New regulation for credit default swaps

Chairman of the House Agriculture Committee Collin C. Peterson (D-Minn.) thinks that credit default swaps (CDS) played an important part in the current economic crisis.

"[Few] people know the significant role they have played in the financial and credit crisis that has threatened the stability of our economy," said Peterson during his committee's hearing on reviewing the role of credit derivatives in the U.S. economy.

"The sudden collapse and gradual fallout of the insurance giant AIG and the difficulties experienced by other financial firms in recent months have served to demonstrate that the CDS market is extremely opaque and that market positions, as a result, are nearly impossible to value during times of stress."

To confront these concerns over lack of transparency, attempts have been made to find regulatory solutions for CDS markets. Last week the Federal Reserve System, the Securities Exchange Committee, the Commodity Futures Trading Commission (CFTC), and the Treasury Department signed a memorandum of understanding that would establish a clearing house for CDS which would be under the signers cooperative oversight.

"Financial institutions need to make changes in their risk management practices for [over the counter] derivatives by improving internal incentives and controls and by ensuring that traditional credit-risk management disciplines are in place for complex products, regardless of whether they take the form of CDS or of securities," said Patrick M. Parkinson, Deputy Director of the Division of Research and Statistics Board of Governors of the Federal Reserve System.

"The Federal Reserve is working cooperatively with other domestic and international authorities to strengthen the infrastructure through which CDS trades are cleared and settled and to address weaknesses that have been identified in the risk-management practices of major market participants."

Anada Radhakrishnan, Director of the Division of Clearing and Intermediary Oversight of the CFTC discussed the expertise the commission would bring.

"The CFTC has developed extensive institutional knowledge and regulatory expertise regarding derivatives clearing...we at the CFTC will continue to work collaboratively and cooperatively with our colleagues...to bring transparency and financial integrity to the CDS market through clearing and infrastructure improvements."

Financial regulation lessons learned by the SEC and Congress

The Security Traders Association (STA) held their Twelfth Annual Washington Conference this week, with discussions with legislators and regulators. Securities and Exchange Commission Chairman Christopher Cox, the keynote speaker, said maintaining vibrancy in markets requires adaptability and vigilance. He said the framework of the federal service regulation for investment banking was dangerously inadequate and behind the times, and that this was the first time a bank like Bear Stearns faced such a crisis of confidence. He said the SEC needs to immediately change standards and expand regulations for investment banks, establish different scenarios for risk management, and be able to supervise investment banks on a consolidated basis.

SEC Commissioner Paul S. Atkins also spoke at the conference, and said the SEC and other regulators should begin to apply lessons learned from this experience and the past. He included lessons such as remembering that capital markets are resilient and go through difficult times, and learning not to devise regulatory policies without understanding the problem. He said strong relationships should exist between regulators before problems arise. He also suggested that regulators should draw from those with experience in the industry, since the industry is always changing.

Several congressmen and senators spoke at the event, including Sen. Jack Reed (D-R.I.). Reed said it is essential to step back and assess SEC resources and their capacity for regulation. He urged regulators to look at what happened and what they had anticipated, so it does not happen again. He wants to strengthen the market and its transparency, and bring back investor confidence. Sen. Robert Menendez (D-N.J.) says this challenge goes beyond just one industry, and that regulators need to look ahead rather than just “cleaning up” after problems.

Congressman Ed Perlmutter (D-Colo.) said the House of Representatives is voting on several financial service bills, such as a bill to provide funding to local governments to purchase and fix up closed properties in order to stabilize neighborhoods. Congressman Dennis Moore (D-Kan.) said the country needs financial literacy and understanding. He also said Congress needs to work together to take action and address financial situations, despite party differences. These views were similarly expressed by Perlmutter and Congressman Paul E. Kanjorski (D-Pa.).

Fed called to answer for bailout of Bear Stearns

Why did you bail out Bear Stearns? It was the resounding question heard over and over in the Senate Banking, Housing, and Urban Affairs Committee hearing on "Turmoil in U.S. Credit Markets: Examining the Recent Actions of Federal Financial Regulators." Federal Reserve Chairman Ben Bernanke, SEC Chairman Christopher Cox, United States Treasury Under Secretary Robert Steel, and President of the Federal Reserve Bank of New York Timothy F. Geithner, all attempted to answer that question to Congress.

In his opening statement, Senator Chris Dodd (D-CT), said the stunning fall of Bear Stearns was matched only by the sweeping response to its collapse put together by the New York Fed and the Federal Reserve Board of Governors, which, with the support of Treasury, "exercised powers in some instances that had not been used since the Great Depression." However, he said, people on 'Main Street' are struggling to pay their mortgages, and so was the rescue of Bear Stearns justified to prevent a systemic collapse of financial markets, or was it a $30 billion taxpayer bailout for a firm on Wall Street?

Yes, but how big do you have to be, to be too big to fail? Senator Jim Bunning (R-KY) posed that question in his opening statement. Why, exactly, was it necessary to stop the invisible hand of the market? That is Socialism, he said, adding that he was very troubled by the failure of Bear Stearns. A big question, he said, was who let our financial system become so fragile?

Chairman Bernanke said the that pressures in the short-term bank funding markets have increased, and many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and they have increased the amount of collateral they required to back short-term security financing agreements. Credit availability is restricted, and some key securitization markets (including those for nonconforming mortgages) continue to function poorly if at all.

Bernanke, nearly at the end of his prepared statement, arrived to the explanation as to why they had assisted Bear Stearns. The news that Bear Stearns would have to file for bankruptcy, he said, raised difficult questions of public policy. "Normally, the market sorts out which companies survive and which fail, and that is as it should be. However, the issues raised here extended well beyond the fate of one company." He said that our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of "critical markets." The damage caused by a default by Bear Stearns "could have been severe and difficult to contain."

The chaotic unwinding of Bear Stearns could have cast doubt of the financial positions of some of Bear Stearns' thousands of counterparties, Chairman Cox said. But a question remained on whether or not investors were at risk. Despite the run on the bank to which Bear Stearns was subjected, Cox said, its customers were fully protected. At no time during the week of March 10-17th were any of the customers of the Bear Stearns's broker-dealers at risk of losing their cash or their securities.

Under Secretary Steel gave an explanation as to why Bear Stearns was assisted, saying a strong financial system is vitally important for all Americans. When our markets work, he said, people throughout our economy benefit, and when our financial system is under stress all Americans bear the consequences. The focus was more on the strategic concern of the implication of a bankruptcy. The failure of a firm that was connected to so many corners of the market would have caused financial disruptions beyond Wall Street.

The risk has its protections, Geithner said. There is a substantial pool of professionally-managed collateral that was valued at $30 billion, the agreement on the part of JPMorgan Chase to absorb the first $1 billion of any loss that ultimately occurs in connection with this arrangement, and a long-term horizon during which the collateral will be safe-kept.

In the written statement of James Dimon, Chairman and Chief Executive Officer of JPMorgan Chase, he said they got involved in the matter because the collapse had the potential to cause serious damage to the financial system. They could not, and would not have assumed the risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed, and that the transaction is not without risk for JPMorgan. However, they informed the New York Fed and Treasury that the risks were too great for JPMorgan to buy the entire company on their own. The statement also explains the reason for bailing out Bear Stearns: a Bear Stearns bankruptcy could have touched off a chain reaction of defaults at other major financial institutions, and the consequences could have been disastrous.

The repeated phrase by each and every witness was that the failure of Bear Stearns was a result of a lack of confidence. According to the written statement of Alan Schwartz, President and CEO of the Bear Stearns Companies, even though the firm was adequately capitalized and had a substantial liquidity cushion, "Unfounded rumors and attendant speculation began circulating in the market" that Bear Stearns was in the midst of a liquidity crisis. The unfounded rumors grew into fear and there was a run on the bank.