Friday, January 22, 2010

Obama's New Bank Restrictions Increase Systemic Risk: The VIX Rose 19 Percent

Congressional and Executive Branch changes to laws, regulations and policies to reduce the systemic risk of the financial system, such as Obama's new banking restrictions, often have an opposite effect and increase the systemic risk.

As an example, Franklin Edwards and Edward Morrison explained in an article "Derivatives and the Bankruptcy Code: Why the Special Treatment?" (Winter 2005, Yale Journal of Regulation) that simple, logical changes to laws and regulations to prevent systemic risk in a bankruptcy proceeding created the need for the Federal Reserve to step into the collapse of LTCM (Long Term Capital Management) to prevent a systemic risk crisis. The very Congressional changes to the US Bankruptcy laws for derivative settlements intended to prevent a systemic risk crisis exacerbated the LTCM crisis and forced the Federal Reserve to intervene to prevent the failure of other financial institutions.

Edwards and Morrison state:
Thus, one view of the potential for LTCM to have caused a systemic crisis is that this crisis was precipitated by the very provisions of the Bankruptcy Code that were designed to assure stability in derivatives markets.

Had these provisions not been adopted, it is very likely that there would not have been either an “abrupt and disorderly close-out of LTCM’s positions” or an “unwinding [of] LTCM’s portfolio in a forced liquidation.” There probably would have been no need for the Federal Reserve to intervene to prevent a “seizing up of markets . . . [that] could have potentially impaired the economies of many nations, including our own.”
Earlier in the article, they write:
The collapse of Long Term Capital Management (“LTCM”) in Fall 1998 and the Federal Reserve Bank’s subsequent efforts to orchestrate a bailout raise important questions about the structure of the Bankruptcy Code. The Code contains numerous provisions affording special treatment to financial derivatives contracts, the most important of which exempts these contracts from the “automatic stay” and permits counterparties to terminate derivatives contracts with a debtor in bankruptcy and seize underlying collateral. No other counterparty or creditor of the debtor has such freedom; to the contrary, the automatic stay prohibits them from undertaking any act that threatens the debtor’s assets. It is commonly believed that the exemption for derivatives contracts helps reduce “systemic risk” in financial markets, that is, the risk that multiple major financial market participants will fail at the same time and, as a result, drastically reduce market liquidity…. Risk of a systemic meltdown arose there and prompted intervention by the Federal Reserve precisely because derivatives contracts were exempt from the automatic stay. Derivatives contracts may merit special treatment, but fear of systemic risk is a red herring.
Yesterday (Thursday), the S&P Volatility Index (CBOE VIX) rose 19.2 percent for a gain of $3.59. Market participants expect stocks to be almost 20 percent riskier than they were before President Obama announced his banking risk proposal. The market does not believe his proposal reduces systemic risk.

Franklin R. Edwards is the Arthur F. Burns Professor of Economics and Finance, Columbia Business School.

Edward R. Morrison is an Associate Professor of Law, Columbia Law School.

[Also see my other post: "Obama-Volcker Rule Will Not Prevent A Future Financial Crisis"]

1 comment :

  1. If securities rules applied to federal research grants, half the professors would be in jail! Obama's constituencies are universities, lawyers and unions. The universities are in it for the grants. Any Republican that votes money for universities is a traitor.

    UPI June 6, 1992 Sovern took over at Columbia after student protests of 1968 and New York's fiscal problems in the '70s resulted in less financial support for the school, a situation made more dire by recent federal government budget cuts. . . But Columbia will be looking for a new president in a period troubled by criticism for destroying records that were being reviewed for improprieties. Universities in general have been under greater scrutiny for how they charge the government for federally sponsored research.

    They love third world students because they don't expect the professors to work for the tuition! Surely You Are Joking Feynman p 215 "If I ask you a question during the lecture, afterwards everybody will be telling me, 'What are you wasting our time for in the class? We're trying to learn something. And you're stopping him by asking a question'."

    When Obama falls in 2010, we should go through the grant-grubbing Ivy Leagues that produce commie-nutty organizers with a flame thrower! Ivy League universities are not good at getting students jobs, only grants to be commie nutty organizers. If you are liberal, anything you do is inherently ethical for the cause, but if you are a conservative, and believe in GOD, family or business, your very moral fiber, even down to trivial autonomic responses, is subject to persecution as either dangerously criminal or the result of clinical illness. Bush 43 had two Ivy degrees and they treated him as stupid because he was conservative even though he had better grades and entrance scores and took a lot tougher courses than Gore. Professors are the ultimate molestor high priests because they extort and control your transcripts and your grants if you turn them in. Like a cult, they will make your children denounce you and everything you stand for as unworthy. The lowest level university bureaucrats actually suffer the worst affectations and are likey to be the most vicious persecutors of your children. No business ever trusts such left wing graduates who don't believe in capitalism and become crooks because they are taught the only way business makes money is crooked so they seek to avenge their unemployability through their own crookedness. The universities consider real jobs and competition beneath them, so they want their little sissies to live off grants, even in the hard sciences or business. How many of their engineering professors have Professional Engineering certification? Almost none! They love foreign students because they slave up and don't expect professors to actually work for the tuition, like American students do. No middle class parent should consider sending their kids there, because these schools will destroy your entire family. The only schools that understand middle-class values are for-profits. Middle class parents foolish enough to buy into the Ivy League dream die way too young.