Sunday, October 18, 2009

Don’t Let Exceptions Kill the Rule

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CONGRESS began the work of reforming our troubled financial system last week, and a bill aimed at regulating derivatives passed the House Financial Services Committee on Thursday.

Derivatives — contracts that theoretically protect buyers from unforeseen financial calamities but more often are used to fuel raw speculation — were, lest we forget, at the heart of the banking crisis.

Credit default swaps, Wall Street-style insurance contracts that let speculators bet against a company or debt issue, propelled the American International Group off the cliff. Those swaps also linked millions of trading partners, creating a web in which one default threatened to produce a chain of corporate and economic failures worldwide.

And derivatives aren’t going away. In the right hands, they help parties manage risk. In the wrong hands, they are among the most destructive financial products ever invented. So reforming the $42 trillion market for credit swaps is crucial if taxpayers are to be protected from future rescues of institutions deemed not only too big but also too interconnected to fail.

The best aspect of the House bill is that it requires many swaps to be traded on exchanges just like stocks, subjecting them for the first time to the light of day. But elsewhere in the bill, known as the Over-the-Counter Derivatives Market Act of 2009, exceptions to this exchange-trading rule undermine its regulatory power.

Derivatives regulation has been on the nation’s financial reform agenda for months. Undoing the Clinton-era law that exempted swaps from oversight is seen as imperative, except perhaps by big banks that deal in the contracts. It’s worth noting that many members of the Clinton economic team, including Lawrence Summers, Timothy Geithner and Gary Gensler, now hold pivotal policy-making positions in the Obama administration.

In August, the White House sent its derivatives proposal to Congress, recommending that all standardized contracts trade on an exchange. But big banks dealing in swaps don’t want exchange trading, where pricing and the identities of participants would be more publicly transparent. Savvier swaps customers would soon pay less on their transactions and bank profits would fall.

Some swaps buyers also dislike exchange trading because it would require them to put up a cash cushion — or margin — before a transaction. This is to help prevent counterparty failures, but participants in the market prefer not to pay this freight. They’d rather taxpayers foot the bill for a possible collapse later on, as they did with A.I.G.

Representative Barney Frank, the Massachusetts Democrat who is chairman of the House Financial Services Committee, dismissed criticism of the bill he is steering along, saying that it would create incentives to make exchange-traded swaps the norm. “We passed the bill to drive most of the swaps onto exchanges,” he said in an interview Friday. “End users will move in that direction to save money.” But Michael Greenberger, a University of Maryland law professor and an expert in derivatives, criticized the House bill. “While I know there was a good-faith effort to improve the regulation, the plain language of the legislation can only be read as a Christmas tree of decorative gifts to the banking industry,” he said. “And this is being done when people acknowledge the unregulated O.T.C. derivatives market was a principal reason for the meltdown.”

A SIGNIFICANT exception in the bill says that if a transaction involves a company that uses a swap to offset its commercial risks — the bill defines this entity as an end user — its trade does not have to be put on an exchange. This was intended to address complaints from swaps customers — like airlines or oil companies that hedge their commercial risks — that their costs would rise unnecessarily under the bill.

The problem is the bill’s lack of specificity about what an end user is. Indeed, what is to stop a hedge fund or private equity firm from setting up companies to meet the “end user” definition so their trades could escape scrutiny?

Another questionable exemption says that if a swap is to be exchange-traded, it must be deemed “clearable” by facilities known as clearinghouses. Some of these are partially owned by banks. If a clearinghouse decides that the swap can be cleared, then it can trade on an exchange.

Gee, do you think the banks might be a tad hesitant to punt a very lucrative line of business onto less profitable exchanges? Do you think they might have an incentive to say that the most profitable swaps simply aren’t clearable?

Conflicts posed by swaps dealers’ stakes in clearinghouses is no small thing. Those on the House committee who amended the bill recognized the problem and decided to restrict swaps dealers’ ownership of clearinghouses to 20 percent; the balance might go to public investors.

To be sure, the House bill is just the first step in what is likely to be a long road to reforming this huge and opaque market. And more oversight is surely better than none. The House Agriculture Committee, which oversees the Commodity Futures Trading Commission, will take up the matter now.

But the stakes for taxpayers who might have to take on yet another wave of financial bailouts in the future are even higher. And allowing the very institutions that imperiled our economy to weaken derivatives reform would be a grave insult to those whose rescue money is being used, even today, to generate bank profits and a recent round of outsize bonuses.

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