There seems little doubt tighter regulation of esoteric financial derivatives that have played a major role in the financial crisis is on the way, but one influential lawmaker is weighing a more drastic measure: banning them outright. Sen. Tom Harkin (D., Iowa), chairman of the Senate Agriculture Committee, which regulates derivatives and so has a claim to authority over credit default swaps, has repeatedly questioned whether the $60 trillion industry should be outlawed. The unregulated derivatives, which insure lenders against borrowers' default on debt, have been blamed for the financial meltdown of companies like American International Group ( AIG - Get Report), which required a multi-billion government bailout last month. "They've been touted as reducing risk, but as we have seen, it has actually increased the risk, the systemic risk, of the whole society," Harkin said during an Oct. 14 hearing exploring the need for greater regulation of the derivatives. It is unclear how much support an outright ban of CDS would have in Congress and Harkin has not yet introduced legislation on the subject. Still, the debate has exposed the enormity of the gulf between a Democratic party that looks to have a significant mandate to regulate business for the first time in decades and a Wall Street community that is used to being left alone by Washington. "People on trading desks don't really typically know how to interact with people who are making laws, because most of the stuff we do is unregulated," says a senior trader at a large bank, who declined to be identified.
The federal government's aggressive actions to protect the financial system, including a plan to invest $250 billion in preferred equity stakes in major banks like Goldman Sachs ( GS - Get Report), Morgan Stanley ( MS - Get Report), JPMorgan Chase ( JPM - Get Report) and Citigroup ( C - Get Report), suggest that strings will be attached in the form of stricter laws, although we haven't yet had much of a taste of what those laws might be. That may be why the threat to ban CDS has caught Wall Street totally unprepared. The financial industry's chief lobbying arm in this area, the International Swaps and Derivatives Association, seems unable to bring itself to admit the need for any regulation at all. Ask ISDA if it supports regulation, and it doesn't provide a clear yes-or-no answer. "ISDA continues to support the development of options for participants in the credit derivative markets to undertake their business in the most prudent and efficient manner and to the highest standards of commercial conduct," the trade group says in an emailed statement. "ISDA is not the most constructive force in all of this," says John Coffee, a law professor at Columbia University. The Wall Street trader agrees. "Congress is swinging all the way in one direction with a pendulum, the Street is saying 'no regulation,' and we're going to end up in the wrong place," he says. "We're going to have to work together to come up with good regulations." CDS are unregulated, privately negotiated contracts that allow creditors to insure themselves in the event that their borrower defaults. But the derivatives have also been used for speculative purposes -- these are known as "naked" CDS, in which third parties trade the derivatives as a way of betting on the health of a given company or, in some cases, a basket of securities.
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.
Columbia University's Coffee says setting up a clearinghouse is critically important. "Until we get a clearinghouse, there is the continuing possibility, maybe even more than a possibility, that sooner or later we'll have a major crisis in the over the counter derivatives market," he says. "It still could develop because AIG appears to be still several billion -- several dozen billion short of what it needs to remain as a going concern." AIG spokesman Nick Ashooh says AIG is working on selling assets and still has access to several billion dollars worth of credit, but says he "will not speculate," on whether AIG might need to borrow more money from the government. Despite the threat of a CDS-led market meltdown, Coffee says an outight ban is ludicrous. "This would be the 21st century equivalent to the Luddites, who 200 years ago tried to destroy all the knitting mills because they were putting workers out of business," he says. "The credit default swap lacks transparency today, but in terms of what it does: it's basically a sophisticated insurance policy, and it makes every bit of sense that people who want insurance should be able to purchase it." That way of thinking has led several observers to argue that the market should be restricted to creditors who want to insure themselves against a default by a debtor, as a ban on naked CDS would do. Michael Greenberger, law professor at University of Maryland and a former director of trading and markets at the Commodity Futures Trading Commission, favors that solution, which he estimates would shrink the market by 80%. Naked CDS should probably be banned, he says.
"I'm perfectly happy to have a discussion with those who would advocate otherwise, but I don't understand what the economic interest in
naked CDS is," Greenberger says. "It is nothing more than taking a flyer, for example, that AIG will fail, or Lehman will fail, and I don't think we should be writing those guarantees. They're essentially shorts on companies outside of the regulated stock market. If you want to short a company, short it on the stock market; don't buy a derivative." But such a remedy would amount to an outright ban, according to the trader, who says banks that write CDS protection must be also able to hedge themselves, which he says is done by actively buying and selling naked CDS. While hedge funds are big users of CDS and would probably prefer to have them around as another weapon in their arsenal, they have less to lose than the banks if the instrument goes away. David Tepper, founder of hedge fund Appaloosa Management, says CDS should be centrally cleared with less leverage allowed and more money down required. "There's nothing inherently wrong with CDS," Tepper says. "The problem was when you only put down 2% and could do things endlessly. But if they ban, it they ban it. I'll live with that." The banks are likely to be less blasé, as is evident from the frustration in the words of the CDS trader who suddenly finds his livelihood threatened by a regulatory zeal in Congress that has been dormant for a generation, at the very least.
"Literally 85% of the information that's out there, whether it's in
The Wall Street Journal or on TV or in the Senate hearings, it's just flat out wrong," the trader says. He may be right, but it's hard to sympathize with him. Wall Street is a secretive place, as evidenced by his refusal to speak on the record. When 60 Minutes did a report on credit default swaps earlier this month, it was also turned down for interview requests by all the major investment banks. Wall Street didn't want anyone to understand this business, and now it may be too late. The economy is in shambles, the Democrats are in charge, and patience is thin.