Think Twice Finance

The Subprime Crisis, Part 3: The Empire Strikes Back.

The reaction against futures, once their existence was validated by the Treasury-Federal Reserve Study (see Subprime Crisis, Part 2) in the early 1980’s, took a more tactical form. The question became what tribe would dominate the offering of these contracts, and how would their use by the bottle-babies of the regulatory world, the 12,000 or so small banks that the US bank regulators saw as a particularly vulnerable part of their protectorate, be prevented from using them?

The regulatory position on both issues was clear as day to insiders. The futures market would be best managed by the New York Financial Institutions – the devils the regulators knew – rather than a bunch of Chicago grain and cattle traders – the devils the regulators didn’t know. And the accounting rules for futures would be rigged so that regional bank use of futures would look very ugly to stockholders.

The first tactic failed. Futures remained the province of Chicago traders until electronic trading technology made location semi-irrelevant in this decade. Futures trading appears to be something of a melee and futures traders, not the belts and braces type. But the reality is the profession requires a variety of scarce and valuable skills. New York never appreciated this and so was doomed to failure.

But the regulator’s dubious accounting rules succeeded. These accounting rules were opposed by the AICPA (the accountants who recommend changes in accounting rules) by the banks themselves, and by the exchanges, to no avail. The regulators threatened to introduce a set of regulatory accounting rules (acronym RAP) to coexist beside the appropriate accounting method, Generally Accepted Accounting Principles (GAAP.) This was unacceptably compromising to the Financial Accounting Standards Board, which promptly caved in for more than a decade, until the proper rules were finally introduced in 1998. This episode has an eerie resonance with the 2003 regulatory push to permit banks to offer off-balance-sheet Mortgage Conduits in opposition to the original accounting standards promulgated by accountants implementing Enron reforms.

Next post shows how the new accounting rules had the unintended effect of precipitating the explosion of interest rate swaps in the late 1980s, the first of a series of “innovations” in derivatives markets, that as derivatives aged, moved them closer and closer to the abyss that is the subprime mortgage crisis.