Saturday, October 10, 2009

A warning on derivatives regulation

If it ain't broke, don't fix it. This is what the LSTA is saying about the Total Return Swap (TRS) market.
Bloomberg: Proposals to regulate privately negotiated derivatives may reduce “sorely needed liquidity” in the high-yield, high-risk loan market, according to the Loan Syndications and Trade Association [LSTA].

TRS has been utilized before, during and after the crisis, and credit losses associated with the product have been immaterial. The reason is simple. TRS providers have generally required significant initial margin as well as variation margin. Even during the worst of the crisis, JPMorgan (which is generally extremely conservative) was providing TRS financing on leveraged loans. It had the ability in many cases to terminate the contracts (not to roll maturing TRS), but it didn't. It increased initial margin for new transactions, but kept the business running.

Banks can not hold the bulk of the corporate loans they originate because they are balance sheet/capital constrained. There are numerous investors out there interested in this product, but require some leverage. In this environment TRS is the only way to achieve it. The proposed derivatives regulation may significantly hurt this market and other markets. The concept that if it's not standard, kill it, will not only hurt large corporate finance, but will impact middle market companies as well.

Bloomberg: The highest capital requirements, while not defined, would be imposed for derivatives that aren’t backed by clearinghouses, which would likely include total-return swaps because they differ from deal to deal. “TRS, which are customized, could see punitive capital charges,”

As a general comment, included below is the statement from Dave Hall of Chatham Financial for the House Committee on Financial Services. It's a warning about unintended consequences of derivatives regulation:

OTC derivatives are very important tools for businesses to efficiently and effectively reduce risk. Their use is now accepted for many good reasons and is now common – in fact, 94% of Fortune 500 companies and thousands of small businesses use derivatives to manage business risks.

Dave Hall - Chatham Fin Corp

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