DERIVATES DISASTER DEFERRED - - FOR NOW / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

Up and Down Wall Street

WEDNESDAY, JUNE 15, 2011

Derivatives Disaster Deferred -- For Now

By RANDALL W. FORSYTH


Jamie Dimon is anything but reticent. The chief executive of JP Morgan Chase (ticker: JPM) does not hesitate to speak his mind, especially to express his criticism of something or someone.


Federal Reserve Chairman Ben Bernanke was on the receiving end of Dimon's rhetorical thrusts last week. In a question-and-answer session following a speech by the central-bank chief, Dimon pointedly asked if anybody has studied the cost of compliance with all the new financial regulations. Bernanke admitted nobody had.


The story that got played in the media was that America's arguably top banker would publicly confront the head of the central bank and one of the most important regulators. It would be surprising indeed if Bernanke hadn't heard this from Dimon before in private. I know from personal experience that Dimon isn't reluctant to place a phone call to let somebody know what he's thinking, especially if he's not happy with your position.


That said, Dimon's key point -- that the new set of financial reforms enacted after the financial crisis of 2008 have unintended consequences in terms of costs and constraints on banks that are harmful to the economy -- has some validity. Not that reforms aren't needed; but what's been legislated in haste lacks the regulatory infrastructure.


Recognition of that came Tuesday when the Commodity Futures Trading Commission delayed the implementation of rules covering derivatives under the Dodd-Frank reform legislation that were to take effect in a few weeks, on July 16, until year-end. Last week, the Securities and Exchange Commission took similar action.


What's the problem? More than two years after the worst financial meltdown since the Great Depression we can't fix what went wrong?


From the Left comes the simplistic answer that Republicans have thwarted the rule-making process by holding up staffing of key positions in the hope that they'll be in charge after 2012.


Whatever truth there is to that assertion, there are huge questions with Dodd-Frank that prevent its effective implementation. Not the least was the definition of a swap, the most basic sort of derivative. You might think the question ranks with "What is 'is?'" But you're probably not a lawyer.


In the beginning of the swaps market, back in the 1980s, the simplest were interest-rate swaps, in which one party paid a short-term floating interest rates such as Libor (the London interbank offered rate) and received a long-term fixed rate. Over the years, they burgeoned in size and complexity. And they were traded over the counter, not on any listed exchange.


Eventually Warren Buffett would label derivatives of all stripes "weapons of financial mass destruction" (even as he used them extensively at Berkshire Hathaway) and the label stuck. Arguably, derivatives were an enabling agent of the credit bubble and collapse. That bubbles inflated and popped years before the creation of modern derivatives was ignored. Still, derivatives were the murder weapon, even though fallible humans failed to take care adequately.


Be that as it may, Steve Lofchie, a lawyer with Cadwalader, Wickersham & Taft who advises derivatives dealers on the regulatory process, writes that the definition of swaps under Dodd-Frank could possibly be deemed to take in a heating-oil contract with a homeowner that includes a capped price. The oil company, not being a registered swap dealer, would be in violation of Dodd-Frank. But there is no way to register as a swaps dealer with the CFTC or SEC, Lofchie writes.


If you're not "eligible contract participant," you can't enter into such a contract except on an exchange that trades swaps, Lofchie continues. But no such exchanges exist. That sounds like Catch-22, squared.


There are other implications. William J. Chepolis, a managing director of DWS Investments, the asset-management arm of Deutsche Bank, points out the commodity mutual fund he manages uses commodity-related swaps.


Under Dodd-Frank, the amount of commodity swaps the DWS fund could buy might be constricted -- because of the swap exposure of disparate parts of the giant global bank, none of which have anything to do with the mutual fund. Nevertheless, the swap exposure for all of Deutsche Bank is put in one, big basket, regardless of how the parts are related, or not, he explains.


The SEC and CFTC have given themselves a nearly six-month extension to work out how financial reform will be implemented. Whether that's enough is one question. The more basic one, posed by JPM's Dimon, is whether the benefit is worth the cost.
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