In the 2008 financial crisis, financial derivatives played an outsized role. While there would not have been a financial crisis if a trillion dollars of substandard mortgage loans had not been made, the carnage was amplified when savvy investors bet against those mortgages by buying derivatives known as credit default swaps. They could not have bought such derivatives without willing counterparties, and indeed, the fees those counterparties earned were so large that those swaps were eagerly sold in large volumes by a number of large (but naïve) financial institutions, including AIG and several prominent German banks. When those mortgages went bad, a number of those institutions posted huge losses and all but failed, adding hundreds of billions of dollars to the global cost of the crisis.
Given this, you might think that lawmakers and regulators would be particularly focused on making sure that information on credit derivatives would be fully available and easily obtained by those studying the economy. Dodd-Frank is the law designed to prevent the next financial crisis and did address the derivatives market. It has some useful aspects in this regard, but also significant limitations. And Dodd-Frank doesn’t apply to financial institutions in most of the globe.
So derivative information is still fragmented, incomplete, and often difficult to obtain. See the chart below, which shows clearly how rapidly derivative volumes grew at German banks—60% in a scant 24 months—and was a clear indicator the coming troubles. Note how these chastened German banks have since pulled back on this activity.
In the United States, derivative information is available, except for a troubling loophole that allows banks to avoid reporting derivatives if they are in a “deguaranteed” foreign subsidiary. Is there a lot of unreported volume because of this loophole, or only a little? Probably the former. And information on derivatives at non-bank institutions is fragmented and difficult to obtain.
Chinese derivative data is largely unavailable, perhaps because the volumes are small—but China is that part of the world with the most troubling credit trends, so the omission is especially concerning.
Data for British banks is largely unavailable. The Bank of England has that information, but will not share it due to confidentiality agreements with the British banks.
Beyond these, there are more major countries than not where it is difficult to obtain derivative information.
You may recall the Brooksley Born story. As early as 1998, Born, then head of the Commodity Futures Trading Commission, had advocated greater reporting and regulation of derivatives, but President Clinton’s Treasury Secretary Robert Rubin (and later Treasury Secretary Larry Summers), Securities and Exchange Commission chairman Arthur Levitt, Fed Chairman Alan Greenspan, and various senators derailed her efforts, not wanting to constrain activity in derivatives. This contributed to our 2008 global disaster. Will we be able to spot the next financial crisis in the making? It will be significantly harder given the fragmented, limited derivative information available.
