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October 19, 2008

OP-ED CONTRIBUTOR

Swapping Secrecy for Transparency

 

By CHRISTOPHER COX

 

Washington

THE historic volatility in the financial markets has raised important questions about the lack of meaningful regulation of financial instruments known as credit-default swaps. The $85 billion government rescue last month of the insurance conglomerate American International Group, for example, was needed in large part to protect those who held A.I.G.’s credit-default swaps and risked crushing losses if those instruments weren’t honored.

A.I.G. had issued $440 billion in credit-default swaps — which are like insurance contracts on bonds and other assets that are meant to pay off if those assets default. But as markdowns on A.I.G.’s investments in subprime mortgages led to downgrades in its credit ratings, the holders of the credit-default swaps demanded more collateral, which A.I.G. could not provide.

As large as A.I.G.’s swaps exposure was, it represented only 0.8 percent of the $55 trillion in credit-default swaps outstanding — this total market is more than the gross domestic product of all nations on earth combined.

Yet despite its enormous size, the credit-default swaps market has operated in the shadows. There is no public disclosure nor any legal requirement for these contracts to be reported to the Securities and Exchange Commission or any other agency. So government regulators have had no way to assess how much risk is in the system, whether credit-default swaps have been accurately valued or honestly traded, and when people issuing and trading them have taken on risk that threatens others.

Because these instruments have been bought and sold widely and in many cases anonymously, they have trapped the large financial institutions in a web of transactions. This has created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down.

All investors — from individuals through their 401(k) plans to pension funds and asset managers — are paying a price today for the lack of oversight. We must urgently address the problems created by this unregulated environment.

Credit-default swaps are not inherently good or evil. They play an important role in the smooth functioning of capital markets by allowing a broad range of institutional investors to manage the credit risks to which they are exposed. They are also a useful means for investors to signal their view of an entity’s business prospects and creditworthiness.

But our markets function best when they are highly transparent, when everyone can see exactly which transactions are occurring and what the instruments being traded are worth. This gives investors confidence that they can accurately assess risk.

Back in 2000, Congress specifically decided not to regulate credit-default swaps. At that time, this market was just a few years old and still very small. For example, in 1999 a report by the President’s Working Group on Financial Markets envisioned no systemic risk from such derivatives since “private counterparty discipline” — investors’ natural desire to keep their own risks to a minimum — would work to protect the broader financial system.

But the market for credit-default swaps has recently mushroomed. In just the past two years, it has doubled in size. And as the market has grown, private counterparty discipline has proven inadequate. As we have seen, individual market participants did not pay enough attention until it was too late.

To place a value on credit-default swaps and the mortgage-related securities they insure, buyers and sellers of swaps relied too heavily on financial models that couldn’t predict the mortgage market meltdown. They also trusted too much in the credit ratings of the securities and of the firms selling the credit-default swaps, and these ratings underestimated the risk.

Congress needs to fill this regulatory hole by passing legislation that would not only make credit-default swaps more transparent but also give regulators the power to rein in fraudulent or manipulative trading practices and help everyone better assess the risks involved.

Congress could require that dealers in over-the-counter credit-default swaps publicly report both their trades and the value of those trades. This would make the market more transparent, and make it easier for everyone engaged in credit-default swaps to assess their value. It would also provide regulators with the information they need to uncover unfair or fraudulent practices and to monitor risk.

Then, the Securities and Exchange Commission should be given explicit authority to issue rules against fraudulent, deceptive or manipulative acts and practices in credit-default swaps.

Finally, Congress could provide support for federal regulators to mandate the use of one or more central counterparties — financially stable clearance and settlement organizations — and exchange-like trading platforms for the credit-default swaps market. As it is now, it is often impossible even to know who stands on the other side of a swap contract, and this increases the risk involved. We at the S.E.C. are already working with the Federal Reserve, the Commodity Futures Trading Commission and industry participants to accomplish these goals on a voluntary basis, using the authority we currently have.

Because of the truly global nature of the over-the-counter derivatives market, we will need to work closely with governments in other major markets. The climate for such cooperation is good, because the cross-border impacts of the current market problems are obvious to all.

Transparency is a powerful antidote for what ails our capital markets. When investors have clear and accurate information, and when they can make informed decisions about where to put their resources, money and credit will begin to flow again. By giving regulators the authority they need to bring the credit derivatives market into the sunshine, we can take a giant step forward in protecting our financial system and the well-being of every American.

Christopher Cox is the chairman of the United States Securities and Exchange Commission.

 

Copyright 2008 The New York Times Company

Cox said:

As you will see, the conclusion to which these data point is that the fate of Bear Stearns was the result of a lack of confidence, not a lack of capital. When the tumult began last week, and at all times until its agreement to be acquired by JP Morgan Chase during the weekend, the firm had a capital cushion well above what is required to meet supervisory standards calculated using the Basel II standard.

Specifically, even at the time of its sale on Sunday, Bear Stearns’ capital, and its broker-dealers’ capital, exceeded supervisory standards. Counterparty withdrawals and credit denials, resulting in a loss of liquidity – not inadequate capital – caused Bear’s demise.

 Sirri testified:

Therefore, there is simply no provision in the law that requires investment bank holding companies to compute capital measures and maintain liquidity on a consolidated basis. Nor does the law provide for a consolidated supervisor that is knowledgeable in their core securities business, and that would be recognized for this purpose by international regulators.

Further, he said:

In essence, the entire CSE program was constructed around an alternative net capital regime at the broker-dealer, which carried as a condition the affiliated holding company’s consent to group-wide supervision by the Commission. This is a significant regulatory extrapolation that the Commission believed was necessary to fill a significant statutory gap.

 And

An imperative from the Bear Stearns crisis is addressing explicitly how and by whom large investment banks should be regulated and supervised, and specifically whether the Commission should be given an explicit mandate to perform this function at the holding company level, along with the authority to require compliance. We look forward to working with you on these broader questions.