New Derivatives Regulations
May 15th, 2009 - 34 Comments
The Obama Administration on Wednesday announced a proposal to regulate the credit derivatives market as part of an effort to avoid another financial crisis. According to Smeal’s Jean Helwege, “The lynchpin of the plan is the requirement that all credit default swaps (CDS) contracts trade on a regulated exchange so that they involve a reasonable amount of capital and to increase the transparency of the market.”
But, Helwege says, “The plan to require a CDS exchange misses the crux of the crisis, as it does almost nothing to reform the current setup.” She says the country would be better served by focusing reforms in the mortgage market, specifically targeting Fannie Mae and Freddie Mac.
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The motivation for this reform is the failure of the giant insurance company, A.I.G., which became financially distressed as a result of writing hundreds of billions of CDS contracts (essentially offering insurance on bonds).
The plan to require a CDS exchange misses the crux of the crisis, as it does almost nothing to reform the current setup. If the requirement is extremely onerous to Wall Street, the CDS as we know it will cease to exist and the bankers will invent a new contract that evades the regulations but includes the essence of a CDS contract. If the regulation is not onerous, the CDS will start to trade on the exchange and two changes will occur that President Obama believes are very important.
First, the trades will be written down in a central place so that regulators can observe the depth of the market and understand the prices involved in these transactions. While this sounds like a major innovation, regulators can and do buy data on the CDS market from a vendor whose coverage is quite comprehensive.
Second, the CDS exchange will require that sellers maintain a margin account and put up more cash as the CDS premium increases. The market already requires that CDS sellers put up more cash as bond default probabilities increase. Indeed, this is the source of AIG’s cash crunch—their trading partners were requiring more and more collateral as the economy collapsed and corporate bond prices declined. Putting this requirement into writing as part of a CDS exchange would not have made AIG more or less vulnerable to losses surrounding CDS contracts.
Proponents of the CDS exchange argue that regulators would now be able to see that firms like AIG have such a large exposure to this market and prevent another $160 billion taxpayer bailout. They pair this argument with a plan to have a systemic regulator to make sure firms like AIG do not go unregulated. They overlook the fact that the world can see the extent of AIG’s exposure in its SEC filings and more importantly, that AIG and many other financial holding companies are required to report their activities to their current regulator, the Office of Thrift Supervision (OTS). The OTS, like the Fed for bank holding companies, is charged with examining the health of their deposit-taking firms and understanding the nature of their risks to make sure the deposits are safe and sound. On this score, the CDS exchange would make no difference except to change regulators.
Even if the establishment of the CDS exchange successfully leads to improved oversight of the CDS market by raising the transparency of prices, making sure all involved parties put up sufficient capital, and getting another stronger regulator involved in the supervision of CDS sellers, the plan is unlikely to do much to avoid another financial crisis. The current crisis did not stem from the failure of the CDS market. The crisis did not begin with the failure of AIG. Recall that the crisis started with the collapse of the housing market and the subprime mortgage market. It is almost as if President Obama has confused the CDS market with the CDO (collateralized debt obligation) market. A CDO is a bond that is backed by other bonds, which themselves may be backed by more bonds. The bonds used as collateral in CDOs are often backed in part by subprime mortgages. While some CDS contracts are written to cover potential losses on CDOs, most of the CDS market insures defaults of ordinary bonds, not bonds backed by subprime mortgages.
Whenever a major financial crisis hits Main Street, public outcry drives politicians to reforms that are aimed at avoiding another crisis. Our last financial crisis felt by Main Street involved savings and loans (S&Ls), which culminated in the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989. When President George H.W. Bush proposed these reforms, the S&L debacle was estimated to cost the U.S. taxpayer upwards of $100 billion. Though this may seem like chump change in light of the current billion dollar bailout, at the time, the price tag was sufficient to outrage the ordinary taxpayer. Bush’s plan required S&Ls to keep more capital, to avoid risky assets such as junk bonds, and to improve regulatory oversight by folding the S&L insurance fund (FSLIC) into the FDIC and eliminating the Federal Home Loan Bank Board (FHLBB), then the regulator of S&Ls. FHLBB, which was widely considered to be a weak regulator of depository institutions and snidely referred to inside the Beltway as “Flub,” was essentially turned into a new regulator with a new boss and became part of the Treasury Department to make sure they were integrated into the administration. Ironically, that new regulator was the Office of Thrift Supervision (OTS).
In their defense, OTS cannot be blamed for causing the current crisis, although they could have carried out their job as the main regulator of AIG with much greater skill. The crisis stems from the housing bubble and the growth of the subprime market. The former can be much more squarely blamed on Alan Greenspan’s low interest rate policy of the early 2000s and the latter in part on the perpetually misplaced support for the mortgage behemoths, Fannie Mae and Freddie Mac. Fannie and Freddie’s shareholders made money by packaging mortgages into bonds and the two were severely overleveraged going into the housing bubble of the 2000s. They were only able to survive in such a shaky state with the support of Congress, who ensured their ability to raise funds at rates reflective of Treasury backing. Congress believed the support of Fannie and Freddie would help homeowners get cheap mortgage financing and therefore increase homeownership in the U.S., especially among the part of the population that could scarcely afford to carry a home (the subprime market).
This confusion about the source of the current crisis is a poor strategy for carrying out reform. While the establishment of a CDS exchange seems relatively harmless—it will either be ineffectual or simply put more of the same structure on the market as already exists today—the downside of such a proposal is that it takes our eye off the ball. The main problem is the mortgage market and the number one area for reform in that market should involve Fannie and Freddie. When these two enterprises stop receiving government backing, we stand a chance to avoid another mortgage-related financial debacle. We can also ask that reform include a plan to beef up our existing regulators and make sure that regulated financial firms are well capitalized. We supposedly already did that with FIRREA in 1989, and subsequent reforms such as FDICIA in 1991, but we did not carry through on those policies as well as we could have (for example, the Secretary of the Treasury does not seem to acknowledge a decade later that the OTS is part of his department), and capital requirements have been relaxed not strengthened since then. The bottom line is that existing regulations were not sufficiently enforced and regulators abdicated their responsibilities to ensure safe and sound banks.