Tilting at windmills.

Senators Maria Cantwell (D-Wash) and John McCain (R-Ariz) have joined together to in a show of bipartisanship to promote what should be obvious: Our banking system is structurally flawed, and the changes instigated by the passage of the Financial Services Modernization Act of 1999 should be fundamentally reconsidered. Cantwell and McCain have proposed legislation to reverse the provisions of the 1999 Act that ended the Depression-era Glass Steagall Act rules that separated investment and commercial banking.

While the conventional wisdom is that Cantwell and McCain are tilting at windmills, Congress must consider three simple notions as it considers financial services reforms. First, that institutions playing with insured deposits should be limited in what they do with public money. Second, that institutional size is a threat, and therefore large banks should be broken up into smaller banks. Finally, that financial innovation and trading in financial derivatives must be evaluated and regulated with respect to risks and benefits.

Interestingly, the arguments against these notions have remained largely unproven. Paul Volker—one of the few remaining Wise Men on financial matters in Washington, with the death of Bill Seidman—has wryly argued that for all the talk, there has been no financial innovation of widespread value since the invention of the ATM. Financial derivatives—heralded by Alan Greenspan as tools that would transfer risk to those most able to afford it—have turned out, in the words of Financial Times editor Martin Wolf, to have transferred risk to those least able to understand it.

Financial derivatives, and in particular credit default swaps, were at the center of the collapse of AIG. A credit default swap (CDS) contract is in its essence an unregulated form of insurance against the risk of default on a bond, wherein the purchaser of the contract pays the counterparty—the insurer—an annual payment in exchange for protection in the event of a bond default.

The CDS market is a huge market, with the bulk of the insurance provided by our largest banks. For those banks providing insurance, there is no requirement for setting aside capital against the risks that are undertaken, and as such the annual payment on the contracts constitute a type nearly unlimited leverage.

One question that has to be asked is what societal purpose is served by CDS contracts. Consider the two possible scenarios, using a company we will call YRC, Inc. In the first scenario, an investor holds a portfolio of YRC bonds. The bonds were purchased at a dollar price of 100, and if all goes well, the investor will receive 100 cents on the dollar at the maturity of the bonds. In this case, the investor would like to insure against the risk of YRC going bankrupt, and purchases a CDS contract that will protect it from any losses in the bonds if YRC goes belly-up. While this may sound like a fine idea, it is a socially destructive proposition, as in the event of financial problems at YRC it places that investor in a position of preferring bankruptcy to a negotiated restructuring of the company that would preserve the company but require some sacrifice on the part of the bondholders, as traditionally happens in a workout. Therefore, instead of aligning the interests of stakeholders, it undermines the alignment of interests that is necessary for navigating difficult situations.

In the second scenario, traders that do not hold YRC bonds decide to speculate on YRC’s financial condition, and purchase CDS contracts on YRC bonds in the hope of selling those contracts later at a higher price—when the likelihood of a YRC default is perceived to have increased. (Remember, the value of the CDS contract rises as perceived default risk on the bond rises, as the contract pays out upon bankruptcy).

In this scenario, the CDS contracts do not serve a fundamental societal purpose, but rather are trading instruments, or—in the words of Michael Lewis—side bets. With approximately $60 trillion of CDS contracts outstanding—an amount that far outstrips the outstanding principal amount of corporate bonds—these side bets constitute the bulk of outstanding CDS contracts.

The case against allowing such CDS contracts was made early on in the financial crisis by Lehman Brothers CEO Richard Fuld, who argued that traders at Goldman Sachs and Bear Stearns exacerbated the collapse of Lehman by shorting the stock and going long (purchasing) the Lehman CDS contract, with each trade—pushing down the stock price and pushing up the CDS price (or spread)—creating a reinforcing cycle that confirmed the market perception that the collapse of Lehman was inevitable. As the collapse neared, the traders won on both trades.

And, of course, YRC is a Fortune 500 trucking company—YRC Worldwide—that almost went the way of Lehman Brothers. As reported yesterday in the Wall Street Journal, the company almost failed to win bondholder consent for a restructuring plan, as bondholders holding CDS contracts preferred to hold out for bankruptcy to trigger a payout on those contracts. The bondholders consented only after threats of public protests by the Teamsters against institutional fund managers led in an agreement. The fundamental point regarding the destructive role of the CDS contracts was made in the WSJ article, in a comment by Mike Green of Tenex Capital, an advisor to YRC:

“It’s fundamentally improper that people can force an insurer to pay a policy when the person insured has the right to destroy his property.”

Congress appears to be ready to accept fundamental principles that must be questioned. First, institution size creates an inherent risk to the system. Arguments that institutional interconnectedness means that smaller institutions also create systemic risk does nothing to respond to the suggestion that the risk is greater with larger institution size. The problems created by institutional size include financial risk, institutional complexity that will inhibit both regulatory oversight as well as effective resolution actions, and the political power that increases with size and will mitigate against enforcement action and legislative reform over time. The latter issue should be self-evident as we watch the growing stranglehold that Wall Street has over federal policy.

Second, there should be a connection reestablished between deposit insurance and institutional role and function. Bank lending is a core function in the real economy, and this function is not augmented by institutional size or trading prowess.

Third, there should be a connection reestablished between participation in the Federal Reserve System and institutional role and function. It is hard to imagine the continuing rational for Goldman Sachs and Morgan Stanley to continue as bank holding companies.

Fourth, while the rhetoric of efficient transfer of risk sounds like an admirable principle, attention should be given to the notion that risk is an important element of lending and credit decisions. Accordingly, products that appear to mitigate transactional risk—such as credit default swaps—may exacerbate systemic risk. If CDS contracts undermine the alignment of interests between bondholders and the company, those contracts should not be allowed.