The new William Kristol-Keith Hennessey think tank Economic Policies for the 21st Century has posted a new article by the think tank's managing director, Christopher Papagianis, who was special assistant to domestic policy to President George W. Bush. He writes:
The International Monetary Fund (IMF) estimates that aggregate under-collateralization in the OTC derivatives market is likely to be between $2 trillion and $2.5 trillion. The IMF estimates that the five largest U.S. bank holding companies have roughly $500 billion in under-collateralized derivatives exposure, while the five largest European banks owe $600 billion more to counterparties than they've posted in collateral. This is an enormous capital hole at the very heart of the financial system and an obvious source of systemic risk.
...Rather than eliminate the efficiencies that come from allowing lenders and derivatives dealers to operate under one roof, Congress should simply eliminate the advantage swaps dealers have afforded one another by mandating uniform margin and collateral requirements on all contracts. Parties wishing to insure against credit events or adverse movements in currencies or interest rates should be required to post collateral that covers the entire fair value of the position plus some additional margin to account for further movements.
Mr. Papagianis's invocation of "systemic risk" brings to mind Professor Eugene Fama's comment: "The term 'systemic risk' is less than 20 years old. It has become a scare term that governments use to justify bailout actions detrimental to taxpayers." In this case, Mr. Papagianis isn't suggesting a bailout, but a rule-tightening.
Whenever a sentence begins with "Congress should simply," I get nervous. "Mandating uniform margin and collateral requirements on all contracts" isn't as simple as Mr. Papagianis might think. Assessing the value of collateral or the creditworthiness of a counterparty is a complex skill that bankers are paid a lot of money to get right. Do we really trust Congress to write rules that will protect bankers from their own mistakes?
If the IMF or Mr. Papagianis think the big five banks have under-collateralized derivatives exposure that is "enormous," they should sell any stock that they have in those banks, or short the stocks. But since when did it become the role of Congress to protect Goldman Sachs's shareholders -- Warren Buffett, Lloyd Blankfein -- from taking on too much risk? Managing risk is supposed to be a core competency of bankers, not of congressmen.
If the fear is that this kind of betting is going to take down an FDIC-insured bank, or that the Federal Reserve is somehow subsidizing the risky behavior with cheap access to capital, then maybe the better solution would be to rethink federal deposit insurance or the role of the Federal Reserve, rather than having Congress insert itself into contracts between consenting parties.