Fallout: The Financial Crisis

Reforms to derivatives could be costly

John Dimsdale Jun 8, 2009
HTML EMBED:
COPY
Fallout: The Financial Crisis

Reforms to derivatives could be costly

John Dimsdale Jun 8, 2009
HTML EMBED:
COPY

TEXT OF STORY

Tess Vigeland: The Obama administration is working on its soon-to-be-released blueprint for regulating the financial industry. One buzzword you will no doubt find in that blueprint? Derivatives. Traders bought and sold hundreds of trillions of dollars worth of them over the last decade. But no one bothered to see if the traders who guaranteed those contracts could actually pay up. And we all know how that turned out. Marketplace’s John Dimsdale reports from Washington on what comes next.


JOHN DIMSDALE: Derivatives contracts let companies avoid price fluctuations on commodities that might spike in the future, say the price of wheat for a cereal company. Developed nearly 30 years ago, derivatives took off in the 1990s, says University of Maryland law school professor Michael Greenberger.

MICHAEL GREENBERGER: It’s a contract that locks in a price in the future for, in the best purposes, for commercial ventures. In the worst purposes it’s much like going to a horse race and betting on a horse.

For example, insurance company AIG used a type of derivative called a credit- default swap to insure hundreds of billions of dollars of securities backed by mortgages. When borrowers began defaulting on those mortgages, the securities collapsed. And AIG was caught with more bad bets than it could cover. To prevent a wave of losses for investors that bought AIG’s guarantees, including banks and pension funds, taxpayers had to come to the rescue with $170 billion. Bill Singer is a former regulatory attorney.

BILL SINGER: To some degree the seeds of this problem was in a failure by our regulators to recognize the potential destruction that these new products that were being developed in the 90s would cause on this side of the new century.

Now regulatory reformers want to bring derivatives out of the shadows and make sure issuers have the resources to cover their contracts. One way to do that is to move derivatives from private trades to a formal trading exchange. That way everyone can see how many contracts get traded and at what price. Plus, traders would be required to post collateral to back up their bets. A few weeks ago a group of top experts and financial executives endorsed tougher regulations. The director of that group, called the Committee on Capital Markets Regulation, is Hal Scott. He says when it comes to a formal exchange…

HAL SCOTT: The administration is currently saying we encourage it. We think we should go further than encourage. We should require.

But at the Securities Industry and Financial Markets Association representing the financial industry, Cory Strupp says an exchange would make derivatives inflexible.

CORY STRUPP: One of the huge benefits of derivatives products is they can be customized to meet the needs of companies that use them to manage risk.

On a regulated exchange, he says, derivatives contracts would have fixed sizes and last for set periods of time. That means companies looking to hedge their risk might have to lock in a price for longer than they want, or pay to cover more risk than they need with a standard contract.

And big banks say that requiring more collateral to cover derivatives would be a “drain” on their capital. But, Iowa Senator Tom Harkin, the sponsor of a bill to regulate derivatives, says that’s necessary to avoid future failures like AIG.

TOM HARKIN: I want to state emphatically I’m not opposed to the financial sector making profits. We have to balance this desire for making profits with the countervailing balance of the public interest here.

In other words, providing real insurance for derivatives contracts is likely to cost more. And Maryland University professor Michael Greenberger, says it’s time Congress stood up to the industry.

GREENBERGER: My answer to that is fine, if you need these risk-shifting instruments, great. But let’s do it in a regulated environment where the federal government knows what’s going on and isn’t surprised by mines going off in a battlefield.

Explosions that could end up leaving taxpayers with an even bigger tab.

In Washington, I’m John Dimsdale for Marketplace.

We’re here to help you navigate this changed world and economy.

Our mission at Marketplace is to raise the economic intelligence of the country. It’s a tough task, but it’s never been more important.

In the past year, we’ve seen record unemployment, stimulus bills, and reddit users influencing the stock market. Marketplace helps you understand it all, will fact-based, approachable, and unbiased reporting.

Generous support from listeners and readers is what powers our nonprofit news—and your donation today will help provide this essential service. For just $5/month, you can sustain independent journalism that keeps you and thousands of others informed.