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Real Regulation for Credit Default Swaps Is Necessary

photo: Captainspears23 via Flickr

It is now official, credit default swaps made the Great Crash worse than it needed to be. From a New York Times column by Joe Nocera:

Oh, and one other thing is starting to become clear: synthetic C.D.O.’s made the crisis worse than it would otherwise have been.

Synthetic CDOs, which hold credit default swaps instead of debt securities, could be created infinite varieties, even as the underlying subprime mortgage market dried up. That made it possible for the ignorant to continue betting, and made it possible for the savvy to take their money. Paulson & Co., Inc. (PCI) wanted to short the housing market, and sought the help of several Wall Street firms. Goldman Sachs agreed and formed ABACUS 2007-ACI, the subject of the recent SEC lawsuit. Here’s what the SEC complaint (.pdf) says:

17. A Paulson employee explained the investment opportunity as of January 2007 as follows:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

In other words, PCI figured it could make piles of money shorting because most purchasers willing to bet on the long position were ignorant of the reality of the housing market.

Blanche Lincoln has a proposal to regulate derivatives. From the section by section analysis (pdf):

Section 106. Prohibition against Federal Government Bailouts of Swaps Entities

This section prohibits federal assistance (including federal deposit insurance, and access to the Federal Reserve discount window) to swaps entities in connection with their trading in swaps or securities based swaps.

I have some quibbles about the language of § 106 and its interaction with the rest of the bill, (large .pdf), but let’s assume it works as intended. It would require all banks to separate their investment banking activities completely from their commercial and retail banking business. I assume that would bar any transactions in which the banking side in any way transferred money to the investment banking side. This seems like a very good idea, much stronger than the current language in the Senate bill.

This language would not require bank holding companies to sell their investment company arms, but it would come close to doing so. What would that mean? Let’s look at JPMorgan Chase. In its first quarter 2010 earnings release, JPM says it earned $2.47 billion in its investment banking business. Retail financial services lost $131 million, and credit cards lost $303 million. Total net income was $3.33 billion, so 74% of profits came from investment banking.

All banks report their swap positions to the Office of the Comptroller of the Currency every quarter. The OCC report (.pdf) for the fourth quarter of 2010 says that JPM was a party to swaps with a notional value of $78 trillion. According to that report, JPM was a party to $6 trillion in credit derivatives, almost all of which was CDSs. The total exposure from all swaps is $362 billion. If the swaps business were segregated, it would require capital to be segregated from the banking business. That could be an expensive proposition, and might impact the balance sheet of the retail banking side.

According to the JPM 10-K, p.174,, at 12/31/09, JPM had written protection credit default swaps with a notional amount of $2.95 trillion, and a fair value of a negative $107 billion. Of that, a total of $1.23 billion was written on non-investment grade securities. We don’t see the reference entities in these figures. It’s fair to ask if any of these relate to transactions like those in the SEC complaint where a synthetic CDO was formed to enable a Wall Streeter to short the housing market.

What other dominos are out there?

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