Thursday, January 29, 2009

Credit Swaps Industry Says Limits Would Hamper Market

By Matthew Leising and Shannon D. Harrington on Bloomberg:

A draft of a bill aimed at reining in $28 trillion of credit-default swaps would hinder recovery of debt markets, according to academics and an industry group.

The proposal “would radically shrink” the market, said Scott MacDonald, head of research at Aladdin Capital Management in Stamford, Connecticut, which oversees $16.5 billion in assets. “While it’s important that there’s a drive to return to some degree of plain-vanilla in financial products, this would be considerable overkill.”

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The draft, distributed by e-mail from the committee, would also force U.S. trades in the $684 trillion over-the-counter derivatives markets to be processed by a clearinghouse. Hearings on the draft will be held next week.

U.S. regulators and politicians are stepping up pressure on banks to use clearinghouses and agree to increased oversight of the markets to improve transparency amid a credit crisis that began in 2007. Bad bets on credit-default swaps led to the collapse and government rescue of American International Group Inc. in September.

Credit-default swaps “have been the only means of hedging credit exposures or expressing a view at a critical time for the industry,” Eraj Shirvani, chairman of the International Swaps and Derivatives Association and the London-based head of European and Pacific credit sales and trading at Credit Suisse Group AG, said in a statement. “Impairing their use would be counterproductive to efforts to return the credit markets to a healthy, functioning state.”

Market Ballooned
Total credit-default swaps outstanding ballooned almost 100-fold within seven years to top $62 trillion of contracts by the end of 2007, according to estimates from the New York-based ISDA, which represents dealers, hedge funds and other investors in the privately negotiated derivatives industry.

While created initially as a way for banks to hedge their risk from loans, the derivatives became a popular vehicle for hedge funds, insurance companies and other asset managers as a way to speculate on debt because they were often easier and cheaper to trade than actual bonds.

Secondary trading on bonds diminished after industry regulators forced transactions to be publicly disclosed on a computer system called Trace, which proved unpopular with dealers.

Bondholder Protection
Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a company’s ability to repay debt. They pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Peterson’s plan “is anti-derivative,” said Mark Williams, a finance professor at Boston University. “Saying you only can trade if you have the physical is like saying you only can write calls if you own the underlying. Imagine what impact that would have on our existing options market if such a ‘naked’ rule was mandated.”

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bonds, according to Eric Dinallo, superintendent of the New York Department of Insurance. Dinallo in September proposed regulating the part of the market in which investors own the bonds. He shelved the proposal two months later because of progress by federal regulators on broader oversight of the market.

‘Kill’ the Market
Hearings will be held on Feb. 3 and 4, after which the Agriculture Committee may make changes to its language. Peterson hopes to have the bill passed out of committee before the President’s Day holiday in the U.S. on Feb. 16, he said yesterday, before it would go to the House.

“This is a bad idea,” said Robert Webb, a finance professor at the University of Virginia and a former CME trader. “It is reminiscent of the opposition in the 19th Century to futures trading in the belief that speculators were controlling the market and driving agricultural prices down.”

The draft bill is a “negotiating tactic” and is unlikely to become law, said Andrea Cicione, a credit strategist at BNP Paribas SA in London. “Going to extremes isn’t a good thing and it doesn’t make much sense,” he said. “The corporate market has worked well and shown itself to be quite resilient.”

European Union Financial Services Commissioner Charlie McCreevy said today he wouldn’t support a ban on trading credit- default swaps without owning the underlying bonds. Speaking in an interview at the World Economic Forum in Davos, Switzerland, McCreevy also said he favored creating a clearinghouse for OTC derivatives.

Forcing interest-rate swaps and credit-default swaps through a clearinghouse, which would establish prices for the privately traded contracts, may reduce how much banks are able to make from them.

As much as 40 percent of profit at Goldman Sachs Group Inc. and Morgan Stanley comes from OTC derivatives trading, according to CreditSights Inc. Estimating the new income that exchanges such as CME Group Inc. could earn from processing the OTC trades is difficult because clearing fees and volumes aren’t known yet, said Bruce Weber, a finance professor at the London Business School.

JPMorgan Chase & Co. held $87.7 trillion of derivatives as of Sept. 30, more than twice as much as the next largest holder, Bank of America Corp., which had $38.7 trillion, according to data from the Office of the Comptroller of the Currency. Of the holdings at New York-based JPMorgan, 96 percent were in the OTC market, compared with 94 percent for Bank of America.
JPMorgan, Bank of America

The largest positions at JPMorgan and Bank of America, based in Charlotte, North Carolina, were in interest-rate swaps. Banks enter into interest-rate swaps with clients such as cities or hospitals that sold bonds and seek protection against adverse moves in interest rates. They also hedge their exposure to rates in the inter-dealer market.

The OCC data only included U.S. commercial banks, so Morgan Stanley and Goldman Sachs Group Inc. weren’t listed at the time. Both New York-based investment banks converted to banks regulated by the Federal Reserve on Sept. 21.

A provision in Peterson’s bill, which will be discussed in hearings next week, allows for the U.S. Commodity Futures Trading Commission to exempt certain OTC contracts that are too customized or don’t trade frequently enough to be cleared.

Added Stability
Funded by its members, a clearinghouse adds stability to markets by becoming the buyer to every seller and the seller to every buyer.

The standardization necessary to process a contract in a clearinghouse may harm the market and drive the trading overseas, Weber said.

“It’s a big deal because the OTC market has developed almost as an alternative to the exchange market with its clearinghouses,” he said. “It would be advantageous for places like London, Hong Kong or Singapore where OTC trading wouldn’t have that kind of restriction.”

Weber said that if price transparency is what Peterson wants, it can be achieved in other ways, such as putting OTC derivative prices on a system such as the Trace bond-price reporting system of the Financial Industry Regulatory Authority.

Peterson’s draft bill would also authorize a study by the CFTC to determine if OTC trading influences prices on exchange- traded contracts such as oil. If the commission found such an influence it would be authorized to set limits on the size of positions held by OTC traders.

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