Geithner Endorses Naked Credit Default Swaps
[Editor’s note: Marcy’s liveblogging of Geithner’s appearance before the House Financial Services Committee continues here. You can find her take on the morning session here.]
Today Joe Donnelly (D-IN) asked Timothy Geithner a simple question — why can’t they ban naked credit default swaps?
DONNELLY: We saw naked credit defaut swaps cause extraordinary devastation to our economy and I know regulation is coming. do these naked credit default swaps provide any value added, or is this simply just gambling?
GEITHNER: Uh….I know there are strong opinions on this issue so I say this with some trepidation. My own sense is that banning naked default swaps isn’t necessary and wouldn’t help fundamentally in this case. It’s too hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome. If we could find a way to separate those two types of transactions from each other, we could do that…we would have done that a long time ago across a whole range of financial innovations but it is terribly hard to do.
And, uh…but we will listen carefully to any ideas in this area and understand why people feel so strongly about them.
DONNELLY: I would love to see if there is something we can do in regulation in this area because to me, those are just simple bets. And the American people have been required to take money out of our truck drivers pockets, our waitresses pockets, to pay off bets on Wall Street. And it’s not that there was any real product there, it was simple — at least to me, from the midwest, on Main Street — it just seems like gambling.
GEITHNER: Well our issue is not whether we want to protect the American economy from these things in the future, which we do, the question is how best to do that. And our view is that the absolutely essential thing is to make sure there is more capital held against those positions, so that we never again have to face the situation where those type of judgments could imperil the system and therefore leave Americans in the position where they’re facing much lower pension values, higher borrowing costs, much greater risk of losing their jobs. That’s our basic objective. The only question is whether along side what we do for capital and margin, and these broad efforts to bring these things into central clearing houses, whether we need also to look at banning certain instruments. And I…my own judgment is don’t need to do that, very very hard to do that, but understand there are other views on that and happy to listen to any suggestion.
In Dean Baker’s primer on AIG, he noted that we still don’t know what the government’s policy of paying off credit default swaps has been — did taxpayers have to pay off because a company was trying to protect against losses on a mortgage backed security, or simply because it was gambling that a bond it didn’t hold would go bad? If the latter is the case, he said, "it is difficult to see how a failure to honor the CDS would impose a serious hardship." He also asks why we paid them at full value rather than their market value, and wonders if we paid them off before the underlying bonds had defaulted. "This seems like a straight gift to the banks," he said.
If Geithner thinks that naked credit default swaps have value and need to be preserved, it would be good for the public to know what happened with them in the bailout and what the government’s policy will be about paying them off going forward.
I asked Dean what he thought about this, and he believes that at the very least, we should be taxing naked credit default swaps. "We tax gambling in Las Vegas," he says.