Credit Default Swaps: Bad Enough to Ban?

Fear of the destructive potential in this little-understood but massive market was an important reason -- if not the only reason -- the Federal Reserve did not allow Bear Stearns or AIG -- both big players in the CDS market -- to fail. Many observers argue the Fed's decision to let Lehman Brothers fail on Sept. 14 threw the CDS market and, in turn, the stock market into turmoil, which led to Congress' passage of the controversial $700 billion bailout on Oct. 6 and its $250 billion investment in the banking system eight days later.

Credit default swaps have also caught the attention of New York state and federal attorneys who are investigating market manipulation in the product, The New York Times reported Monday.

Harkin suggested that if CDS cannot be outlawed, they should be traded on an exchange and subject to regulation by state insurance commissioners. It is unclear, however, exactly what he contemplates banning or better regulating. Congressional Quarterly on Oct. 14 reported Harkin planned to introduce a ban on naked CDS. But in hearings, Harkin often seemed to lump them in with other complex financial derivatives. At one point, he referred to a $587 trillion market for "all types of financial swaps," and later a $62 trillion CDS market, so when he asked "shouldn't we just outlaw all of these fancy little things?" observers were left to draw their own conclusions.

Harkin's press office did not return calls asking them to clarify his position.

The Fed, which has been trying to get some control over the industry for more than three years, is also getting more involved. The central bank is suddenly pushing hard to centralize trading in CDS by establishing what is known as a clearinghouse, which would make sure both parties to a trade meet certain regulatory and capital requirements. Fed officials have told banks a clearing function needs to be established in a matter of days, says Jamie Cawley, CEO of credit derivatives broker IDX Capital. A New York Fed spokesman declines to comment on how urgently the Fed is pushing its agenda.