May 7, 2008 / 12:39 AM / 11 years ago

Unregulated OTC derivatives steady in credit crisis

WASHINGTON (Reuters) - The collapse of the U.S. housing market and an array of mortgage-based securities has pushed Washington toward tighter regulation, but the often-feared and unregulated market for over-the-counter derivatives looks set to escape oversight.

A condominium under construction is seen in Miami, Florida October 15, 2007. REUTERS/Carlos Barria

Banks worldwide have suffered billions of dollars in losses on complex mortgage-related bets in recent months, but the similarly complex off-exchange derivatives market, whose notional value of $516 trillion is nine times that of global economic output, has performed well during the upheaval.

The OTC derivatives market is where businesses, pension funds, hedge funds and other professional investors go to hedge against and bet on changes in interest rates, currency values and just about any commodity from oil to oranges.

For years, the sheer size of the market has fueled calls for oversight, but U.S. officials believe the hands-off approach has worked and that the market has helped fend off what could have been worse losses.

After a lengthy review, the President’s Working Group on Financial Markets — the top U.S. market regulators — said on March 13 that the OTC market had “coped quite well” at a time of heightened price volatility and surging trading volumes.

Many experts agree.

“If you look at the credit derivatives market and you look at the swap market, they have performed as expected: rather well,” said Sharon Brown-Hruska, former chairman of the Commodity Futures Trading Commission, who helped shape the current hands-off regulatory approach.

“It’s not been demonstrated that derivatives have had much of anything to do with this subprime (mortgage) crisis,” she said.

While regulators have decided not to push for oversight power, they have prodded this sophisticated and private market to improve how it reports trades and values transactions. The Federal Reserve is expected to release recommendations for further changes this month.

WRONGLY TARRED?

With nearly every key financial crisis in the past 20 years — the recent demise of Bear Stearns BSC.N, the bankruptcy of Orange County, California, in the 1990s and the unwinding of the hedge fund Long Term Capital Management — accusing fingers have often pointed toward the OTC derivatives market.

The U.S. housing crisis is no exception.

“I think a very strong argument can be made that the OTC stuff is what is driving the economic downturn,” said University of Maryland professor Michael Greenberger, a former head of trading and markets at the CFTC.

“These instruments are so opaque and ill-reported ... I’m not sure that the (chief financial officers) themselves fully understand all their liabilities,” he said.

Greenberger worked at the CFTC in the 1990s, when he and then-Chairman Brooksley Born made a push to beef up regulation of these products, which had been determined by the courts and lawmakers to be neither futures contracts nor securities, and therefore not appropriately regulated by either the CFTC or the Securities and Exchange Commission.

The top industry group says the market has been wrongly tarred in the U.S. subprime debacle and warns against confusing problems with securitized debt products issued to raise capital and derivative transactions undertaken to manage risk.

“There is a lot of confusion between different types of financial transactions that has led people to calling some of the underlying instruments in the (housing) turmoil derivatives. Those are not derivatives,” said Gregory Zerzan, who heads global policy at the International Swaps and Derivatives Association.

RISK MANAGEMENT WORKING

Even as troubles in the housing and mortgage-backed securities markets exploded, the OTC derivatives market kept growing as firms sought hedges against heightened risks.

“We’ve seen increasing levels of interest-rate swap activity. These contracts are helping financial institutions manage volatile rates in a way no other contracts can,” said Mark Brickell, chief executive officer of swaps broker Blackbird Holdings Inc.

For example, the San Francisco Federal Home Loan Bank, part of a Depression-era system established to purchase mortgage assets and widen access to credit, last week reported a surge during the first quarter in derivatives income to $120 million from $12 million during the same quarter a year ago.

“This increase was primarily due to an increase in net interest income on derivative instruments used in economic hedges,” the bank said.

Brickell, an industry veteran, said regulation was unlikely to improve on a market that was already working well.

“Government involvement at almost every step of the housing finance process did not prevent the subprime crisis. The lender is regulated. The underwriter of the mortgage-backed security, the securities salesman, most of the largest investors are regulated,” he said. “It’s a reminder that you can’t simply regulate risk away.”

Reporting By Joanne Morrison; Editing by Jonathan Oatis

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