Friday, May 14, 2010

In Defense of Over-the-Counter Derivatives - Swaps grew out of the banking system because writing risky, custom contracts is a lot like making loans

In Defense of Over-the-Counter Derivatives. By MARK C. BRICKELL
Swaps grew out of the banking system because writing risky, custom contracts is a lot like making loans.
WSJ, May 14, 2010

In 1989, there were $2.5 trillion of swaps outstanding, according to the International Swaps and Derivatives Association. Today there are $464 trillion. Why?

Few business activities grow by 30% annually for decades, so this success deserves scrutiny. The first step is to understand that swaps—as federal law calls the custom-tailored derivatives that banks and their corporate customers privately negotiate—help companies shed the risks they don't want and take on risks they prefer to manage.

McDonalds, for example, is expert in training young workers, marketing, and managing global real estate. But if selling hamburgers worldwide generates revenue in Japanese yen and New Zealand dollars, it also means smaller profits when those currencies decline in value. A swap contract can shift that risk to a bank that is as good at managing currency risk as the corporation is at buying beef. By outsourcing the management of its financial risks, a company can focus on its true sources of comparative advantage. That strengthens the firm and speeds economic growth.

Within the financial system, transferring risks is no less important. Different banks specialize in managing different risks and have customers with differing needs. If banks lent money to or wrote swaps with no one but their clients, they would accumulate too much risk in their portfolios. They manage this by writing swaps with other banks or nonbank risk-takers like hedge funds to transfer some risks away.

More companies, governments and banks are using swaps for two reasons.

First, swaps can be custom tailored in helpful ways. For example, anticipating falling interest rates, a company with fixed-rate debt can "swap" from fixed to floating by having its bank pay the fixed interest rate on the firm's five-year bonds, precisely to the dollar and to the day. In return, the company pays the bank the floating rate of interest, as it changes during those five years. Simpler derivatives, like futures, lack this attribute because they must be standardized to trade on futures exchanges.

Swap contracts are also customized to manage the credit risk of losing money if a counterparty defaults. Using private credit information, banks can decide to make a swap without taking collateral, just as they would to make an unsecured loan.

Futures traders, in contrast, outsource the credit risk of all their derivatives to central counterparties called clearinghouses, which require cash collateral or "margin" payments. If American companies were required to make such margin payments on their swaps, they would have to set aside billions of dollars that would no longer be available, as 3M testified last year, to build more factories or create new jobs.

Second, it costs less to move risks with swaps than with cash. The treasurer of the company that prefers floating-rate liabilities could ask his investment banker to track down the investors who own his fixed-rate securities and buy them back. He could negotiate a new, floating-rate bank loan to pay for it. But think of the transaction costs involved. One phone call to a swap desk achieves the same result at less cost.

You can see why swap activity grew out of the banking system. Writing custom-tailored, long-term contracts with credit risk is a lot like making loans to companies. That's why a very high proportion of interest-rate, currency, equity, and credit default swaps has a bank on at least one side of the deal.

This is also why, in this country, a policy consensus has existed for more than 20 years that swaps are not appropriately regulated as futures or securities. Instead, swap activity has been monitored for the most part by the banking authorities. Banking supervisors have had a good window on the business, and the opportunity to give a nudge when they think banks need it. The contracts the banking supervisors don't see (the ones between nonbanks) are unlikely to be systemically important. They are fewer, smaller and shorter term—and with proper credit analysis even these swaps will pop up on the radar of banks and their supervisors.

Good business systems improve as they grow. Recently, swap banks have chosen to send roughly $200 trillion of interbank swap contracts to central clearinghouses. They have created central data repositories to record their deals and give all regulators a wider window on the business. They have increased their use of technology to confirm trades. All this was achieved without new laws or regulations.

But what of AIG? That federally regulated thrift holding company lost billions by writing mortgage insurance, purchasing mortgage-backed securities, and writing credit default swaps that guaranteed mortgage bonds owned by others. Its losses across multiple business lines were not a swaps problem, they were a mortgage problem—and what was true for AIG was true across the financial system.

More than a trillion dollars of losses accrued when virtually every institution in the housing finance chain, including mortgage lenders, securities underwriters, rating agencies, Fannie Mae and Freddie Mac, investors, and the federal regulator at each step of the process underestimated the likelihood of an increase in defaults by mortgage borrowers. No one, certainly not the federal banking supervisors who already have reviewed derivatives activity before and during the crisis, has attributed this problem to swaps. But swaps did enable a few, wiser investors to let some air out of the housing bubble by putting on short positions efficiently.

A system-wide misjudgment of mortgage risk caused the financial crisis; understanding how that happened is the essential first step toward the policy reforms that will help us achieve the goal of financial stability. Legislation that targets over-the-counter derivatives will not further that goal.

Mr. Brickell was a managing director at J.P. Morgan and served as chairman of the International Swaps and Derivatives Association.

U.S. Alliances in East Asia: Internal Challenges and External Threats

U.S. Alliances in East Asia: Internal Challenges and External Threats. By William Breer, Senior Adviser, Center for Strategic and International Studies
The Brookings Institution, May 2010

May 20 marks the 60th anniversary of the ratification of the U.S.-Japan alliance by Japan’s House of Representatives. While the alliance is a bilateral arrangement, it has had a significant impact on Asia as a whole and is regarded by other nations as a key part of the regional security structure. The following is a brief survey of the treaty's role in the maintenance of peace and stability in the Asia-Pacific. It also demonstrates that the tensions currently confronting the U.S.-Japan alliance are not unique, but in fact have been faced by various bilateral alliances in the region; some have been resolved successfully and some have not.

Most experts believe that the series of alliances the United States created after World War II was one of the most astute and far-sighted acts of diplomacy in history. The alliance with Japan laid the foundation for reconciliation between two enemy nations and the groundwork for the reconstruction of a nation whose industrial power, infrastructure, and morale lay in shambles but which rose to become the world’s second largest economy. The alliance played a key role in the Cold War by allowing the United States to cover the USSR's eastern flank and demonstrating to China and North Korea that we would defend our interests and those of our allies in East Asia.

The arrangements with Japan provided a base from which the U.S. was able to defend its Republic of Korea ally from aggression by the North. Although the Korean War ended in an armistice—not a victory for the ROK, U.S., and their allies—without the use of facilities in Japan the peninsula could have been lost. Another plus was that American protection relieved Japan of having to acquire an offensive military capability, possibly including nuclear weapons. This reassured Japan’s neighbors that it would not again become a threat to their independence.

The result has been five decades of peace in Northeast Asia without a serious arms competition and remarkably few serious threats to the peace. This, along with the stimulus of Korean War procurement, enabled Japan to devote its resources to economic development which resulted in a previously unimaginable economic expansion and improvement in living standards. The ROK, Taiwan, and later China, piggy-backing on Japan's success and partaking of Japan's foreign aid and investment policies, replicated Japan's experience and delivered even faster rates of economic growth and prosperity to their people. None of this would have been possible without the American alliance system and the stability it provided throughout the region. The American presence in East Asia has been reassuring to allies, and our naval and air deployments beyond the region have played a major role in protecting the key energy trade routes through the Malacca Strait and Indian Ocean.

American alliances around East Asia

While the results have been good and generations of alliance managers on both sides can take considerable satisfaction in their accomplishments, the presence of foreign military bases in sovereign countries is not necessarily a natural phenomenon. Many Americans feel that we are motivated by altruism in undertaking to defend other peoples and that our actions are benign. But this view is not necessarily shared by citizens of host countries, many of whom view the American presence as an extension of the occupation in the case of Japan, an intrusion on sovereignty, or as a nuisance. These feelings are reinforced by a complex legal regime governing our bases and serious incidents (rape, hit-and-run accidents, etc.) involving American personnel. At the same time, the base arrangements provide significant employment opportunities for local populations there are some who welcome their presence. The policies of the new Hatoyama government reflect these contradictory views.

Governments have responded to these issues in different ways. In Japan we have developed mechanisms for dealing with problems and have accumulated a great deal of experience in working together. As a result Japanese citizens have tolerated a foreign military presence remarkably well. This may be a historic first. The leaderships of both nations realize the important role that the alliance plays in maintaining stability in East Asia and have striven to protect it.

In the Philippines, where we had maintained major naval and air facilities for many decades, a combination of domestic political pressure, the destruction of one base by a volcanic eruption rendering it unusable, and a strategic reassessment in Washington resulted in the withdrawal of U.S. forces, but the continuation of the defense treaty. In recent years, small numbers of U.S. military advisors have assisted the Philippine armed forces in countering Muslim insurgents in the southern islands of Mindanao and the Sulu Archipelago.

This was followed a few years later by the New Zealand government's refusal to allow port calls by U.S. Navy vessels, as clearly envisioned in the ANZUS treaty, without a prior finding by the prime minister of New Zealand that the ships in question were not carrying nuclear weapons. This was contrary to our long-standing policy of neither confirming nor denying the presence of nuclear weapons aboard our ships and put at risk our arrangements with Japan. The result was a suspension of our defense relationship with New Zealand and strained relations with this ally for a number of years. When the U.S. Navy revised its "neither confirm nor deny" policy our defense relationship gradually improved. However, as Secretary of State George Shultz stated at the time of the break in 1986, "We remain friends, but we are no longer allies."

We do not have a security treaty with Taiwan and do not maintain forces on the island. Under the Taiwan Relations Act, however, we are obligated to provide certain defensive weapons and equipment and it is understood that we would come to Taiwan's defense in a clear-cut emergency. While this is not an explicit or legal commitment, U.S. policy toward Taiwan has assured the people of Taiwan and other countries in the region that the United States takes the security of Taiwan seriously and that only a peaceful, non-coercive resolution of the political issues across the Taiwan Strait would be satisfactory.

Under our mutual defense treaty with the Republic of Korea we deploy sizable ground and air forces to the peninsula to backup ROK defenses in the event of aggression by North Korea. We have made clear to the North that the American commitment to the defense of South Korea is rock solid, and the peace has been maintained. While the U.S. posture has effectively deterred North Korea from a frontal attack, it has not prevented North Korea from mounting provocations, ranging from the capture of the USS Pueblo in 1968, through the tree-cutting incident in 1976, to the recent apparent sinking of an ROK warship. The biggest challenge posed by North Korea is its determination to acquire deployable nuclear weapons which would threaten U.S. interests throughout East Asia, potentially pose an existential threat to Japan, and create a proliferation problem of vast proportions. Our treaty relationships with Japan and Korea, and our many decades of experience working together, have greatly facilitated our cooperation on this issue.

From time to time, base issues (one of our major bases is in the center of Seoul) and occasional incidents caused by American personnel have aroused latent nationalism among the people, which has in the past resulted in large scale demonstrations, strains in our relations with the host government, and pressure to relocate our facilities. That we are making necessary adjustments to our deployments without significantly reducing our support for the ROK or the effectiveness of our deterrent is a credit to the common sense and foresight of Korean and American officials, many of whom have devoted entire careers to the management of the defense of the ROK.

Australia and Southeast Asia have been direct beneficiaries of America's alliance structure. While Australia is a member of ANZUS it has never become a platform for large scale American deployments. It has a keen interest in the stability and economic well-being of Northeast Asia because of its enormous and profitable economic ties with the region. It is also a beneficiary of American attention to the sea lanes to its West and North on which it depends for the bulk of its international commerce. Australia has been a valued ally in a large number of military operations in which the U.S. has engaged over the last fifty years, despite periodic internal opposition to American policy.

What about the future?

Despite periodic outbursts of opposition to nuclear ship home-porting or other aspects of the U.S. deployment in Japan, support among the Japanese people for the security relationship has remained at a remarkably high level. As a result the U.S. has had a relatively free hand in the use of our facilities and in the deployment of forces there. Generations of Japanese leaders have cooperated with U.S. security needs. These include a contribution of $13 billion in support of the first Gulf War, the dispatch of ground forces in support of our operations against Saddam Hussein, and generous foreign assistance to many places in which we have a strategic interest, including Afghanistan. Japan has also for the past 25 years made major contributions - $4-5 billion per year - to the support of U.S. forces in Japan. Who would have imagined 60 years ago that there would be significant U.S. military facilities in Japan in 2010?

There are some clouds on the horizon. The planned relocation of Marine Corps Air Station Futenma has posed major political issues for both Japan and the United States. Okinawa is host for the majority of U.S. forces in Japan and has endured the lion's share of the impact of foreign bases. Under considerable local pressure, Tokyo and Washington in 2006 reached an agreement to move the noisy Futenma facility from a densely populated area in central Okinawa to a sparsely populated region in the north. But the new Japanese administration, which took office in September 2009, ran on a platform calling for the removal of the facility from Okinawa. The U.S. side has adamantly insisted that the agreement be implemented as is and the two sides have reached an impasse which could result in the resignation of the prime minister. This is not a satisfactory situation, especially when it is not clear that the Marine Corps deployment in Okinawa is a vital piece of our deterrent posture on which it is worth Japan spending more than $10 billion to relocate.

The decision to attack Iraq in 2003 and the sloppy execution of the war called into question American judgment and leadership. Uncertain progress in Afghanistan has compounded this. Neither of these has significantly weakened Japanese support for the alliance, but these creeping doubts, coupled with an increasingly inward-looking Japanese public, have helped create an era in which American strategic assessments and solutions will be viewed with greater skepticism. Another serious incident involving U.S. military personnel would put further strain on the relationship. This is not to say that we cannot cooperate on a wide range of issues, but such cooperation will require higher level USG attention and a willingness on both sides to listen more attentively to the other's point of view. On the Japanese side, it will require the development of greater expertise among its political leaders and greater awareness among the general public of the changing environment. The increasing economic, military, and political importance of China demands that our two nations work together to assure a successful outcome in Asia.

Press Briefing

May 14, 2010

Gender-Based Violence Must Be Addressed in Fight Against HIV/AIDS

The Wrong Kind of Toyotathon, by Ronald Bailey
The unintended consequences of an unintended acceleration panic

Remarks with Afghan President Hamid Karzai in a Moderated Conversation

New START Will Require Diligent Senate Consideration

The European Rescue Plan: Opportunities and Limitations. By Domenico Lombardi, Nonresident Senior Fellow, Global Economy and Development
The Brookings Institution, May 13, 2010

Congress’ Historic Decision to Ignore Its Basic Duty

Hello Supply Side, by Alan Reynolds
On Kevin D. Williamson's Goodbye Supply Side

Can We Revoke Faisal Shahzad's Citizenship? - The challenge of terrorists with U.S. passports is serious. We are not powerless to deal with it.

Joint Statement By The Delegations Of The Russian Federation And The US On New Start Treaty

In Defense of Over-the-Counter Derivatives - Swaps grew out of the banking system because writing risky, custom contracts is a lot like making loans

The David and Nick Show - Call it the audacity of hope. [On David Cameron and Nick Clegg]

Still Segregating Voters - Texas defies racial gerrymandering. WSJ Editorial
WSJ, May 14, 2010

The courts and the U.S. Congress continue to insist that racially gerrymandered voting districts are necessary to elect minority candidates, but election returns tell another story.

On Saturday, Irving, Texas held its first city council elections under a new system imposed by a federal court last year. Hispanic activists had sued the city, which is more than 40% Latino, arguing that Irving's at-large system was discriminatory because no Hispanic had ever won a council seat. As part of the settlement, Irving created six single-member voting districts—including one that was drawn specifically to ensure the election of an Hispanic—and two at-large districts. So what happened?

The newly created "Hispanic district" was won by Mike Gallaway, a black candidate who easily beat Trini Gonzalez, an Hispanic. And Roy Santoscoy, another Hispanic, defeated a white incumbent for one of the open at-large seats that was supposedly out of reach to Hispanics due to Irving's allegedly racist voting system.

Texas is hardly an outlier when it comes to upending the notion that racial gerrymandering is necessary because whites vote in lock step against minority candidates. U.S. Representatives Keith Ellison of Minnesota and Emanuel Cleaver of Missouri are black Democrats who represent districts that are more than 60% white. In 2008 President Obama did better among white voters in North Carolina, South Carolina, Virginia, Georgia and Texas than either John Kerry or Al Gore had done.

"The irony is that the American voter has moved on," says Edward Blum, an expert on the Voting Rights Act at the American Enterprise Institute. "He's willing to take race and ethnicity out of the election equation, yet the liberal advocacy groups and the courts refuse to accept this reality."

The Credit Raters Brawl - Al Franken wants a cartel and a trial lawyer payday. George LeMieux rides to the rescue

Hypothetical, Preemptive Alarmism on Replacements for BPA

Is Free-Range Meat Making Us Sick?

US-China Ten-Year Framework for Cooperation on Energy and Environment

U.S. Alliances in East Asia: Internal Challenges and External Threats

Joint Statement on US-Russian Consultations on Adoption

Eating soybeans increases soybean-specific IgG antibodies

Incentives vs. Government Waste - What if bureaucrats could benefit financially from finding cost savings?

Kagan and the 'Public Safety Exception' - Does the nominee share Justice Stevens's view on Miranda warnings?

U.S. Satellite Shootdown: The Inside Story