AIG had issued US$440 billion in credit-default swaps (which are like insurance contracts on bonds and other assets that are meant to pay off if those assets default). But as markdowns on AIG’s investments in subprime mortgages led to downgrades in its credit ratings, the holders of the credit-default swaps demanded more collateral, which AIG could not provide.
As large as AIG’s swaps exposure was, it represented only 0.8% of the US$55 trillion in credit-default swaps outstanding, this total market is more than the gross domestic product of all nations on earth combined. Yet, despite its enormous size, the credit-default swaps market has operated in the shadows. There is no public disclosure nor any legal requirement for these contracts to be reported to the Securities and Exchange Commission or any other agency. So government regulators have had no way to assess how much risk is in the system, whether credit-default swaps have been accurately valued or honestly traded, and when people issuing and trading them have taken on risk that threatens others.
Because these instruments have been bought and sold widely and in many cases anonymously, they have trapped the large financial institutions in a web of transactions. This has created systemic risk that is particularly serious in the current stressful economic environment, contributing to a gravitational pull that stands to drag everyone down.
All investors, from individuals through their 401(k) plans to pension funds and asset managers, are paying a price, today, for the lack of oversight. We must, urgently, address the problems created by this unregulated environment.
Credit-default swaps are not inherently good or evil. They play an important role in the smooth functioning of capital markets by allowing a broad range of institutional investors to manage the credit risks to which they are exposed. They are also a useful means for investors to signal their view of an entity’s business prospects and creditworthiness. But our markets function best when they are highly transparent, when everyone can see exactly which transactions are occurring and what the instruments being traded are worth. This gives investors confidence that they can accurately assess risk.
Back in 2000, Congress specifically decided not to regulate credit-default swaps. At that time, this market was just a few years old and still very small. For example, in 1999 a report by the President’s Working Group on Financial Markets envisioned no systemic risk from such derivatives since “private counterparty discipline”, investors’ natural desire to keep their own risks to a minimum, would work to protect the broader financial system. But the market for credit-default swaps has recently mushroomed. In just the past two years, it has doubled in size. And as the market has grown, private counterparty discipline has proven inadequate. As we have seen, individual market participants did not pay enough attention until it was too late.
To place a value on credit-default swaps and the mortgage-related securities they insure, buyers and sellers of swaps relied too heavily on financial models that couldn’t predict the mortgage market meltdown. They also trusted too much in the credit ratings of the securities and of the firms selling the credit-default swaps, and these ratings underestimated the risk.
Congress needs to fill this regulatory hole by passing legislation that would not only make credit-default swaps more transparent but also give regulators the power to rein in fraudulent or manipulative trading practices and help everyone better assess the risks involved.
Congress could require that dealers in over-the-counter credit-default swaps publicly report both their trades and the value of those trades. This would make the market more transparent, and make it easier for everyone engaged in credit-default swaps to assess their value. It would also provide regulators with the information they need to uncover unfair or fraudulent practices and to monitor risk.
Then, the Securities and Exchange Commission should be given explicit authority to issue rules against fraudulent, deceptive or manipulative acts and practices in credit-default swaps.
Finally, Congress could provide support for federal regulators to mandate the use of one or more central counterparties — financially stable clearance and settlement organisations — and exchange-like trading platforms for the credit-default swaps market. As it is now, it is often impossible even to know who stands on the other side of a swap contract and this increases the risk involved. We at the SEC are already working with the Federal Reserve, the Commodity Futures Trading Commission and industry participants to accomplish these goals on a voluntary basis, using the authority we currently have.
Because of the truly global nature of the over-the-counter derivatives market, we will need to work closely with governments in other major markets. The climate for such cooperation is good, because the cross-border impacts of the current market problems are obvious to all.
Transparency is a powerful antidote for what ails our capital markets. When investors have clear and accurate information, and when they can make informed decisions about where to put their resources, money and credit will begin to flow again. By giving regulators the authority they need to bring the credit derivatives market into the sunshine, we can take a giant step forward in protecting our financial system and the well-being of every American.
This article was previously published in the New York Times on 18 October 2008
