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Analysts Mull Treasury’s Calls for Derivatives Regulation

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.

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