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?Democrats Push to Regulate Key Factor in Meltdown

Image has not been found. URL: /wp-content/uploads/2008/10/stock-exchange.jpgNew York Stock Exchange (Flickr: ralphunden)

As Congress mulls how to buoy a sinking economy, lawmakers seem increasingly determined to rein in the unregulated derivatives industry, which many suspect has caused much of the mess.

During two congressional panels convened this week, key lawmakers have vowed to push new regulations for the derivatives market, with a particular focus on complex instruments called credit default swaps, or CDS.

Those swaps — effectively private insurance contracts in which one party pays another when a third party defaults — are used by banks and other financial institutions to spread risk. Unlike insurance contracts, however, no one in Washington is charged with overseeing them. The practice has left trillions of dollars in exposed debts — including mortgage-backed securities — in the hands of the same firms that are flailing under the current economic crisis.

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Illustration by: Matt Mahurin

The lack of oversight, combined with the sheer complexity of the layered transactions, has left lawmakers convinced that new protections are needed, but unsure what form they should take. The agriculture committees in both the House and Senate took up the issue this week, because past deregulations of CDS had fallen under their jurisdiction.

“There is an estimated $55 trillion in credit default swaps somewhere out there,” Rep. Collin Peterson (D-Minn.), chairman of the House Agriculture Committee, said Wednesday, “but no one knows for sure if any of these swaps offset each other, exactly who is on the hook for these swaps, who is trading with who and on what terms. And worst of all, no one has any idea who is solvent and who is upside down.”

These comments emerge in the middle of an economic downturn that’s already caused Washington to intervene in the finance industry in ways not seen since the Great Depression. On Tuesday, the Bush administration officially announced a partial nationalization of the banking industry, pledging to invest as much as $250 billion directly in the nation’s largest financial institutions before the end of the year. Word of the plan sent stocks soaring on Monday. Yet on Wednesday, news of slow consumer spending sent the Dow Jones Industrial Average plunging more than 700 points.

In the face of the downturn, both Congress and the White House are scrambling to search for possible remedies. Regulating the CDS market has been increasingly floated as one such reform.

On Wednesday, some administration officials joined Peterson and other House lawmakers in calling for a system allowing “clearinghouses” to scoop up the CDS, thereby mitigating risk among the participants in CDS contracts. All are hoping this might help thaw out the frozen credit market. There is growing debate about how many clearing entities would be created, and whether they would fall under the jurisdiction of the Commodity Futures Trading Commission or the Federal Reserve.

“Clearinghouses ensure that every buyer has a guaranteed seller and every seller has a guaranteed buyer,” said Walter Lukken, acting chairman of the Commodity Futures Trading Commission. “No U.S. futures clearinghouse has ever defaulted on its guarantee.”

The rise of CDS as tools of the finance industry has been meteroric. Lukken said the global notional (or face) value of CDS has doubled each year this decade. In 2007, according to the Bank for International Settlements, that value was roughly $58 trillion — close to the gross domestic product of the entire world.

There’s good reason for that skyrocketing popularity. First, CDS can be traded, or swapped, by large financial firms more easily than insurance policies can. And second, the buyer doesn’t have to prove it can cover the risk if the deal goes south.

The swaps were used by financial institutions to back their obligations — including mortgage-backed securities — in order to make even risky investments appear healthy.

Experts agree that, used properly, CDS are vital tools for managing market risk. But there are perils. Testifying before the House committee Wednesday, Henry T.C. Hu, a finance expert at the University of Texas School of Law, attributed the downfall of American International Group largely to its estimated $440 billion exposure to CDS. “It’s hard to disentangle [AIG's CDS ventures] from the failure of the entity itself,” Hu said.

The enormous leverage assumed by CDS inspired Warren Buffet, in 2003, to warn, “The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).”

Complicating the picture, CDS are private over-the-counter deals, not traded openly on any exchange. Not only do Washington regulators not monitor these swaps, they are legally prohibited from doing so.

Testifying before the committee, Erik Sirri, director of the SEC’s trading and markets division, pointed out that his agency, charged with regulating broker dealers, is authorized to intervene in the CDS market only in cases of fraud. In recent years, he said, many firms tended to hold their swaps outside the realm of broker dealers, in unregulated corners of the finance industry.

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Sen. Tom Harkin (WDCpix)

Both Lukken and Sirri urged lawmakers to consider a model in which separate, global entities act as competitive clearinghouses. But that idea also raised concerns among some Democrats. Rep. Jim Marshall (D-Ga.) wondered how the competitive clearinghouse model would differ from the competitive swap model that many contend just failed. “It would potentially be another layer of lip-gloss,” Marshall said.

On Tuesday, Sen. Tom Harkin (D-Iowa), chairman of the Senate Agriculture Committee, held a similar hearing on CDS, concluding that legislation will be needed to rein in the industry.

“The credit-default swaps and derivatives have been put together by mathematics and physics geniuses, but carried out without an understanding of human behavior and market behavior,” Harkin said. “We must have regulations that will protect the rest of the economy from the excesses of the financial markets.”

If, indeed, the absence of a regulated derivatives market is partly to blame for the current economic crisis, both parties share the responsibility for bringing that environment about. In late 2000, Congress passed an enormous end-of-the-year spending bill packed to the gills with goodies. One law tucked into that package was the Commodity Futures Modernization Act (CFMA), which explicitly prohibits Washington regulators from overseeing CDS. Congress passed the bill easily, and President Bill Clinton signed the legislation into law later in the month.

A description of the CFMA says it would “promote legal certainty, enhance competition, and reduce systemic risk in markets for futures and over-the-counter derivatives.” Now some lawmakers are looking back on the passage of that bill will rueful eyes.

“Instead of alleviating risk,” Rep. Earl Pomeroy (D-N.D.) said Wednesday, “we compounded it.”

In the face of the scrutiny, voices for the derivatives industry insist that it’s been wrongly blamed. Appearing before the House panel Wednesday, Robert Pickel, CEO of the International Swaps and Derivatives Assn., defended the industry, placing the blame for the mess squarely on “ill-advised mortgage lending.”

“Both the role and effects of CDS in the current market turmoil have been greatly exaggerated,” Pickel said. “To say that CDS were the cause, or even a large contributor, to that turmoil is inaccurate and reflects an understandable confusion of the various financial products that have been developed in recent years.”

Such responses didn’t go over so well with the primarily Democratic House panel. Rep. Tim Walz (D-Minn.) said Pickel’s argument represents a delusional optimism about the industry’s role in the crisis — “like the band playing on the Titanic.”

Peterson also had a terse message for the industry. “Your folks need to get real,” he told Pickel, “if they think they’re not going to get regulated.”

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