DAVE DAVIES, host:

This is FRESH AIR. I'm Dave Davies, senior writer for the Philadelphia Daily News, filling in for Terry Gross.

As the Obama administration and Congress work to revive the economy, they're also beginning to consider reforms aimed at making the financial system less vulnerable to the chaos that gripped the country over the past year. High on the agenda is the regulation of derivatives, those complex financial instruments that have brought big profits and dangerous volatility to financial markets.

Among the most troubling of the derivatives are credit-default swaps. They're a kind of insurance policy on bonds. Tens of trillions of dollars worth of credit-default swaps were sold in recent years. They had escaped regulation due to laws passed in the 1990s and at the end of 2000. Thus, financial institutions that sell these swaps don't have to report what they've sold or who they've sold them to. They also don't have to have the money on hand to pay off the contracts should the insured bonds fail.

When AIG was unable to make good on credit-default swaps it issued on mortgage-backed bonds, it had to be bailed out with $170 billion of taxpayers' money.

The Obama administration sent a letter to Congress a month ago proposing new regulations for derivatives, and banks, many of which got billions of dollars in federal bailout money, have hired lobbyists to resist new controls.

For some insight into the debate, we turn to Gretchen Morgenson. She's a financial and business columnist for the New York Times. Well Gretchen Morgenson, welcome back to FRESH AIR.

Okay, so the Obama administration indicated several weeks ago that it wanted to regulate derivatives. The Treasury secretary, Timothy Geithner, wrote a letter to the Senate majority leader and others, and there have been other expressions by the administration of its plans. What do they want to do?

Ms. GRETCHEN MORGENSON (New York Times): Well, what I would characterize the letter that Mr. Geithner sent to Capitol Hill as is sort of a halfway step. They want to try to get a lot more of these kinds of contracts to be traded on an exchange or some type of clearinghouse where they could be overseen by a regulator.

The difficulty is that many of the contracts are very highly specific and written with the particular entities who are striking the deal in mind, meaning that they're not sort of plain vanilla. They're not sort of white-bread, everyday contracts.

They might have a particular aspect of them that's highly unusual, and it's, you know, related only to the entity that's buying the insurance, and those cannot be traded as easily as, say, 100 shares of IBM, these people say, and so the halfway aspect of this proposal is that those kinds of hand-tailored or highly specific credit-default swaps will not see the light of day. They will continue to be traded privately, and those were the very contracts that AIG wrote and that got AIG into trouble.

DAVIES: That sounds very problematic.

Ms. MORGENSON: Well, it just sounds like there are going to be ways for dealers and market participants to sort of say oh, well, this is one of those hand-tailored ones. It can't possibly trade on an exchange or a clearinghouse and sort of keep a lot of the market away from the scrutiny that I think it really deserves and merits.

And so you have to wonder who's going to be making those decisions about which contracts actually do see the light of day.

DAVIES: Okay, so there's also the issue of when a company decides to write a credit-default-swap contract, in other words to commit to pay in the event of a default by someone. Don't investors need to know whether, in the end, they will have the financial reserves to meet that obligation if, indeed, the default occurs? Does the Obama administration propose reserve requirements so that people who are making these commitments - are we going to be assured that they have the financial means to fulfill them?

Ms. MORGENSON: They will require what is called margin, and that is similar to, as you describe it, a reserve. What that is is that's money that is required to be put up when the transaction occurs to satisfy, you know, the participants' fears, as you point out, that maybe the person writing the insurance will not have the money, you know, necessary to pay off if a default does occur.

But you bring up a good point, which is there is a difference between exchanges and clearinghouses. They Treasury has proposed more of a - that this market go in the direction of a clearinghouse. It has not required that these things be traded on an exchange, which is far more transparent, and you know, we all know how exchanges work, and they've been around for hundreds of years, and they actually work pretty well.

But the clearinghouse, in my view, which the Treasury has sort of proposed a little bit more strongly, has some problems associated with it that go to the heart of what you're talking about, which is, you know, who will be on the hook, and will they be money-good when the time comes?

A clearinghouse relies on a central intermediary, a clearing party, as it were. So I am a customer. Let's say I am buying insurance from a bank. If I worked this trade on a clearinghouse, then I would work with an intermediary. And the intermediary is sort of that entity, for that period of time anyway, that has to be money-good. And so you do add an element of concern there, that there's another party involved that would also have to be overseen and regulated quite closely to make sure that, you know, if there were major defaults or a cascade of problems, that this intermediary could, in fact, make good.

DAVIES: So if the requirement is that derivatives be traded on a clearinghouse, that I guess sort of would be managed by all of those who deal in these, is there a difference in the amount of public disclosure, how much information the public gets about these?

Ms. MORGENSON: Well, you ask a very shrewd question. The clearinghouse that is vying for the biggest part of this business is here in New York, and it is called the ICE Trust, I-C-E Trust, and it is an entity that's relatively new, but it trades other commodities, but it is very closely affiliated with the major dealer firms who trade derivatives in very big size.

And so another concern that some have is that those dealers will be able to sort of control how much disclosure there is on this ICE clearinghouse, and they might be able to say oh, well, this should be traded privately. It's really not, remember, one of those plain, vanilla contracts, and so they might be able to influence such decisions, which really do have a bearing on the amount of scrutiny that the public will have on these kinds of transactions.

DAVIES: You know, at the risk of getting too technical, I want to ask you one question about what you just said a moment ago, about the unlikelihood that the government will be able to regulate these custom derivatives because they are so arcane and intricate, and how could you trade them. It seems to me that, I mean, if it's a political problem that you won't be able to get that through because there's such opposition, that's one thing, but it seems to me that you could simply require them to be disclosed.

I mean, there are certain - for example, certain loans, such as mortgages, which are publicly on file in every city in the country. Can't we at least make the extent and terms of these contracts public, even if they can't be traded like, you know, shares of Wal-Mart?

Ms. MORGENSON: I think, Dave, you are absolutely right, and it's very astute. Disclosure and lack of disclosure is really at the heart of so much of this crisis that we've been through and that we continue to go through, the disclosure of mortgages in pools of securities that were defaulting, the lack of disclosure about off-balance-sheet entities and obligations of our major banks, which were not disclosed, which had to come back onto the balance sheet, and so therefore, you know, were directly related to their, you know, huge losses and difficulties.

So disclosure is absolutely crucial here, and so yes, I think that that is a terrific answer to their allegations that these things cannot be traded. Well, let's just shine the light of day on them, and at least people will know the kinds of obligations that are out there and who's making them, and who's agreeing to them.

DAVIES: Now how have the banks and others who write and trade derivatives responded to these threats of regulation?

Ms. MORGENSON: They have responded by, you know, getting together and forming a coalition, or a consortium actually, which they are using as a lobbying entity to try to get their point across to Congress. They have hired some of - the same people are working together on this project that worked on it in 2000, and they're spending an awful lot of money to make sure that derivatives will continue to be as profitable to them as they have been up until now.

DAVIES: They're spending money on campaign contributions, lobbyists?

Ms. MORGENSON: Yes. Their lobbyist is a person named Edward Rosen, who is an expert on derivatives, and he led the charge for the banks back in 2000, when Brooksley Born of the CFTC lost her battle to regulate derivatives, and he's back, and you know, is a very formidable force and figure and lobbyist, and this is a consortium of about nine major dealers, major banks both foreign and domestic who are very huge participants in the credit-default-swap market.

DAVIES: And maybe this goes without saying, but I'm assuming that a lot of these same banks who are spending money on campaign contributions and lobbyists to protect derivatives are some of the same banks that got billions in federal bailout money.

Ms. MORGENSON: Yes, these banks actually formed their consortium just about a month after five of them received billions of dollars in TARP money. So you know, that's a paradox that I think is intriguing.

DAVIES: What's their case? I mean, what's the argument that derivatives ought to continue to operate in the shadows?

Ms. MORGENSON: Their argument is that AIG was a rogue operator, that apart from AIG, credit-default swaps have not produced problems in world markets, that in fact they have helped corporations and large investors hedge positions reduce their risks. You know, these are the arguments that you always hear. They really aren't any different from any of the other arguments that you have heard over decades about why regulation is bad.

You know, if these things are regulated, these people say, jobs will disappear. They will go to Europe or somewhere else overseas. Profits will decline. You know, the corporations will no long be able to hedge their positions. You know, they're focusing a lot on the hedging aspect of it, not really so much on the speculative nature of these things, which far, far outweighs the hedging that credit-default-swap customers do.

DAVIES: We're speaking with Gretchen Morgenson. She's a financial and business columnist for the New York Times. We'll talk more after a break. This is FRESH AIR.

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DAVIES: If you're just joining us, we're speaking with New York Times business and financial columnist Gretchen Morgenson. You know, the banks, you know, a lot of the banks are getting together to oppose further regulation of derivatives, but they were really harmed by this financial crisis, also. Why would they want to preserve the status quo?

Ms. MORGENSON: Well, the derivatives business that these banks do is very profitable. In fact, it's one of their few profitable enterprises at the moment, and it's helping to offset, you know, massive amounts of losses. So they're just trying to protect one of their, you know, one of their very, very sort of big honey pots, and a last one, as it were.

I mean you know, they do have other profitable areas, but derivatives are hugely profitable. So that's one reason, but you know, yes the banks were hurt mightily by this mess, but hey, they brought us to the brink. They pushed us over the edge, and their shareholders have paid the price, the taxpayers have paid the price, the employees have paid the price, but I'm not sure the executives who were, you know, on the scene making decisions and the boards of these companies have paid the price.

DAVIES: Are derivatives still profitable in this kind of economic climate, where you know, defaults loom around every corner?

Ms. MORGENSON: Yes, they are still profitable because the person who is constructing these deals, the intermediary, the dealer who sells them, is still able to capture enormous profits because they are still being kept under wraps. There still is no market that says here is what an investor or a buyer should pay for that particular credit-default swap. It's still kept under wraps.

And one of the reasons that the large dealer firms, who have been trading these derivatives, selling them to their clients, want to keep them under wraps is because the profits in privately traded credit-default swaps are far, far larger than the profits will be when the customers can see what others are paying for those similar transactions and what other dealers are charging for those similar transactions.

DAVIES: So if you sell a credit-default swap - someone is purchasing, betting on - you know, insuring some bond by some company - if that bond goes bust, and I've written that credit-default swap, I assume I'm going to take a huge loss, right?

Ms. MORGENSON: Yes, but the bank is not necessarily the person who's writing it. The bank who wants the - the dealers who want derivatives to continue to be traded, you know, in the shadows are the facilitators. They're the people who make the transactions happen. They're the people who put together the company that's writing the insurance with the buyer of the insurance, and that's where their profits lie.

DAVIES: And so the companies that are actually writing the insurance, they're not the ones that want to continue this stuff?

Ms. MORGENSON: Well, they are to some degree, but it's really more about the people who are acting as the intermediaries in this market, the facilitators, you know, that step in to devise these kinds of transactions, sell them to their customers and pocket the profits on those transactions. It's just a fee-based business. It just so happens that the fees are sizable because it's an obscure market. It's not a market where everyone knows what a credit-default swap with this particular entity should cost.

DAVIES: So you know, AIG bet way too much on these derivatives, on these credit-default swaps and then got into terrible trouble.

Ms. MORGENSON: They were essentially betting that mortgages were not going to default.

DAVIES: Right, and so they got into terrible trouble, and the taxpayers had to bail them out, and if you have all these financial players out there continuing to write these credit-default swaps in the shadows, in an unregulated environment, and another coming calamity occurs, I mean whether it's commercial real estate or a credit card, and a bunch more of these bets go bad, what happens? I mean, are they going to come back to the taxpayers again?

Ms. MORGENSON: Absolutely they will. I mean, have we not learned that when these banks get in trouble, if they go to daddy, they'll get what they want? I mean, that's the lesson that we have unfortunately learned from this mess, that you know, the kid took the convertible, you know, went on a joy ride, drove it off the cliff. He survived, the convertible didn't, and he goes back and says hey dad, you know, I want a new car. And dad says okay, here's the money.

DAVIES: Any chance the government might say sorry?

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Ms. MORGENSON: We've set such a precedent here for bailing out everybody, it seems impossible to imagine that a large participant of any market that might have, you know, a big impact if it failed would not be bailed out.

DAVIES: You know, Ben Bernanke, the Fed chairman, is a student of the Depression, and it seems that he believes that an important lesson of that catastrophe was that you have to maintain confidence in the banking system, that once there are runs on banks that calamity follows. Has he drawn the right lesson here?

Ms. MORGENSON: Well certainly confidence is crucial to, you know, the kind of open-end fair operating of markets, but I would argue that we have not built confidence by the way we have approached these failures. In fact, you know, there's been a sort of a sense that the government was picking winners and losers without any kind of a playbook.

We arranged a marriage of Bear Stearns with JP Morgan when Bear was about to fail, but we let Lehman Brothers go. Then five minutes later, we bail out the world's largest insurance company, which was not even overseen by the Fed or, you know, any bank regulators.

So you know, that is not the kind of operation that instills confidence, and in fact you have to wonder about the idea that these regulatory actions, you know, that have sort of kept some of the larger banks afloat, like Citigroup, you know, I would argue that that does not necessarily instill confidence.

I think what confidence is created by is a clarity of the problem, is a sense that people understand where we are, how financially sound or unsound these institutions are. And from my view, we've just been sort of papering over their problems or allowing them to sort of do the least toughest thing that they can do to raise capital. It's been, I think, a very easy, sort of too easy, set of actions taken by regulators, not tough enough, and I think that that has led to a sort of feeling that we're not sure where we stand, and if we had been a little bit more aggressive and clear about companies that really should not be allowed to go on, then you'd have confidence come back far quicker than you will now.

DAVIES: Gretchen Morgenson, thanks so much for your time.

Ms. MORGENSON: Anytime, Dave.

DAVIES: Gretchen Morgenson is a business and finance columnist for the New York Times. I'm Dave Davies, and this is FRESH AIR.

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