street firms are rewriting their rules, but the Obama administration has decided it should take control of compensation reform. Nobody seriously believes high pay caused the financial meltdown; it was bubblicious groupthink. But cutting executive pay just polls so well.

Every great action can be done in a spirit of humility or in a spirit of overconfidence. Regulating pay in a spirit of humility would mean rebalancing the power between shareholders and executives, without getting government involved in micromanaging individual pay decisions.

But this is not a moment of humility. Treasury officials are now making individual pay-package decisions across an array of different companies — and they must have really big brains to understand the motivational psychology of all those different people. The Federal Reserve, meanwhile, has decided to police banks and veto pay deals that lead to excessive risk. Those experts must have absolutely gigantic brains if they can define excessive risk years before investments pay off.

The best and the brightest in government are now rewriting existing pay contracts and determining that certain firms will be compelled to pay much less than their competitors. They’re not leveling the playing field, as a humble government would do. They’re making it less level in complicated ways.

Reality, of course, has a way of upending finely crafted plans. The effort to cap golden parachutes in 1989 perversely caused companies to increase their golden parachute packages right up to the legal limit. A 1993 law to cap C.E.O. pay led to greater use of stock options and encouraged riskier behavior.

In advance of the current new pay restrictions, 12 out of the 25 highest-paid executives have already left A.I.G., and 11 out of 25 have left Bank of America. We’ll never know how much future talent was dissuaded from working at these ailing firms.

Citigroup used to have a really high-performing energy unit. But under the new salary regime, the bank wasn’t permitted to pay the chief of that unit what he thought he was worth. Citigroup was forced to sell that profitable unit at bargain-basement prices to Occidental Petroleum.

These rules probably won’t even have a big effect on executive wealth. They’ll just drive compensation into back channels and risk-taking into unseen parts of the market.

Again, the issue is not whether government acts, but whether it acts with an awareness of the limits of its knowledge. Sometimes we seem to have a government with no sense of those limits, no sense that perhaps government officials don’t know how to restructure General Motors, pick the most promising battery technology, re-engineer the health care system from the top, or fine-tune the complex system of executive pay.

Furthermore, when extending federal authority, the Obama folks never seem to ask how Republicans will use this power when they regain the White House. The Democrats trust themselves to set private-sector salaries and use extralegal means to go after malefactors, but would they trust a future Dick Cheney?

I hope they know what they’re doing. Because when a future Cheney comes into office, I’m pretty sure he’ll be coming after columnists’ salaries first.