Should the big banks monitor risk for credit-default swaps?

The law, lawyers, and the court.
Dec. 3 2009 9:26 AM

The Foxes Guard the Financial Henhouse

Whom is Congress putting in charge of the market for credit-default swaps?

Representative Stephen Lynch. Click image to expand.
Rep. Stephen Lynch tried to limit banks' role in credit-swap regulation

Ever since his inauguration, President Obama has confronted charges that he has let proverbial "foxes" stand guard over the financial henhouse. Commodity Futures Trading Commission Chairman Gary Gensler is a former Goldman Sachs partner, and Treasury Chief of Staff Mark Patterson is a former Goldman lobbyist. In both cases, Obama actually tapped ex-foxes: Gensler left Goldman in 1997; Patterson severed ties to the firm in 2008.

Now imagine the uproar if Obama actually allowed Goldman, rather than its ex-employees, to regulate risk in the financial markets. And yet the administration and its allies in Congress are poised to do just that.  The awkwardly named Over-the-Counter Derivatives Markets Act of 2009 would give Goldman and eight other big banks a government-guaranteed oligopoly over the market for credit-default swaps—with a license to set the rules of the road. In effect, the bill would allow a cartel to control trillions of dollars in transactions that entail enormous risk to the financial system as a whole.

If this proposed legislation passes, the big banks will strengthen their grip on a massive chunk of the economy. As of June, the amount of outstanding credit-default swaps totaled $36 trillion—more than two-and-a-half timesthe U.S. gross domestic product. These swaps enable banks, insurers, and hedge funds to bet on whether some institution or individual that owes money—a "reference entity," in Wall Street dialect—will default on its debt. The reference entity might be a Third World government or a Fortune 500 company. Or, if you have a mortgage or a credit card, the reference entity might be you.

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You don't have to understand exactly how these instruments work in order to be affectedby them. If your bank uses credit swaps to hedge the risk that you won't repay your loans, then transaction costs in the swaps market indirectly influence your interest rates. And when credit swaps cause a major financial firm to fail, the ripple effects extend far and wide. AIG has used more than $22 billion of federal funds to pay debts arising from its own ill-advised credit-swap bets, which means it has cost each individual taxpayer—on average—$158 to clean up the credit-swaps mess.

To guarantee that the swaps market can run smoothly even if a major player like AIG goes belly up, the Obama administration has introduced OCDMA, as acronym-loving corporate lawyers call the legislation. The bill would require that banks, insurers, hedge funds, and other "major swap participants" conduct credit-swap transactions through a central clearinghouse.

In theory, that's a good thing, because it provides a safeguard in the event that a single firm fails to pay its credit-swap debts. Until now, if Goldman Sachs wanted to protect itself from the risk that you won't repay your mortgage, it would find another party to take the opposite end of a credit-swap bet. (AIG and Goldman bet with each other on $20 billion of debt.) Each quarter, Goldman would pay a small fee straight into AIG's account. If you and a critical mass of other mortgagors defaulted on your debt, AIG would make a lump-sum payment directly to Goldman Sachs.  Under OCDMA, all this would change. Goldman would make quarterly payments to a clearinghouse, which would forward those payments to AIG. If enough mortgagors defaulted, then AIG would compensate the clearinghouse, and the clearinghouse would compensate Goldman.

The crucial point is that the clearinghouse would be on the hook to Goldman even if AIG went bust. Thus the failure of one firm wouldn't trigger a chain reaction in financial markets because the clearinghouse would be there to backstop the damage.

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