Good morning ladies and gentlemen. I am delighted to be the keynote speaker at this symposium on the regulation of OTC derivatives. As many of you know, I retired as CEO of the International Swaps and Derivatives Association ("ISDA") at the end of 201 1. While I remain an advisor to ISDA and its Board, my remarks today will strictly be my own. I take full responsibility for my opinions and hope they give one and all pause for thought and discussion as we proceed through the symposium.
While I am a graduate of Fordham Law School, I have never practiced law. My background has been in management, trading and underwriting, and analysis. As you know from the introduction, I was the first Global Head of JP Morgan's Derivatives Group, the head of Global Markets at Merrill Lynch, founder of the first AAA-rated swap company, one of a team that liquidated Long Term Capital Management in 1998 and 1999, and a manager of my own hedge fund for a number of years. I also had a valuable stint on the board of a credit reinsurance company. I should also mention I spent several years at JP Morgan as a lending officer to large companies and banks in the United States. These were all important experiences.
Today, I will talk about facts and numbers as well as the common sense needs for regulatory reform. I will suggest that we may be heading for some regulatory overkill just as we may be seeing the same with respect to bank capital requirements. I will start my remarks by discussing the role of OTC derivatives in the financial crisis. Then I'll comment on counterparty losses sustained by the U.S. banking system on OTC derivatives. Some of what I say may surprise you. In my next topic, I will discuss the present marketplace, and how much has been accomplished to make the markets safer and more efficient - to use ISDA's new tag line. I think some of this will also surprise you. Then I will look at overkill - how proposed regulations create enormous costs with very little benefit. I will offer alternatives as well. But please remember these opinions are my own.
I. OTC DERIVATIVES IN THE FINANCIAL CRISIS
Shortly after my arrival at ISDA, I published an Op-Ed in the Financial Times. In that piece, I argued that the main cause of the financial crisis was the US residential and commercial mortgage markets, and bad lending and underwriting decisions and practices.1 I did not go into why this happened. We have all read explanations, and I believe blame was widespread: regulators and policymakers made terrible mistakes; Government-sponsored enterprises ("GSEs") had conflicted business models; mortgage bankers were unscrupulous in originating mortgages; rating agencies developed horrid rating practices; securities dealers structured complex mortgage products around the rating agency criteria and then actually decided they could hold them on their balance sheets once AIG Financial Products ("AIG FP") closed for business. An entire insurance industry class disappeared as they insured these toxic securities, some at the beckoning of dealers who realized that their holdings were plummeting in value, and some at the request of investors who wished to bet against mortgages. I then listed many of the dozens of companies that had ceased to exist due to one underlying cause: tremendous losses on real estate exposure.2 Some of the exposure was taken in derivative form but a good deal of this was meant to insure dealers that already had taken the risk.
In September 2008, Lehman Brothers filed for bankruptcy.3 Panic unfolded when money market funds broke the buck.4 These funds had invested in cash securities issued by Lehman Brothers. At least we have not heard pundits say that derivatives caused the money fund problems. Lehman's derivatives portfolio was duly unwound. Much interdealer exposure was unwound at SwapClear, where $8 trillion was moved at a cost of around $200 million, all covered by initial margin. Dealers and other counterparties unwound positions in due course and submitted claims in bankruptcy. …