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Analysts Mull Treasury’s Calls for Derivatives Regulation

May 14, 2009 at 6:30 PM EDT
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The Obama administration has called for Congress to tighten regulation on risky trade derivatives, the kind of complicated financial instrument that brought down insurer AIG. Analysts examine what the move means for financial markets.
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JIM LEHRER: Next, the government’s plan for dealing with some of the financial world’s most unregulated deals. Jeffrey Brown has that story.

JEFFREY BROWN: They were created as a form of managing risk, but the exotic financial instruments known as derivatives grew over the last decade into a vast and largely unregulated market that is widely blamed for fueling the global financial crisis and bringing down a number of major institutions.

Yesterday, the Obama administration proposed new rules for monitoring and restricting their use. More on that in a moment.

But, first, a reminder of how derivatives work, particularly the type known as credit default swaps. Paul Solman explained those in a report for us last fall. Here’s an excerpt.

PAUL SOLMAN, economics correspondent: Credit default swaps, these paper contracts turn out to be a key culprit in the current crisis, implicated in the demise of the giant brokerage company Bear Stearns, the giant insurer AIG, and perhaps more giants to come.

As of last year, according to an industry group, there were not $62 million, not $62 billion, but $62 trillion worth of credit default swaps out there. That’s more than four times as much as the GDP of the entire U.S. economy.

But what are these things? In essence, they’re just insurance contracts that pay off in the event of a disaster, a credit default.

But before explaining any further, a brief reminder as to why any of us in the NewsHour community might buy insurance, because, as we’ve learned from childhood, life is full of risks.

A flood or fire could destroy our house, at the very least costing us a fortune. We could have a motor vehicle accident, another pretty penny. A bad fall? And without health insurance, where would we be?

CARTOON CHARACTER: Who are you?

CARTOON CHARACTER: Mr. Magoo, my name is Tire Biter, the fly-by-night insurance company.

PAUL SOLMAN: So we protect against the possibly disastrous tab by paying a small one, buying insurance policies.

CARTOON CHARACTER: I’m covered!

PAUL SOLMAN: In return, the company assumes the risk, by pooling the premiums from lots of people and paying out from the pool in the event of disaster. The insurance company takes a cut for the service.

Past history dictates how much they should charge to afford the expected payouts.

So, say for the sake of argument and good footage, that we invest in a successful firm like Hyundai here. We buy its bonds, thereby lending to Hyundai, instead of buying shares of the company.

Offering credit is safer than buying equity, because lenders get their money before shareholders, should the company ever go bust.

So imagine a Hyundai bond for a million dollars pays an annual rate of interest, principal to be paid back in full after a certain number of years. But even this might make us nervous. What if disaster struck Hyundai?

And that’s our cue for the villain of the piece to make its re-entrance: the credit default swap.

We can buy a credit default swap — thanks very much — that would pay us in the event that Hyundai defaults on its bonds. Its credit goes up in smoke. We would have swapped our money for just such a disaster in buying the credit default swap.

And who would have sold it to us? Anyone who might have looked at the solid and successful history of Hyundai and rightly thought, “Default? Ridiculous. Write default insurance and make a quick buck from nervous Nellies like those at the NewsHour.”

Now, I don’t know if there actually were Hyundai credit default swaps. This market is so unregulated, no one may know.

Derivatives are like bets

JEFFREY BROWN: Well, in the future, the Obama administration now says, someone -- a regulator -- should know the answer to Paul's question.

Among its new proposals from the administration: requiring that derivatives be publicly traded on electronic exchanges or a central clearinghouse; mandating traders and players to put up minimal capital reserves to cover losses; and empowering regulators to demand more information and to crack down on market manipulation. All this next goes to Congress.

But first, we parse the problem and proposals with two securities law professors, Lynn Stout of UCLA and John Coffee of Columbia.

Well, Lynn Stout, let's continue with the explanation first. How do you define the problem that most needs to be addressed?

LYNN STOUT, UCLA School of Law: I think it would be useful to start by defining a derivative, which isn't easy, because the Wall Street folks who came up with the idea of derivatives have worked pretty hard to surround them with jargon that makes them seem like they're very difficult to understand.

But they're actually very simple: They're bets. They're bets on something that's going to happen in the future. And in the case of credit default swaps, they're a bet on whether or not a company that issues a bond is going to default on that bond.

Now, you can use bets to reduce your risk. So if I own a bond and I buy a credit default swap, then I'm protected in case the bond becomes valueless. But what's been missed is that you can also use bets to just speculate, and that's what happened in the derivatives markets.

People who didn't even own bonds were buying and selling derivatives because they thought that they could predict the future. Some of those people were banks and insurance companies. And when their bets went bad, they discovered they didn't have any money, and that meant they couldn't lend to anybody else.

So I'm very glad to see that the Obama administration is taking the lead on this and trying to come up with some way to address the problem and get the derivatives genie back in the bottle.

Dealing with systemic risk

JEFFREY BROWN: So, John Coffee, when you look at these proposals put on the table, what jumps out at you, in terms of dealing with the problems that Lynn Stout just raised?

JOHN COFFEE, Columbia Law School:  Well, essentially, the government is trying to deal with the problem of systemic risk. Systemic risk is the danger that the failure of one financial institution will trigger a cascade, like a parade of falling dominoes, until a number of financial institutions have failed and the availability of credit is frozen. And we were staring that problem in the face last October.

The best way to deal with that is to make sure that the industry as a whole -- through clearinghouses and other bodies, and through capital adequacy regulation -- will guarantee the obligations of its members.

In effect, we've always done that with banks, but there are -- there's now this new shadow banking system in which there are hedge funds, there are insurers, there are all kinds of other players who are performing functions much like banks.

And so I think what the government is saying here, very simply, is, if you are too big to fail or too entangled to fail, then we have to regulate you so you don't fail, and that means regulating your risk, your leverage, your capital adequacy, and the potential for market manipulation.

These are important first steps, but the devil is in the details, and that still very much has to be filled in.

JEFFREY BROWN: Well, before we get to that, Lynn Stout, what about the call for larger capital requirements? That, too, would help address some of the things you raised?

LYNN STOUT: I think that's a very good start. If you're going to let people gamble, you ought to at least make sure that they have the money to gamble with.

But this legislation, or the proposed plan, would go further than that. It would not only require derivatives traders to report their trades so that we actually know who is betting what with whom where and how much -- which is a very good start -- it would not only have capital requirements for derivatives traders, but some derivatives would be required to be traded on a regulated -- in effect, an exchange, under the watchful eyes of the regulators, who might even impose position limits, essentially telling some traders, "No, you can't make that trade."

Different kinds of derivatives

JEFFREY BROWN: Now, John Coffee, you just mentioned the devil being in the details. One of the questions that still seems to be out there is treating some derivative trades differently from others, so-called standardized trades versus non-standardized. So I'm going to ask you to explain what the difference is.

JOHN COFFEE: Well, the key point is that, if you regulate only the standardized derivatives, which are kind of plain-vanilla derivatives that deal with an easily estimated risk, then the other unregulated derivatives may still create the volatility and systemic risk that we're worried about.

And if you regulate one intensively and the other sector not at all, you're creating a very strong incentive for the players in this market to avoid regulation by shifting over to the use of non-standardized derivatives. And I think we will see some migration in that direction.

This whole market was non-standardized or customized derivatives negotiated on a one-to-one basis. I think what we're going to see, as this moves on to exchanges and clearinghouses, is a necessary movement towards greater standardization.

But there will be those who resist that, either because they need customized derivatives or because they wish to risk -- to avoid and evade regulation. I think the government has to be careful about that.

The other critical element here is, who is this jurisdiction going to be given to? Washington is a world in which it matters critically which agency is empowered, and there are at least three agencies that are contending in a kind of bureaucratic rebounding contest for enhanced power: the Federal Reserve, the SEC, and the Commodity Futures Trading Commission.

And the government has not yet addressed how they plan to parcel out this new authority, and there will be a lot of fighting over that issue.

JEFFREY BROWN: Yes, Lynn Stout, what do you think about that? But here there's a call for more regulation, but it's not clear quite who would do that regulation, right?

LYNN STOUT: Yes. And I think one of the problems is that there is a long-standing turf battle between the Securities and Exchange Commission, the SEC, and the Commodities Futures Trading Commission, the CFTC, over derivatives. And, in fact, that turf battle, in part, is one of the reasons why they were not well-regulated in the first place.

The Commodities Futures Trading Commission, interestingly enough, actually has more of a history in regulating this kind of speculative derivatives trading and is more experienced at it. The SEC traditionally has taken more of a hands-off approach, simply requiring disclosure and not getting too involved in how people actually do their business.

But the SEC is the much larger agency, has lot more clout. So you've got a smaller agency with less clout, but maybe more experience with this particular problem, going up against a much larger agency that swings more weight.

Which agency will regulate?

JEFFREY BROWN: And, John Coffee, as this goes into the political process, you'd also expect a lot of debate over the details, I suppose, as you go along, from the industry, for example, right?

JOHN COFFEE: Well, the industry is not all on one side. The industry is different interest groups. Some of them would much prefer to have regulation by the Commodities Future Trading Commission. These are basically the futures industry in Chicago. And we have the large banks that would prefer the Federal Reserve. And we have the securities brokers that are comfortable with the SEC.

The danger in all of this is the problem of regulatory arbitrage, because if you get to pick your regulator, everybody will run to the regulator of least rigor, the regulator that requires you to do the least. We've seen that happen in the past.

There are arguments for each of these. I personally think the SEC has the best capacity for enforcement. They are the most experienced and toughest of the enforcement agencies, and we need a good deal of that right now.

But we really do need to unify some of the regulatory fragmentation we now have. We, frankly, have a balkanized system of financial regulation, and different interest groups can exploit that.

JEFFREY BROWN: All right. We will leave it there and watch as the process goes forward. John Coffee and Lynn Stout, thanks very much.

LYNN STOUT: Thank you.

JOHN COFFEE: Thank you.