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Clear Example of Why Dodd-Frank Was Stupid

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Craig Pirrong gives a very clear, cogent analysis of one piece of Dodd-Frank legislation that has intent in the correct place, but in practice will be a nightmare.

Recall Dodd-Frank was supposed to stop a situation like 2008′s AIG melt down from happening again. Instead, it could happen again because of the legislation, but only more times and on a grander scale.

Craig writes,

“Diving into the Risk article reveals more details–troubling ones. It notes that unlike dealers, whose books are typically close to matched, end users are likely to have one-way positions with commensurately greater exposure to margin calls. Which just provides just another reminder that clearing would not have been a panacea for AIG, which had huge directional positions, and was brought down by the need to fund margin calls–and would have been brought down by the need to fund margin calls in a cleared environment. Indeed, the expansion of clearing threatens to increase the population of potential AIGs.

The article also emphasizes that the contingent funding obligations on banks could be huge, and are likely to be huge precisely when funding market conditions are stressed. The various solutions proposed by the banks rely very heavily on repo markets, and in particular repo markets for lower quality, less-liquid instruments. In essence, banks will repo out lower quality assets and use the cash to fund margin calls. But repo markets for lower quality assets are the ones that are the most problematic during periods of market stress. Note that haircuts on everything but high quality sovereign paper increased dramatically when the financial crisis took hold. Companies that depended on the repo market for funding found this source cut off. The shadow banking system was built on repo, and runs on the repo market are what cratered that system. The death knell for Lehman was the decision by JP Morgan and BNY Mellon–the clearing banks–to refuse to take low quality assets to collateralize tri-party repo.”

Here is a link to the whole thing.

Craig and I sometimes disagree on the structure of markets, and on clearing. But in this case we are on the same page. Mandated central clearing will be bad for the marketplace. It will force certain derivatives into clearing houses that have no business being there.

Another facet of the bill, clearinghouses ($CME, $ICE, $NYX, $NASD) will have access to the Federal Reserve window. That ought to send a chill up your spine right there. If they can margin the positions correctly, and the customer has the margin money to hold the postion, why do they need to be able to borrow from the Fed?

Read more at Points and Figures


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