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Join Rep. Peterson in solving the credit-default-swaps mess

Minnesotans have an opportunity to take an active role in partnering with Rep. Collin Peterson, D-Minn., to ban the further use of credit default swaps.

Minnesotans have an opportunity to take an active role in partnering with Rep. Collin Peterson, D-Minn., to “effectively” ban the further use of credit default swaps. Nouriel Roubini, professor of economics and international business at New York University’s Stern School of Business, has cited credit default swaps as a pivotal factor in the collapse of our financial system.

House Speaker Nancy Pelosi has appointed Peterson as her leader to get the derivative mess under control. Last November, he traveled to Europe to meet with international banks to get perspective on how to unwind the credit-default-swap derivative mess, which today still weighs heavily on the ability to restore our financial system.  Peterson, who chairs the House Agricultural Committee, has an accounting background and a strong understanding of exchange-traded derivatives, through his committee’s work with the Commodity Futures Trading Commission (CFTC).

Draft language for a bill, ”Derivatives Markets Transparency and Accountability Act of 2009,” was posted on the Agriculture Committee’s website last week and is being debated in Congress today. One part of this bill serves to place all credit default swaps, interest-rate swaps and foreign-currency forwards currently being traded in the inter-bank or over-the-counter market on a regulated exchange. Certain “customized” credit default swaps may be exempt.  The bill proposes that credit default swaps only be used to hedge an underlying bond or position.

Lobbyists are already pushing back
Peterson’s proposed bill is already getting strong pushback from lobbyists, including the International Swap Dealer’s Association (ISDA) and major banks. The Treasury secretary’s nominated chief of staff, Tom Patterson, was a lobbyist for Goldman Sachs until last year. Revenue from financial services firms was over 25 percent of our GDP last year, a significant portion from credit default swaps. There is a strong incentive to maintain this revenue stream, but is this a revenue stream we want?

Taxpayers do not yet have advocates that serve to protect our new ownership interest in AIG and other financial institutions. It may make sense to ask Peterson to consider adding to his bill the stipulation that it would be mandatory for all counterparties to credit default swaps to unwind these contracts, going back to January 2007. The parties to these contracts would exchange profits and losses, alleviating the U.S. taxpayer from taking on the credit default swap counterparties’ obligations. Shifting this burden to the U.S. taxpayer has not solved the problem, and it very well may be a continuing outflow of taxpayer dollars that could be more efficiently invested to generate a higher return, say in jobs, education or infrastructure.

This perspective comes from 13 years in the over-the-counter derivative markets at a major U.S. commercial bank when the swaps markets were first developing in the early 1980s. My experience included advising corporate CFOs on the use of swaps, foreign-currency forwards and over-the-counter options for hedging transactional and translational foreign currency exposures. For the commercial bank’s executive credit committee, I prepared the analysis of the counterparty credit risk in these derivative transactions.

Seen in ’90s as a win-win
It was not until the late 1990s that a J.P. Morgan trader worked to solve the ongoing issue of managing “credit risk” and created the derivative, a credit default swap. The rest is history. There were some vocal skeptics, including Brooksley Born, former chair of the CFTC. Senate Banking Committee testimony in 2005 concluded that the use of credit default swaps was a win-win for all parties and there was no reason not to allow their ongoing use in the over-the-counter markets. 

Counterparty credit risk was not managed with credit default swaps, since inception. Players in these over-the-counter markets — like hedge funds, AIG and investment banks — have typically had a different credit-risk orientation from commercial banks. Derivatives, used in the correct context, are powerful tools to hedge interest-rate risk and foreign-currency exposures. Derivatives have been a source of stability and revenue for major banks in both the over-the-counter market and regulated exchanges, and should continue to be. They are used by banks to manage mismatches in loan positions, to hedge risk of floating rate debt, for example. Small Minnesota importers use them, through commercial banks, when they buy products in foreign currency, to hedge their foreign-currency exposure. Hedging with derivatives is a more conservative position than not hedging.

Mostly used for speculation

In contrast, credit default swaps were used for speculation in the majority of cases. Unlike interest-rate swaps and foreign-exchange forwards, they do not provide any underlying value to the U.S. banking system.

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(For some recent background on the credit default swap market, here is a link to a blog, Naked Capitalism, from August 2007, which details concerns on the credit default swap house of cards. In addition, a May 2008 Bloomberg story provides good history of how the Federal Reserve appointed J.P. Morgan to oversee the black hole of the CDS market with their takeover of Bear Stearns.)

So what is the next step regarding Peterson’s draft bill on transparency and regulation in the derivative markets?

First, ask Treasury Secretary Timothy Geithner’s office to determine the efficiency of using taxpayer dollars for contractual payments in credit default swap contracts. Consider having Peterson’s bill reverse TARP funds and AIG loans used to date for this purpose.  Insert language in the bill that requires the unwinding of existing credit default swaps. Shift the burden of contractual payments required under credit default swaps from the U.S. taxpayer to the original parties to these contracts, effectively by unwinding these contracts.

Second, implement Peterson’s recommendations that all credit default swaps must hedge an underlying position. Yes, all credit default swaps should be traded on a regulated exchange; however, change the language of this bill to ensure there are not any exceptions.

Third, and finally, have the bill focus solely on credit default swaps’ use in the over-the-counter markets.  Do not require interest-rate swaps and foreign-currency forwards to operate on a regulated exchange. To add to this bill the transfer of interest-rate swaps and foreign-currency contracts in the over-the-counter markets to a regulated exchange would add a layer of complexity and cost to commercial banks that can be deferred until the financial crisis is resolved. Do require disclosure and reporting requirements, as stipulated in the proposed bill, on interest-rate swaps and foreign-currency-forward contracts.

Congratulations to Rep. Collin Peterson for taking the lead in unraveling the quagmire created by credit default swaps.

Susan Seltzer is a former assistant vice president, Synthetic Securities of US Bank.