Thursday, July 23, 2009

‘Naked’ Default Swaps May Be Banned in House Bill

Posted on Bloomberg by Dawn Kopecki and Shannon D. Harrington:

“Naked” credit-default swaps may be banned under provisions in the main U.S. House legislation overhauling oversight of the $592 trillion derivatives industry, House Financial Services Committee Chairman Barney Frank said.

“The question of banning naked credit-default swaps is on the table,” Frank, a Massachusetts Democrat, said during an interview on Bloomberg Television today. The legislative proposal will be released next week, Frank said.

House Agriculture Committee Chairman Collin Peterson, a Minnesota Democrat, said he is helping draft the legislation, which could ban credit-default swaps where the investor doesn’t own the debt on which the contracts are based.

“Frank has indicated to me he wants a total ban on naked credit default swaps,” Peterson said in a statement through a spokesman today. “While the Agriculture Committee had concerns about this proposal when we considered it in February, I am inclined to support it because I would rather err on the side of caution when it comes to these instruments.”

Credit-default swaps do “perform a useful function” in the economy, Frank said, and there may be “alternatives to banning naked credit-default swaps” if most derivatives are moved to a regulated exchange.

“If we can get rules where almost every derivative is traded on an exchange, and those that aren’t because they are just too unique” are backed by extra capital, he said, “then that may do it.”

‘Unintended Consequences’

Frank’s proposal would have “unintended consequences” by making it more difficult for bondholders to hedge their risks, driving up funding costs for companies, said Tim Backshall, chief strategist at hedge fund adviser Credit Derivatives Research LLC in Walnut Creek, California.

“It will inevitably lead to higher costs of funding across all U.S. corporations, significantly reduce liquidity in credit markets, and further widen the opacity of the more worrisome” collateralized debt obligation, or CDO, market, Backshall said. Pricing in CDOs is derived from credit-default swaps trading.

Derivatives are financial contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather. Credit-default swaps are derivatives that were created primarily to protect lenders and bondholders from company defaults. A CDO is a portfolio of bonds or credit- default swaps sliced into varying degrees of risk and return.

Market Makers

Under Frank’s current proposal, market makers would be excluded from the ban on naked credit-default swaps, according to Representative Melissa Bean of Illinois, a Democrat and co- sponsor of a competing bill giving the U.S. Treasury authority over derivatives. Market makers continually buy and sell a specific security on the over-the-counter market, and often use derivatives to protect against losses.

As much as 80 percent of the $26.4 trillion credit-default swap market is traded by investors who don’t own the underlying debt, according to Eric Dinallo, who stepped down this month as superintendent of the New York State Insurance Department.

Congress is seeking to impose government oversight on derivatives as part of an overhaul of financial industry rules meant to prevent a repeat of last year, when the collapse of Lehman Brothers Holdings Inc. and American International Group Inc. froze credit markets and worsened the global recession.

‘Important Economic Function’

Treasury Secretary Timothy Geithner rebuffed at a July 10 hearing a separate House proposal by Representative Maxine Waters, a California Democrat, to ban all credit-default swaps. Geithner said that while comprehensive oversight is needed, a ban would be inappropriate.

Credit-default swaps “provide an important economic function in helping companies and businesses across the country better hedge against their risk,” he said. “I think our responsibility is to make sure those benefits come with protections.”

Dinallo proposed in September 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. Dinallo is now a visiting professor at New York University’s Stern School of Business. He made his estimate of naked trading in a January interview.

Bean is part of group of 69 lawmakers called the New Democrat Coalition that introduced alternative derivatives legislation yesterday. The Derivatives Trading Accountability and Disclosure Act would create an Office of Derivative Supervision within the U.S. Treasury, with the power to set rules for traders, according to a copy of the bill.

‘Disapproval Power’

The bill builds off a proposal by President Barack Obama to move standardized derivatives like interest-rate swaps to an electronic exchange or trading platform, and give the Securities and Exchange Commission and the Commodity Futures Trading Commission industry oversight.

The New Democrat Coalition’s legislation yesterday would still give the SEC and CFTC authority to propose rules for margin and collateral requirements and determine which contracts must be backed by a clearinghouse or traded on an exchange. The Treasury would have “disapproval power” over any regulations, and could censure or suspend traders or revoke registrations, according to the bill.

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