SEC Wants Transparency in Wall Street Credit Gambling
Securities and Exchange Commission (SEC) Chairman Christopher Cox recently emphasized the urgent need for transparency of currently unregulated credit transactions, called credit default swaps (CDS), that contributed to the ongoing economic crisis. Cox is using the SEC's program to modernize its electronic disclosure system as a platform to call for oversight while the agency investigates alleged fraudulent transactions. Meanwhile, two other federal agencies are vying for regulatory oversight of CDS and industry is lobbying to minimize the impact. At issue will be whether transparency is accompanied with any other forms of accountability.
The SEC project, the 21st Century Disclosure Initiative, launched in June, seeks to change the way companies report financial information to the SEC and the way the commission distributes information to investors. The SEC plans to replace the current system — the Electronic Data Gathering, Analysis and Retrieval (EDGAR) — with one that utilizes interactive data structures. EDGAR relies on corporate reporting through paper government forms, whereas the new approach will utilize electronic submission and interactive tagging in a system called Interactive Data Electronic Applications (IDEA). The SEC proposed that companies be required to use the new submission method as early as 2009.
In an Oct. 8 speech at a small conference on modernizing the SEC's disclosure system, Cox made a strong case for transparency, contending that lack of transparency of CDS contributed to our current economic crisis. CDS were originally a form of insurance against bond defaults but have grown into a wildly popular vehicle for speculation. Because CDS are totally unregulated, no one knows how large the market is, although some have speculated that it could be around $55 trillion. The market for these transactions, according to Cox, has drawn the world's major financial organizations into "complex interconnections [that] pose risk to the financial system precisely because of the complete lack of information about who is exposed to whom." To address this transparency problem, Cox approved orders in September to require hedge funds, broker-dealers, and institutional investors to file statements under oath concerning trading of securities including credit default swaps. The statements were due Oct. 6; information about compliance or the content of submitted statements is not yet available.
Credit Default Swaps
CDS are contracts that guarantee to cover losses on certain securities in case of a default, thus acting as a form of insurance. Swaps can occur when banks or hedge funds sell often risky investments such as mortgage-backed securities, municipal bonds, or corporate debt to another financial institution, often anonymously. Ideally, the institution purchasing CDS rests easy, paying premiums to cover itself in case of a default. However, since the Federal Reserve chooses to categorize CDS as "credit derivatives" rather than insurance, the market for the swaps goes entirely unregulated. Over the past number of years, CDS have become more a form of speculation on the health of the companies issuing the bond rather than insurance. The swaps are often reissued to hedge against a default. The end result is the potential $55 trillion in swaps, which is based on roughly $5 trillion in bonds. This can be dangerous for parties that purchase or sell them. For example, the American Insurance Group (AIG) had issued $440 billion in swaps but was unable to meet the promises to cover the defaults on debt. This led to the federal government loaning $123 billion to shore up AIG.
Being unregulated, there are no requirements on CDS sellers to maintain any specific amounts to cover possible defaults. The lack of transparency adds to the problem by preventing purchasers from knowing who the CDS seller is or if they possess the resources to cover the losses.
The CDS market was deregulated by congressional legislation less than 10 years ago with the passage of the Commodity Futures Modernization Act of 2000 (H.R. 5660 and S. 3283). According to Cox, the rate of these transactions has doubled in the past two years, creating increasingly dangerous connections of risky transactions between the world's major financial institutions. In fact, the contracts have increased 86 times since 2000. The SEC fears that CDS, as a tool for speculation, could manipulate stock prices of companies.
That is why the SEC has called for CDS reform as well as transparency. Cox defended CDS in part by stating they "play an important role in the smooth functioning of capital markets by allowing a broad range of institutional investors to manage the credit risks to which they are exposed." As early as September, Cox proposed that Congress create new legislation that would monitor CDS transactions for speculation, grant the SEC rulemaking authority to further prevent manipulation of the market, and establish an official platform for the market so institutions know the parties trading. By requiring reports on these contracts, Congress and the SEC would allow investors to be able to properly assess the risks being taken on by financial institutions and thus better understand their stability. Cox has argued that in the current crisis, such transparency would help investors "make informed decisions about where to put their resources," thus restoring confidence so that money and credit will once again be accessible.
The relationship of CDS to the economic crisis has attracted sharp-eyed attention in congressional investigations and the state of New York. During an Oct. 7 hearing, the House Committee on Oversight and Government Reform lambasted CDS as a key component in the near-collapse of AIG. Rep. John Sarbanes (D-MD) equated AIG's entry into CDS trading to "opening a casino." In New York, Gov. David Paterson (D) announced that the state plans to begin regulating CDS. Such state action, however, would reportedly only cover one-fifth of the entire CDS market. Additionally, the Federal Reserve Bank of New York is proceeding with new transparency requirements for those activities under its jurisdiction. There is also discussion about the Commodities Futures Trading Commission getting involved in regulatory oversight.
The battle over transparency and regulation is heating up in Congress as well. The business industry is lobbying hard to minimize regulation of these private-sector contracts. Action is expected soon.