The usual channel for a financial crisis is the banking sector, which includes the investment banks. In particular, I have been very afraid of a blow-up in derivatives, such as credit default swaps. They are dangerous, because there is no assurance that the counter-parties can make good on their promises to make the swaps-buyer whole, in the event of default. The main reason for this lack of assurance is that nobody knows who they are, nor what their financial strength is.
Because the vast majority of derivatives are written in the U.S. and Europe, it would be useless for the U.S. to improve regulation of derivatives, because the business would just move to Europe. Naturally, the trade group, the International Swaps & Derivatives Association, was opposed to any additional regulation. Negotiations have been ongoing for five years. Frankly, I was just hoping to live long enough to see any meaningful regulation of derivatives.
Buried deep in yesterday’s Wall Street Journal was the news that a deal had been reached! While I don’t know the details yet (such as the effective date), I am just excited that, apparently, all derivatives have to be traded through a clearinghouse, which captures enough data for us to measure who is holding how much risk. This would be a huge step forward!
While it is almost unfashionable to be happy about anything right now, especially when the bears are running down Wall Street, it is the same emotion that a heart attack victim has when he wakes up to find the doctor inserted the stent that will save his life.
Bring on your recession, bring on your bear market — we’ll be just fine!
In fact, I’m already feeling better.