As calls increase for cracking down on trading in derivatives --especially credit default swaps that are purchased to bet on a position rather than to hedge a long position--Congress seems to be responding with a growing awareness that it must act and cannot simply let the financial system regenerate exactly the same systemic risk problems by continuing to operate under "self regulation" (i.e., nonregulation).
Remember that CDS are unregulated--they are an insurance-like product, except that the one who buys the insurance doesn't have to have an interest in the item insured, which creates a significant moral hazard problem. So a bank may buy "credit protection" on a notional principal amount of IBM or GE bonds, not because they have the bonds and want to limit the risk of loss on those bonds, but because they think the bonds are going to go down in value and by buying this "insurance" they will make money when that actually happens. That's pure casino-type speculation. For real insurance, we worry that the holder of a life policy on a person who has no real interest in the life of the insured may commit murder. It's the same with "naked" CDS that are not hedging a long position. They are casino bets that can manipulate the price of the item insured rather than just protecting against losses in that position. And they have no positive social benefit other than the increase in wealth to those who "win" their bet. Greece's problems might not be so deep if the CDS market hadn't pushed Greece's cost of funds so high, etc.
For the Times' selection of resources on CDS, see this link.
For the calls to crackdown on CDS, see Browning & Saltmarsh, European Leaders Call for Crackdown on Derivatives, NYTimes (Mar. 9 2010). A similar story ran in the Mar. 10 Wall Street Journal. The article notes that Goldman Sachs (one of the big banks that profited enormously from the Fed's bailout of AIG when the Fed paid AIG's CDS at par even though they would have brought no more than about 50% on the market or in bankruptcy) pushed its clients into CDS on some EU countries last fall. European leaders note that the swaps don't just sit innocently by--they can worsen the position of the country swapped against. That is, in fact, the way markets work--they record in prices the "bets" that people are making. If enough people make the same bet, efficient market theorists claim, it means that that is the "real price". But the efficient market hypothesis doesn't hold water, since people who want to manipulate the market can do it the same way investors who think they are making investments do it--purchases change the price, and changing the price changes the market. As with most studies focussing on one thing, the study itself affects what can be learned about that thing.
CDS weren't the only cause of the global financial crisis, but they were a significant factor, having grown from a few billion of notional principal amount outstanding in the late 1990s to about $70 trillion at the peak before the financial crisis hit. As the chair of the Commodity Futures Trading Commission noted, they "played a lead role throughout the story" of the crisis. Id. He urges over the counter swaps be regulated. I think that stops far short of what is needed--customized and over the counter swaps must be regulated, traded transparently with pricing posted for all to see, and speculative trading not related to hedging prohibited.
Congress needs to open its financial crisis review to a broader look at the role of particular banks, such as Goldman Sachs, in the markets. Proprietary trading should be limited. Trading on client data (proprietary flash trading programs) should be banned. Speculative trading in derivatives like CDS should be banned. These are tough steps, and the banks can and will put a lot of money behind politicians who will take wishy-washy positions on these issues. If people want a fair government, they will have to help politicians hold the line. Without financial reform that severely limits the power of the big bank holding companies and investment banks, the banks will be calling the shots, and not the American people.
Will Senator Dodd's latest attempt pass muster? The Washington Post today noted that Sen. Dodd to unveil updated legislation to overhaul financial regulatory system, Mar. 11, 2010. He claims it will be "sweeping legislation" following months of negotiations with Republicans Shelby and Corker. Personally, I doubt that any "consensus" package could hold much good news for ordinary Americans. The Republicans don't want an agency to protect consumers from the crerdit card banks' ridiculous, outrageous, even obscene charges, fees, hidden tricks and the mortgage companies similar tricksterism. If banking reform doesn't fix the problems--i.e., if there is nothing protecting the consumer from banks' bullying, nothing preventing the cronyism displayed by the Fed with Wall Street during the September 2008 implosion under the Bush regime, or nothing handling the "too big to fail" problem--it will be just windowdressing and the Big Banks will continue business as usual (which seems to translate to speculating in the financial system in ways that they win, we lose--socialization of losses, privatization of gains).
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