Taming Financial Weapons of Mass Destruction

(March 9) -- The campaign to rein in a type of risky investment villainized in the economic crisis and blamed for the government bailout of AIG and the financial collapse of Greece is gaining momentum in Washington and other capitals, where officials are comparing it to piracy of another age.

On Tuesday, a key U.S. regulator added his voice to the call for tighter rules and less secretive practices for credit default swaps, while the European Union said it is looking into a ban on the complicated financial instruments that have mushroomed into a multitrillion-dollar market.

Credit default swaps were at the core of the $180 billion bailout of AIG, helped banks evade rules to let their capital levels get "dangerously low" and may have played a big role in the stock market collapse of 2008, said Gary Gensler, chairman of the Commodity Futures Trading Commission.

"The 2008 financial crisis had many chapters, but credit default swaps played a lead role throughout the story," he said at a New York conference on financial reform. Gensler called for a new comprehensive reform of how credit default swaps are sold and traded, and noted the White House and Congress have taken steps in that direction.

Modern-Day Pirates?
Credit default swaps are a kind of insurance for bond buyers that have become the most notorious if rapidly growing category of derivatives, which investor Warren Buffett once compared to "time bombs" and criticized as "financial weapons of mass destruction."

They were created as insurance for buyers of corporate and government bonds who want to minimize the risk of their investment. If a company that issues bonds declares bankruptcy, the holder of credit default swaps tied to those bonds can get a huge payoff.

And though they are not technically an insurance product -- and therefore not regulated like insurance -- insurers such as AIG and other financial firms built the credit default swap market from about $630 billion in 2001 to more than $2.99 trillion by June 2009, according to the Bank of International Settlements.

The problem, Gensler and many others argue, is that some of the biggest deals involved "naked" credit default swaps, meaning they were bought by investors who didn't own the underlying bonds and were, in effect, betting that the company wouldn't be able to pay off its bonds.

Gensler compared credit default swaps to a "mischievous kind of gaming or wagering" in 18th-century England where insurers sold insurance on ships to people who didn't own the vessels or their cargo.

"The practice was said to create an incentive to buy protection and then seek to destroy the insured property," Gensler said. "It should come as no surprise that seaworthy ships began sinking."

Some observers of the 2008 fall in stock prices believe credit default swaps figured into that decline, contending that "as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company's prospects," Gensler said.

Similarly, bondholders who have credit default swap protection greater than the money they invest in the bonds have acted as "empty creditors" working against the company with an "incentive to force a company into default or bankruptcy," he added. Credit default swaps can also ruin the firm that sells them when companies go bankrupt, which is what happened to AIG.

The Greek government and some European heads of state, including German Chancellor Angela Merkel, have accused big financial firms of using credit default swaps to bet against Greece and its ability to pay off state bonds.

"If it is true that the current problems in Greece were not caused by speculation on the financial markets, it is also true that this speculation was an aggravating factor," José Manuel Barroso, president of the European Commission, said Tuesday.

Crusade for a Government Solution
Barroso said the commission is considering "banning purely speculative naked sales on credit default swaps" for government bonds, and that new controls of derivatives, "as mobile as they are opaque," require close work with the United States.

Gensler agreed on the need for international cooperation. Within the U.S. he wants greater authority to deal with credit default swaps and other derivatives for his own agency and for the Securities and Exchange Commission.

Gensler, like some other Washington regulators, wants new rules on credit default swaps to:

• Require all derivatives deals to have enough capital to cover potential losses and post collateral on transactions to protect taxpayers from having to bear the cost of dealers that, like AIG, fail.
• Create a more transparent marketplace by requiring derivatives to be traded on exchanges or other trading platforms so everyone has a better idea of the price and the risk. During the financial crisis, both the government and Wall Street had trouble figuring out the worth of "toxic" assets.
• Have derivatives traded through clearinghouses that act as a middleman between two parties and guarantee both sides live up to their obligations, which can help move such transactions off the books of financial institutions to reduce their risk of becoming "too big to fail."

The push for greater regulation of credit default swaps is likely to get more public support from the White House, where President Barack Obama has already been campaigning for tighter financial regulation.

On Tuesday, Greek Prime Minister George Papandreou met with Obama and said later that he explained the European Union's proposals for tighter regulation, and that Obama reacted positively.