Finding the limits of leverage
The Washington Post has a lengthy story on the battle within the Clinton administration on the regulation of derivatives. The head of the Commodities Future Trading Commission was for it and everyone else was against it. Besides Greenspan's opposition there was also Rubin who opposed regulation of the derivatives market.
As I have pointed out repeatedly in discussing the financial crisis, the only way you can lose the kind of money that has been lost in recent months is with leverage. What you learn from the article is how careless almost everyone involved in the transactions were about the amount of leverage used. There appeared to be no limits. A transaction might involve leverage of as much as 100 to 1 or more with no mechanism to determine whether the parties had the capacity to live up to their obligations if the market moved against them. When it did, they did not and it had a cascading effect throughout the financial community.
These transactions have done great damage to the financial sector of our economy. None of the steps taken so far limit the activity of the derivatives market, although the failures have caused the market to seize up.
Regardless of who is regulating these entities, there are practical limits to how much leverage should be permitted. In the stock market a purchaser is generally limited to leverage of less than two to one. In other words he may borrow from the broker to buy a stock position of twice his current equity. These are closely tracked on a day to day basis and if the market moves against his position the customer must put up more cash or stock to keep at the permitted ratio.
In the futures market, the leverage position can be larger, but it rarely exceeds 10 to one and the same requirements of keeping his position within that ratio exist. What was missing in the derivatives market was any mechanism to monitor positions and maintain a safe ratio. Attempts to use mark to market accounting only exacerbated the problem because the underlying assets traded in an imperfect market, i.e. real estate.
The only way to return confidence to the derivatives market is to have some standards for leverage and liquidity requirements. That of course assumes there is a good reason to keep the market to begin with. I will leave to others the that argument. Clearly the original rationale for the product. increasing liquidity for mortgage instruments, is no longer valid.
As I have pointed out repeatedly in discussing the financial crisis, the only way you can lose the kind of money that has been lost in recent months is with leverage. What you learn from the article is how careless almost everyone involved in the transactions were about the amount of leverage used. There appeared to be no limits. A transaction might involve leverage of as much as 100 to 1 or more with no mechanism to determine whether the parties had the capacity to live up to their obligations if the market moved against them. When it did, they did not and it had a cascading effect throughout the financial community.
These transactions have done great damage to the financial sector of our economy. None of the steps taken so far limit the activity of the derivatives market, although the failures have caused the market to seize up.
Regardless of who is regulating these entities, there are practical limits to how much leverage should be permitted. In the stock market a purchaser is generally limited to leverage of less than two to one. In other words he may borrow from the broker to buy a stock position of twice his current equity. These are closely tracked on a day to day basis and if the market moves against his position the customer must put up more cash or stock to keep at the permitted ratio.
In the futures market, the leverage position can be larger, but it rarely exceeds 10 to one and the same requirements of keeping his position within that ratio exist. What was missing in the derivatives market was any mechanism to monitor positions and maintain a safe ratio. Attempts to use mark to market accounting only exacerbated the problem because the underlying assets traded in an imperfect market, i.e. real estate.
The only way to return confidence to the derivatives market is to have some standards for leverage and liquidity requirements. That of course assumes there is a good reason to keep the market to begin with. I will leave to others the that argument. Clearly the original rationale for the product. increasing liquidity for mortgage instruments, is no longer valid.
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