NY Times March 5, 2010
Editorial
A.I.G., Greece, and Who’s Next?
As Greece has tottered on the brink of fiscal chaos, threatening
to drag much of Europe down with it, Wall Street’s role in the
fiasco has drawn well-deserved scorn.
First came the news that Greece had entered into derivatives
transactions with Goldman Sachs and other banks to hide its public
debt. Then came reports that some of those same banks and various
hedge funds were using credit default swaps — the type of
derivative that kneecapped the American International Group — to
bet on the likelihood of a Greek default and using derivatives to
wager on a drop in the euro.
European leaders have called for an inquiry into the Greek crisis.
Ben Bernanke, the Federal Reserve chairman, has told Congress that
the Fed is “looking into” Wall Street’s deals with Greece, and the
Justice Department is investigating the euro bets. That is better
than turning a blind eye, but it is not nearly enough.
The bigger problem is in America, where markets are supposed to be
fair and transparent. These particular — and particularly
complicated — instruments are traded privately among banks, their
clients and other investors with virtually no regulation or oversight.
The Obama administration and Congress have been talking for a year
about fixing the derivatives market. Big banks have been lobbying
to block change. And the longer it takes, the weaker the proposed
new rules become.
Here are some of the problems that must be fixed:
NO TRANSPARENCY Derivatives are supposed to reduce and spread
risk. In a credit default swap, for instance, a bond investor pays
a fee to a counterparty, usually a bank, that agrees to pay the
investor if the bond defaults. But because the markets in which
they trade are largely unregulated, derivatives can too easily
become tools for dangerous risk-taking, vast speculation and dodgy
accounting.
A big part of the problem is that derivatives are traded as
private one-on-one contracts. That means big profits for banks
since clients can’t compare offerings. Private markets also lack
the rules that prevail in regulated markets — like capital
requirements, record keeping and disclosure — that are essential
for regulators and investors to monitor and control risk.
That is why it is so essential to move derivative trades onto
fully transparent exchanges. The administration originally
embraced that idea, with exceptions only for occasional, unique
contracts. But when the Treasury proposed legislation in August,
it included huge loopholes, and a derivative reform bill that
passed the House in December has many of the same problems. (The
Senate has yet to introduce a reform bill.)
Both the administration and the House would exclude from exchange
trading the estimated $50 trillion market in foreign exchange
swaps — similar to the derivatives Greece used to hide its debt.
The rationale for the exclusion never has been clearly explained.
The Treasury proposal and House bill also would exclude
transactions that occur between big banks and many of their
corporate clients from the exchange trading requirement,
ostensibly because those deals are only for minimizing business
risks, not for speculation or for window-dressing the books.
That’s debatable. But even if true, other derivatives users would
almost inevitably find ways to exploit such a broad exemption.
What is clear about the exemptions is that they would help to
preserve banks’ profits. What is also clear is that they would
defeat the goals of reform: to lower risk, increase transparency
and foster efficiency.
LIMITED POWER TO STOP ABUSES When the House put out a draft of new
rules in October, it sensibly gave regulators the power to ban
abusive derivatives — ones that are not necessarily fraudulent,
but potentially damaging to the system. Derivatives investors who
stand to make huge profits if a company or country defaults, for
example, might try to provoke default — a situation that
regulators should be able to prevent. In the final House bill,
however, the ban was replaced with a requirement that regulators
simply report to Congress if they believe abuses are occurring.
NO STATE REGULATION, EITHER Current law also exempts unregulated
derivatives from state antigambling laws. That means that states
have no power to police their use for excessive speculation.
Treasury and House reform proposals have called for maintaining
the federal pre-emption of state antigambling laws. Pre-emption
could be tolerable if derivatives were traded on fully regulated
exchanges. But as long as many derivative products and
transactions are exempted from fully regulated exchange trading,
pre-emption of state antigambling laws is a license for, well,
gambling.
•
The big banks claim that derivatives are used to hedge risk, not
for excessive speculation. The best way to monitor that claim is
to execute the transactions on fully regulated exchanges, pass
rules and laws to ensure stability, and appoint and empower
regulators with independence and good judgment to enforce compliance.
Without effective reform, the derivative-driven financial crisis
in the United States that exploded in 2008, and the Greek debt
crisis, circa 2010, will be mere way stations on the road to
greater calamities.
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