Prime Time? Dodd-Frank’s Central Clearinghouse Problem and Falling Standards

One of the most hoped-for outcomes of the Dodd-Frank Act is its aggregation and accumulation of over-the-counter (OTC) derivatives risks within a small number of central clearinghouses. These highly qualified, terribly conservative, and well-managed organizations have proven themselves expert at what they do, namely setting margin, requiring collateral, and monitoring their markets to the point that mistakes are rare, and even then, mostly inconsequential.

Fair enough. These entities have shown themselves to be first-rate in their understanding of risk and financial instruments. Aside from the occasional fraud (the Chicago Board Option Exchange’s falsifying of reports is one disturbing but rare example), these entities have performed through the worst of markets without the benefit of government assistance or guarantees. The current crop of managers within these entities will certainly carry the lessons of recent years into the future, applying their knowledge and expertise in ways that will go largely unseen, but valuable nevertheless.

They aren’t the problem.

The Future is the Problem

At some point, these seasoned professionals will give way to a younger cadre of whiz kids who will have their own way of looking at the world. They, like we did, will think they have a better way of dealing with such matters and will endeavor to make their mark. It is the way of the world, but it is then that we will face the problems for the decisions we have made since 2008.

I can foresee a day when the new breed of risk “experts” decides that it is time to discard the baggage of the past. Their technology will be deemed so advanced that it will not be susceptible to the problems we faced five years ago. They will think they have solved the margin, collateral, and liquidity concerns that burdened the derivatives Neanderthals of the early 21st century. They will start to whittle away at risk management standards in the same way we did with mortgage-backed securities, all in an effort to boost market share, or profitability, or personal pay, or maybe even social or economic development. Whatever the cause, the result will be the same — lower standards and problems.

Only this time, these clearinghouses will encapsulate all kinds of risks and interconnections that had been dispersed among various banks and investment banks the last time around. And when these super structures hit the wall, all hell will break loose.

Mortgage Lending Standards

All of this comes to mind thanks to a pleasant lunch I had recently with a friend in downtown Charlottesville, Va. The pleasant autumn afternoon was belied by the dark tale he was sharing about his banking competitors in sleepy Cville.

The local housing market, he considered, seems to have turned a corner. Yes, market values declined, but insulated by the seemingly bottomless budget of the University of Virginia and the pseudo-aristocracy in the surrounding county, market values didn’t crater anything like they had in Las Vegas, Phoenix, or various parts of Florida.

But valuations he’d seen were but one data point leading to his assessment. The increase in lending activity in the area was another. But there was one other disturbing data point that signaled a return of the bad ol’ days of 2006 to 2008.

Competitors in the mortgage market, he said, already were making loans equal to 100% of appraised value. And this just five years on from the greatest financial crisis of our time. Most of us can remember where we were when Lehman or AIG failed, or when the U.S. Treasury stepped in to guarantee seemingly all financial contracts. Those heady and frightening days of October 2008 don’t seem that long ago in one sense.

Always Looking to the Bright Side

Hope springs eternal with us finance folks. We are more likely to happily whistle along with Eric Idle’s “Always Look on the Bright Side of Life” from the movie The Life of Brian than to find an inner Morrissey of the band The Smiths. Indeed, bankers are not unlike former NFL media magnate and defensive back Deion Sanders, who was able to forget getting burned by an opponent for a touchdown so that he could focus on how great he was at pass defense. Likewise, finance people are able to ignore the failures and problems of the recent past so that we are able to work on that brighter future.

Working on the psychology of finance people is the work of a lifetime. In the meantime, however, maybe we could take the time to rethink whether it is such a good idea to consolidate derivatives risks within these clearinghouses. And we should move while these institutions still employ risk managers who remember the lessons of the recent past, and are capable of doing something about them.

Photo credit: iStockphoto.com/pkline