Swaps Hold Huge Corner Needing Focus
By SCOTT PATTERSON and SERENA NG
April 1, 2008;
As policy makers plot out a grand redesign of financial-market regulation, one huge corner of the marketplace ought to get a lot of attention: credit-default swaps.
These financial instruments, which don't trade on exchanges, are like disaster insurance on debt defaults. Investors who buy these swaps get a big payment if a bond or loan defaults. In return for the protection, the investor has to make regular payments to the seller of the swap.
The market has become immensely important, yet regulators still haven't figured out how to deal with it. The Bush administration's blueprint for new regulation curiously had almost nothing to say about it.
Credit-default swaps were a factor in the recent troubles of Bear Stearns. Hedge funds and other firms that were on the other side of credit-default swap trades with Bear tried to exit from their positions or pass them on to other brokers. That set off a broader panic about Bear's health as a counterparty, which pushed the firm to the brink.
Swaps also played a deciding factor in the Federal Reserve's dramatic intervention. If Bear went down, others could have been dragged down through their exposure to the firm through swaps.
Many firms have no way of knowing about problems of their counterparties in these trades.
Such swaps were written against $45 trillion of underlying debt as of the first half of 2007, according to the International Swaps and Derivatives Association. In many instances, there are far more of these swaps written than there is actual debt that swaps are meant to insure.
The market is important for other reasons. The explosion in these derivatives occurred at a time when corporate defaults were near record lows. Moody's Investors Service expects the junk-bond default rate to climb to a range of 7% to 7.5% in the next 12 months from just 1.5% now.
"We haven't gone through a massive default cycle," says Gregg Berman, co-head of the risk management unit at RiskMetrics Group. "I do not believe the market is remotely prepared for the fallout if that happens."
Swaps also present potential insider-trading problems for regulators to work out. In 2006 and early 2007, during the leveraged buyout boom, credit-default swaps at times soared in value before details of big deals were announced. Just last week, swap values were moving before news broke that the buyout of Clear Channel Communications was in jeopardy.
One problem for securities regulators: Because these can be considered private contracts, and not securities, it's not even clear if traditional securities laws apply to them.
Large commercial banks do need to file regular reports on their derivative exposures with the Office of the Comptroller of the Currency. The Depository Trust & Clearing Corporation also has set up an information warehouse that stores records of CDS trades. And the Federal Reserve Bank of New York has been pushing dealers and other firms to confirm and process trades more quickly. Last week, large dealers unveiled plans to centralize settlement of their credit-derivative trades by September.
But credit-default swaps have become too important for the wattle and daub approach regulators have given them in the past few years.
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