Housing Bubble or Derivatives Inferno -- Comments on Gensler's FT Article

Last week the Financial Times published an article by CFTC Chairman Gary Gensler – “How We Can Stop Another Derivatives Inferno.”   The article compares the 2008 financial crisis to the 1871 Great Chicago fire, which legend has it was started when Mrs. O’Leary’s cow kicked over a lantern, though the real cause remains a mystery.  With respect to current events, Gensler writes:  “In the autumn of 2008, certain financial institutions kicked over the lantern that set off the financial crisis – a fire that nearly burned down the global economy.”

As one might expect given his current position, Gensler’s article concentrates on derivatives.  Still, it is remarkable that an article about the financial crisis does not mention the housing bubble, subprime mortgages, or securitization.

One of the underlying questions about the financial crisis, on which there is not much, if any serious analysis, is what role the OTC derivatives market played.  The financial crisis is marked by a housing bubble which finally bursted.  Did OTC derivatives help create that housing bubble by enabling financial intermediaries to take on more leverage?  Once the housing bubble burst, did OTC derivatives make things worse?

The causes of the housing bubble will be debated for some time.  There will be discussions about the role of loose monetary policy, lax regulation, the madness of crowds, government policies designed to encourage home ownership, Fannie Mae and Freddie Mac, securitization, capital rules, rating agencies, etc.

The clear evidence that OTC derivatives made things worse was the AIG debacle.  Gensler focuses on that and also mentions the efforts to mask Greece’s true fiscal situation.  His remedies are to regulate OTC derivatives dealers directly and to require standardized OTC derivatives to trade on exchanges and to be submitted to clearinghouses.

While a good case can be made for these recommendations, many of the derivatives that AIG was engaged in would most likely not be viewed as “standardized,” since they were on particular CDOs, which have been identified by CUSIP number and counterparty in a document now publicly available.  Also, all the parties, including AIG were subject to regulation, either here or abroad.  While it is not surprising that the Office of Thrift Supervision was unable effectively to supervise AIG as its holding company regulator, other regulators had tools at their disposal to curtail the growing exposure of regulated entities to AIG if they had become concerned.  In any case, the exchange and clearing house recommendations seem to have little bearing on the AIG situation, nor apparently on what Greece and its financial institution counterparties may have arranged.

If AIG had been subject to regulation as an OTC derivatives dealer, this particular aspect of the financial crisis might have been prevented if its regulator had seen the problem.  But would that have prevented the housing bubble and its bursting?  While financial bubbles are probably inevitable, a better diagnosis of the causes of the financial crisis and an analysis of its effects is needed before anyone says they have definitively figured out how to prevent such large bubbles from forming and mitigating the damage of the bubbles that do form when they burst.

Finally, I am not sure what lantern it is that Gensler thinks financial institutions “kicked over” in 2008.  I would use a metaphor.  The subprime mortgage problems served as the catalyst setting off the crisis by acting to burst the housing bubble, which in turn created a host of other problems.