Derivatives Get Second Look From U.S. Congress That Didn’t Act

By Dawn Kopecki and Matthew Leising

June 22 (Bloomberg) -- Congress will take a second shot at the derivatives industry after its decision nine years ago to forgo regulations led to a $592 trillion market that brought financial firms to their knees.

Using President Barack Obama’s regulatory overhaul proposal last week as a foundation, Senate Banking Committee Chairman Christopher Dodd is holding a hearing today on how to rein in a market that grew almost seven-fold since 2000 and complicated government efforts to assess the risk of banks’ interconnected trading when credit markets froze two years ago.

Lawmakers will field ideas from those who want to move all derivatives trades to monitored exchanges as well as from regulators seeking authority over dealers and an analyst who says some contracts should be banned. Members, who exempted private derivatives from oversight in 2000, are targeting the financial instruments after American International Group Inc. needed a $182.5 billion U.S. bailout because of credit-default swap trades on mortgage-linked securities.

“One of the key underlying problems in the whole lead-up to the meltdown was too much leverage, too little capital or too little collateral,” Mark Halverson, a staff director for Senate Agriculture Committee Chairman Tom Harkin, said in an interview.

Harkin, an Iowa Democrat, is pushing his own legislation that would require all over-the-counter derivatives trades be cleared through a regulated exchange. Such an arrangement would subject the contracts to margin and collateral requirements. Harkin, who endorsed Obama’s proposal to move some trades to an exchange and regulate all dealers, still plans to press forward.

Key Player

“I was pleased that the proposal begins to get a handle on the freewheeling derivatives markets that many economists name as a key player in causing the recent economic downturn,” Harkin said in a June 17 statement.

The economy’s longest recession since the 1930s was triggered when credit markets froze in August 2007 after banks such as Lehman Brothers Holdings Inc. found they couldn’t determine the value of trades linked to mortgage bonds.

Trading in credit-default swaps should be banned, Christopher Whalen, managing director of Institutional Risk Analytics in Hawthorne, California, said in prepared testimony for today’s Senate hearing. Regulators are too cozy with the banks in the market to be counted on to make changes, he said.

“The views of the existing financial regulatory agencies, and particularly the Federal Reserve Board and Treasury, should get no consideration from the committee since the view of these agencies are largely duplicative of the views of JPMorgan Chase & Co. and the large OTC dealers,” he said in the remarks.

Hedge Funds

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates or weather. Credit- default swaps were created initially as a way for banks to hedge their risk from loans. They became a popular vehicle for hedge funds, insurance companies and other asset managers to speculate on the quality of debt or on the creditworthiness of companies because they were often easier and cheaper to trade than bonds.

Citadel Investment Group LLC Chief Executive Officer Kenneth Griffin, whose $11 billion hedge fund may be forced to hold capital to back its trades linked to interest-rate swaps and credit-default swaps under the proposed regulations, is also scheduled to testify today. Griffin, 40, wasn’t available to comment before the hearing.

Obama’s proposal would require standardized over-the- counter derivatives contracts to be guaranteed by clearinghouses. The administration also set as a goal that standardized contracts be “executed on exchanges and other transparent trading venues.”

Other over-the-counter derivatives transactions would have to be registered in trade repositories so regulators would be aware of the activity. All trades in the market would face increased capital requirements.

Dodd’s Support

The Obama plan doesn’t say how much of the over-the-counter market would be moved through clearinghouses, only that if any contract had been accepted by a clearinghouse, it would be required to be cleared. Nor does the plan spell out what would define a standardized contract.

Dodd “expects that efforts will be made to expand on the president’s proposal during the committee’s work,” said Kirstin Brost, a spokeswoman for the committee.

It’s a second chance for Congress, whose 2000 exemption helped the market swell to $684 trillion by June 30, 2008, from about $100 trillion in 2000, according to Bank for International Settlements data. Credit-default swaps outstanding ballooned almost 100-fold within seven years to top $62 trillion by the end of 2007, according to estimates from the New York-based International Swaps & Derivatives Association.

Source of Contagion

The Obama administration said in its regulatory proposal that derivatives “became a major source of contagion through the financial sector during the crisis,” instead of dispersing risk as intended.

Banks such as JPMorgan are already subject to capital requirements through their federal regulator. Unregulated hedge funds, energy companies and other corporations “whose activities in those markets create large exposures to counterparties” could also be required under Obama’s plan to set aside cash and collateral to back trades.

“Any of the world’s largest hedge funds would be viewed as systemically important, and I’d forecast the Fed would include them among the financial players they’d keep an eye on under these new regulations,” said Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business in California.

Thick, Resilient Enough

JPMorgan is the largest user of over-the-counter derivatives, with $87.4 trillion in notional value last year, more than the next two largest, Bank of America Corp. and Citigroup Inc., combined, according to the Office for the Comptroller of the Currency.

Treasury Secretary Timothy Geithner, speaking to reporters last week, cited AIG as an example of a large derivatives dealer that sold credit-default swaps and didn’t have enough capital to make good on its positions when the contracts moved against the company.

“The important thing to do is to make sure there’s enough capital against the commitments firms write, whatever form they take,” Geithner said. “A centerpiece of our reform proposal is to make sure those shock absorbers, which are central, vital to the basic stability of the system in the future, are thick enough, strong enough, resilient enough.”

To contact the reporter on this story: Dawn Kopecki in Washington at dkopecki@bloomberg.net; Matthew Leising in New York at mleising@bloomberg.net.