Thursday, October 16, 2008

Debt insurers, say hello to government regulation. Say farewell to voluntary compliance and disclosure.

Congress and financial regulators for the first time appear willing to impose rules on obscure financial contracts that are increasingly being blamed for igniting the global financial crisis.

“Please excuse the healthy skepticism of my constituents,” Rep. Tim Walz, Minnesota Democrat, said Wednesday during a House hearing, referring to the relative free rein given those involved in so-called credit default swaps. “They’re not buying that right now.”

Republicans, traditional opponents of regulation, acknowledge that Congress needs to lay down the law.

“There are at least some limits to market economics that we’re going to have to make,” said Sen. Richard G. Lugar, Indiana Republican, during a hearing earlier in the week.

Lawmakers and state and federal regulators are a long way from agreeing on specifics. But they’re marching in rare bipartisan lockstep toward making the terms of credit default swaps transparent and subject to government supervision.

Securities and Exchange Commission Chairman Christopher Cox urged Congress last month to begin regulating the market for CDS contracts as part of a financial overhaul that lawmakers will tackle next year. Meanwhile, state regulators in New York announced plans to start overseeing part of that market.

Members of Congress already have proposed legislation to bring the out-of-sight contracts, which operate like debt insurance, under government supervision. A measure authored by Sen. Tom Harkin, Iowa Democrat, would outlaw the riskiest type of credit default swap and put the Commodity Futures Trading Commission in charge of regulating such contracts.

And there’s wide agreement on the need for a so-called clearinghouse for these types of insurers. Under that kind of arrangement, the clearinghouse would be backed by the collective funds of its members to mitigate the credit risk posed by the contracts.

Much of what’s driving the panic is that so little is known about who owes what to whom.

Credit default swaps are a form of insurance for lenders concerned about the risk of default by a borrower and are commonly used for bonds and corporate debt. The lender turns to a third party and buys protection in the form of a credit default contract. The third party agrees to pay the investor the value of the investment in the event that the borrower defaults on it.

But since Congress in 2000 declined to regulate these contracts as it does insurance, the companies that guarantee the assets are not required to keep enough capital on hand to pay them off in the event of a default.

The credit default swap market is estimated at $62 trillion and is being blamed for the near-collapse of insurance giant American International Group, Inc., the bankruptcy of investment bank Lehman Brothers and the downfall of other investment houses and financial institutions.

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