Obama Plan To Rein In Credit Default Swap Market

The Obama administration's blueprint for how to prevent another financial crisis takes aim at credit default swaps. They are the derivatives that got AIG into trouble, requiring a $180 billion government bailout. The administration's proposal would try to regulate those derivatives.

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The administration's blueprint for fixing the financial system contains a few words not exactly easy on the ears - credit default swaps. Credit default swaps are those financial instruments that got AIG in trouble or got AIG in trouble, requiring, as you may recall, a $180 billion bailout from the government.

The administration's proposal would try to prevent that from happening again. Let's go now to NPR's David Kestenbaum with our Planet Money team.

DAVID KESTENBAUM: Regulating credit default swaps is a big deal, because it wasn't just AIG working with them. There's a huge market.

Mr. KEVIN MCPARTLAND (Tabb Group): At this point it's right around $30 trillion outstanding.

KESTENBAUM: Kevin McPartland is an analyst at a research firm called the Tabb Group. He says you can think of credit default swaps as a kind of insurance. Instead of insuring your car you insure an investment. That $30 trillion is the total amount of stuff being insured. And you can insure all kinds of things.

Let's say I have a German treasury bond. I'm worried for some reason Germany might default. Can I buy a credit default swap as insurance?

Mr. MCPARTLAND: Yes, absolutely.

KESTENBAUM: And could I buy a credit default swap on Ford?

Mr. MCPARTLAND: Yes, yes, definitely.

KESTENBAUM: What if I'm worried my yacht might crash into the shore?

Mr. MCPARTLAND: Yeah, well, that's - no, that's a little bit different.

KESTENBAUM: Unlike, say, car or fire insurance, the credit default swap market is pretty unregulated. If you want to buy a credit default swap you call up a big bank and they write a contract for you. It's a private deal.

The Obama administration's proposal would make credit default swaps more like corn or hog futures. Those are bought and sold every day on the Chicago Mercantile Exchange and they've never contributed to a global meltdown.

One reason is that exchanges provide stability. They can require that traders maintain a financial cushion. Under the Obama proposal, some credit default swaps would be forced onto exchanges and contracts that were off exchange would have to be reported.

Kevin McPartland says that's good.

Mr. MCPARTLAND: Reporting requirements will provide a lot more transparency to regulators as to who is doing what and who holds what positions.

KESTENBAUM: Would this have stopped the AIG problem?

Mr. MCPARTLAND: It very well might have with the data available, but also with the regulators in place to be routinely monitoring it, watching that data for potential problems. It very well could have stopped AIG from amassing a position as large as they did.

KESTENBAUM: That's one opinion. Here's another.

Professor LYNN STOUT (UCLA School of Law): It's a proposal that looks like they're going to reform the market.

KESTENBAUM: Lynn Stout, securities law professor at UCLA.

Ms. STOUT: But it would be very easy for Wall Street to hijack it and prevent it from being a real reform at all.

KESTENBAUM: The Obama proposal would require plain vanilla credit default swaps to be traded on an exchange, but not customized specialized ones.

Ms. STOUT: This is a loophole that is potentially big enough to put the state of Texas into because it's not that hard if you're a derivatives trader to claim that a particular contract has to be customized and therefore should not be traded on a regulated exchange.

KESTENBAUM: It's worth pointing out that there are some people who think the Obama proposal is too tough. Cory Strupp is a lobbyist with the Securities Industry and Financial Markets Association, which represents some places that issue credit default swaps.

Mr. CORY STRUPP (Securities Industry and Financial Markets Association): Goldman Sachs, Morgan Stanley, J.P. Morgan.

KESTENBAUM: Is AIG a member of your organization?

Mr. STRUPP: AIG is a member of our organization, I believe. Is that correct, Travis? Do you know?

TRAVIS: Were a member.

Mr. STRUPP: They were a member of our organization.

KESTENBAUM: Strupp thinks the way to prevent another AIG is to better regulate places like AIG. He doesn't like forcing credit default swaps onto exchanges. That would force them to be generic, he says. And the cool thing about credit default swaps is that they can be precisely tailored to insure a specific risk.

Mr. STRUPP: For example, if you have a company that wants to hedge a credit exposure in an odd amount of money, $156,217.25, they can enter into a credit default swap that covers exactly that amount of credit risk to the penny.

KESTENBAUM: There are a lot of pennies at stake here. All sides are taking their arguments to Congress.

David Kestenbaum, NPR News, Washington.

INSKEEP: For more reaction to the president's plan, check out our Planet Money podcast and blog, npr.org/money.

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