By Rich Miller and Shannon D. Harrington
Nov. 25 (Bloomberg) -- Timothy Geithner was among the first policy makers to shine a light on the unregulated $47 trillion credit-default swap market back in 2005. The New York Federal Reserve president has struggled since then to get dealers to carry out reforms.
The industry has yet to launch a structure to safeguard against market-wide losses in case a dealer fails, though its leaders expect to get one off the ground by the end of the year. Geithner, selected yesterday by President-elect Barack Obama to be his Treasury secretary, has made clear that such a step is crucial to help contain the mushrooming credit crisis.
“In classic Tim and New York Fed style, the work has been done behind the scenes, among technocrats, largely by consensus,” said Adam Posen, a former Fed official who is now at the Peterson Institute for International Economics in Washington. “The downside is that it takes awhile to get consensus.”
Geithner may not have the luxury of time in his new job as he faces a credit crisis that has morphed into a global recession. As Obama’s chief economic spokesman, it will be up to Geithner to take the lead in quelling the turmoil in financial markets and turning the economy around.
In the current crisis, Geithner, 47, was the Fed’s point man in the rescues of Bear Stearns Cos. and American International Group Inc., and tried to stem market turmoil after the decision to allow Lehman Brothers Holdings Inc. to fail. In August, he put his staff to work figuring out how much capital major banks would need if the economy worsened, foreshadowing the steps Treasury Secretary Henry Paulson later took to invest some $125 billion in the country’s largest banks.
Skills, Limitations
Geithner’s skills and limitations as a consensus-builder perhaps show up most clearly, though, in his handling of credit- default swaps, where he played a leading role in trying to make the market safer and more stable.
Trading in credit-default swaps, which were conceived to protect bondholders against default, exploded 100-fold the past decade as investors increasingly used them to speculate on creditworthiness. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrowers fail to adhere to their debt agreements.
The big problem Geithner faced in trying to get a handle on the market: It was unregulated, so he lacked authority to make changes on his own and had to depend on his powers of persuasion.
The New York Fed chief began pressing banks in September 2005 to reduce trading backlogs that could prove dangerous should a crisis hit. An average 17 days’ worth of unsigned trades had piled up on dealers’ books, threatening to undermine the market if a wave of defaults hit. A lax system for unwinding and reassigning trades left dealers at times unsure of who was on the other side of their trade.
Delayed Response
It took dealers a while to respond. A year later, they had cut the backlog of unsigned trades by 70 percent and doubled the number of deals that were electronically processed.
“It was like herding cats,” said Brad Bailey, director of business development at Jersey City, New Jersey-based brokerage Knight Capital Group and a former derivatives trader, who praised Geithner for making the effort and getting results.
The New York Fed chief has run into similar problems in trying to get the industry to set up a central counterparty that would absorb losses on trades in the event a dealer went bust.
After the collapse of Lehman Brothers in September sent market participants scrambling to cover an estimated $2 trillion of trades, the New York Fed chief stepped up pressure on the dealers to act.
Competitive Pressure
On Oct. 7, he summoned the dealers and fellow regulators to the New York Fed. This time, he included futures exchanges at the meeting -- Chicago-based CME Group Inc., Intercontinental Exchange Inc., NYSE Euronext and Frankfurt-based futures exchange Eurex -- in a bid to put competitive pressure on the dealers to come up with a satisfactory plan.
The strategy worked. After three meetings in two weeks, the dealer-owned Clearing Corp. agreed to be acquired by Intercontinental Exchange, one of the exchanges vying for a piece of the market. That paved the way for the launch of at least one clearinghouse by the end of the year.
“The Fed can only be commended for being ahead of the game among regulators globally,” said Mark Yallop, chief operating officer of London-based ICAP Plc, the world’s biggest broker of trades between banks and a minority owner in Clearing Corp.
Not Enough
Not everyone agrees. Julian Mann, a mortgage- and asset- backed bond manager at First Pacific Advisors LLC in Los Angeles, criticized Geithner for not doing enough.
“He oversaw the massive expansion in the credit-default swaps market, which arguably is what is behind much of the crisis today,” said Mann, whose firm manages about $9 billion.
Vincent Reinhart, a former senior Fed official now at the American Enterprise Institute in Washington, said that Geithner was quick to recognize some of the problems with the swaps market, though it was tough for him to persuade the industry to carry out reforms while business was booming.
“It shows the limits of what he could do,” Reinhart said, referring to the fact that the market is unregulated. “He had to try to induce good behavior rather than command it.”
To contact the reporters on this story: Rich Miller in Washington at rmiller28@bloomberg.net; Shannon D. Harrington in New York at sharrington6@bloomberg.net
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