U.S. Seeks Greater Oversight Of Derivatives

The government's top economic officials want to regulate the powerful financial instruments known as derivatives that contributed to the economy's meltdown. The markets for these derivatives are largely opaque and free from oversight.

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ROBERT SIEGEL, host

From NPR News this is ALL THINGS CONSIDERED. I'm Robert Siegel.

MELISSA BLOCK, host:

And I'm Melissa Block. President Obama went out on the road today to New Mexico where he pushed for legislation to overhaul how the credit card industry is regulated. Back in Washington, his administration is developing plan to regulate another powerful part of the finance world: derivatives. They played a large role in the Wall Street meltdown. In a moment, we'll hear from the president's town hall meeting on credit cards.

SIEGEL: First, those derivatives. The Obama administration has proposed one of the first of what will likely be many major changes to how the US financial system works. Adam Davidson, part of NPR's Planet Money team, has been studying the administration proposal. Hi, Adam.

ADAM DAVIDSON: Hi, Robert.

SIEGEL: This early move, Adam, governs a type of derivative that was central to the financial crisis. I'd like you to explain the derivative and why it's in need of new regulation.

DAVIDSON: Sure. Basically, this regulation is solving the AIG problem. AIG sold something called a credit default swap, which is basically a bet on how certain bonds are going to do. And AIG sold these all over the world and lots and lots of bonds, especially those subprime toxic asset bonds, blew up and AIG didn't have enough money to cover its bets. And that put the government in a really lousy position because they had a feeling that the whole global economy could collapse, but they weren't sure.

The reason they weren't sure is because these credit default swaps have a few problems. One big problem is each one is handmade, it's made between say, AIG and Deutsche Bank, or between Citibank and some hedge fund somewhere. Each one is made, they call it bespoke, or custom-made. And so you don't know what each one looks like, you don't know how it will behave in a crisis.

The other thing is these all happened between two parties. Nobody knows how many credit default swaps are out there. Nobody knows the size and scope of the problem. And so the government said we don't want that anymore. What we want is for all of these to be traded in one place, like the stock exchange, where each one is exactly like every other one, so we know how they behave. And we know who's buying and selling them, we know what the price is, everything's clear and easy.

SIEGEL: But in the New York Times story today about this, it said that derivatives that are custom-made would not be covered by the regulations the administration is proposing.

DAVIDSON: Right. That is the big - I don't know if loophole is the right word, but that's what some people are saying is a big problem with this new administration plan. So what they want to have happen is for everyone who is trading custom-made ones to say, forget the custom-made credit derivatives, I'm going to go for standardized ones, ones that are traded on an exchange. And I'm going to stop using custom-made ones.

But the law doesn't prevent them from using custom-made ones. The law, in fact, says if you use custom-made ones you can go ahead and keep doing that away from an exchange. There's a strong incentive to keep using the custom-made ones because if you're just selling standardized ones they become a commodity and you don't get a big commission. If you're selling your own custom-made ones and you can convince your customers, my custom-made ones are better than anyone else's, you get a bigger commission. So there's a lot of fear that this is a big, new regulatory rule and a lot of banks will be free to ignore most of it.

SIEGEL: Well, do advocates of this kind of regulation claim that if such rules had been in place, say, three years ago or five years ago, that that would've prevented this crisis?

DAVIDSON: I think that's a pretty hard argument to make. Certainly, if anyone could go back in time and destroy the credit default swap, I think there's an awful lot of people who would love to do that, or at least to change how credit default swaps existed. The problem was that all the financial products we all keep hearing about were specifically designed to sort of evade or move around the existing regulation. So it seems safe to say that whatever the regulations were, the banks would've created products to evade those as well.

SIEGEL: But I've heard the argument made - in particular from a senior administration official not too long ago - that, say, for the next five years investors are going to be very risk-averse. That would imply that they would seek out regulated markets as opposed to unregulated ones, because of the crisis that blew up in their faces over the last couple of years - better to be safe for the next few years.

DAVIDSON: I'm hearing that a lot, that for three years, five years, something like that, banks and investors and everyone's going to be sort of cautious -this is going to be fresh in our mind. And then they start making money again and they forget about all those risky days and they go back to doing risky behaviors and we'll have another bubble. We don't know when that'll come, but I think it's a safe bet it'll come.

SIEGEL: Okay, thank you, Adam.

DAVIDSON: Thank you, Robert.

SIEGEL: Adam Davidson of the Planet Money team. You can learn more about the financial crisis and new proposed regulations at NPR's Planet Money blog and podcast at npr.org/money.

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