It’s worth reading through to the end of Jenny
Anderson’s profile of Tim Geithner today. It’s not just a personal puff-piece
(although it’s that too): there’s also some very good reporting, at the end,
on how Geithner managed to reduce counterparty risk in the CDS market.
In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty
risk. But rather than dump its conclusions on the industry, he chose to stay
behind the scenes while encouraging Mr. Corrigan to reconvene the group. In
January 2005, Mr. Corrigan brought together a group that included some of
the most senior executives on Wall Street. Six months later, the group produced
a report that made 47 recommendations on issues from the very technical to
Central to the report’s findings were shocking weaknesses in the way
credit derivatives were being assigned and traded around without any sense
of who owned what. The so-called “assignment issue” was simple:
credit derivatives were negotiated by two parties, say JPMorgan and Goldman
Sachs. But banks were “assigning” the contracts out to others
— like hedge funds — without telling each other. It was a little
bit like lending money to a friend who is really rich who in turn lends it
to her deadbeat brother and fails to mention it.
“It violated the first and most sacred principle of banking: know your
counterparty,” Mr. Corrigan said.
In September 2005, Mr. Geithner brought together the so-called 14 families
of Wall Street and told them to fix the problems they had found. They set
goals. Then he raised them. “You want to have a tipping-point dynamic,
where the targets were ambitious enough that they would be forced to put a
lot of resources to work, all together, quickly, otherwise you might not get
traction," he said.
Standards were set, and backlogs came down sharply. One particularly effective
tactic was to collect data from everyone and anonymously distribute it to
the group so that every bank — and that bank’s regulator —
could see how it measured up.
The industry felt triumphant about being part of the solution. It was a classic
“collective action” problem solved: the industry had set an abysmally
low standard and no one would budge for fear of losing business, so someone
had to move everyone.
I’m not sure whether or where this has been reported before, but it’s new to
me, and very interesting – although I’d be interested in whether Wall
Street’s biggest CDS players, such as Deutsche Bank and Goldman Sachs, see the
episode in quite the same way.
What strikes me, from the way that the problem is described, is that CDSs were
being treated as though they were securities, which could be "assigned"
rather than sold. Of course, one of the reasons why Wall Street loves the CDS
market so much is precisely that they are not securities, and therefore
they are subject to much less regulation. But you’d think that Wall Street banks
would at least pay lip service to the distinction, and simply write a new contract
rather than "assigning" an old one.
In fact, that’s a big reason, I’ve always understood, why total notional CDS
outstanding has been rising so quickly – when people trade in and out
of a CDS, they generally write a new contract each time, rather than treating
the CDS as a security. Was that not always the case in the past?
Maybe that practice only became universal after Geithner got involved. In which
case, he can consider himself to some degree responsible for the rise
in total CDSs out there!