Update #1: Power

On the 13th, Secretary Geithner wrote a letter to Harry Reid outlining the administration's ideas for what over-the-counter derivatives regulation should look like. The administration's proposal goes further than anything currently before Congress. Here are some highlights:

* Clearance through well-regulated central counterparties. (causing central counterparty stocks to have a very good day!)
* Capital requirements and reporting requirements for dealers
* Allowing SEC and CFTC to regulate the market
* Protection of unsophisticated investors (like the Province of Quebec?)

On the subject of securities regulation reform, it is clear that the administration's thinking is clearer and more organized than that of the Congess. Why are the administration's proposals being offered in such a deferential manner? The administration knows how to play hardball. Why aren't they doing it?

Another Prescription for Over-the-Counter

Congress Daily (2009 WLNR 6514585) reports that the US Chamber of Commerce is lobbying against total regulation of the over-the-counter derivatives market. Alarmed by the rapid progress of bills like the Derivatives Markets Transparency Act, "the Chamber is researching how their member companies use such OTC products and will take the results to argue to lawmakers that the market should be preserved." The Chamber wants to show that while "most derivative products [should] be placed on the burgeoning clearinghouse system [...] certain products, such as some currency contracts, that need the extra flexibility of the OTC market."

SEC Update

Erik Sirri, Director of the Division of Trading and Markets testifies about observations and lessons learned from the CSE program:

* no parent company liquidity pool can withstand a "run on the bank."
* there is a need for focus on illiquid assets held by financial firms
* Recent events have proven the limitations of certain risk metrics such as Value-at-Risk
* critical financial and risk management controls cannot just exist on paper

Julie Zelman Davis has been named Deputy Director of the agency's Office of Legislative and Intergovernmental Affairs, where she will serve as a key liaison between the Commission and Congress.

The SEC will hold an open meeting on April 8th to discuss whether to propose a short sale price test (does this mean the uptick rule?)

New CDS counterparty alert: they're coming fast and furious. Today's victim? The Chicago Mercantile Exchange.

Commissioner Elisse Walter offers a conservative agenda for regulatory reform: regulate OTC derivatives by repealing the CFMA, require hedge fund managers to register as investment advisers, merge the SEC and the CFTC.

Ethiopis Tafara, Director of the SEC's Office of International Affairs offers a more radical prescription.

What ISDA Matter?

Yesterday, the Senior Supervisors Group, composed of national banking regulators from seven countries, released a report titled Observations on Management of Recent Credit Default Swap Credit Events. Although the report is short, it is very tough sledding.

The Senior Supervisors Group examined the process for unwinding a credit default swap when something bad happens. They found that the process works pretty well, but they didn't like that it is ad hoc instead of part of a standard contract.

Standard agreements governing credit default swaps are drawn up by an industry body called the International Swaps and Derivatives Association, Inc (ISDA). Under ISDA's 2003 Credit Derivatives Definitions, when a CDS experiences a "credit event" it terminates and is settled via an auction. There are six credit events, and all of Article IV of the 2003 Credit Derivatives Definitions is devoted to explicating them.

The process of incorporating the auction process into the 2003 Definitions has acquired the unusual name "hard wiring." ISDA has published a hard wiring timetable and a central list of developments.

SEC Update

The SEC had a busy week! It seems Mary Schapiro is starting to reveal her regulatory priorities, viz:

Counterparty Like its 1999: the SEC has approved another central counterparty for credit default swap transactions and even though, as the release admits, they can only regulate "those CDS that are not swaps" (what does that "S" stand for?), they're game.

Round 'n' Roundtable: on April 16th, yet another discussion of how to regulate credit rating agencies. Mary Schapiro calls it "clearly one of this agency's most important responsibilities."

Tweeeet: the SEC has brought in a consulting firm to help evaluate and improve the way it handles whistleblower complaints.

BNA Securities Regulation Law Report Teaser

The most recent issue of the BNA Securtities Regulation Law Report contains a wonderful overview of what the first part of 2009 may hold in terms of regulatory reform. (41 SRLR 128)

It also reports why the SEC's new credit default swap clearing regs may be subject to the president's rulemaking ban. (41 SRLR 106)

Finally, a group of insurers have brought suit to roll back the SEC's controversial new definition of Annuity Contract. (41 SRLR 117)

A Stage Coach Called "Accomodation"

Today's WB Currents Extra has a nice article about companies that have announced they are getting into the CDS trading and/or clearing business. The article points out (as has been noted here) that the SEC has bestowed the mantle of "offical" CDS trading and clearing facility on an NYSE sub. However, the SEC's power to regulate credit default swaps is pretty limited so lots of companies are trying to get into the business.

I guess that's how the New York City subway got built.

Just Don't Call it a Swap

The SEC is attempting to designate a central credit default swaps counterparty (for more on CDS counterparties see this post) for the small piece of the CDS market it can regulate (anything that isn't a swap, thank you very much Gramm-Leach-Bliley). Today it announced that it had exempted LCH.Clearnet Ltd and Liffe (the derivatives trading business of NYSE) from a whole bunch of requirements to allow them to immediately bring their CDS trading and clearing service (opened on 12/22 in Europe) here. Broker-dealers were granted an exemption to allow them to use the Liffe system.

SEC Update: IOSCO task forces, central clearing update

The IOSCO Technical Committee has created three task forces to study:
- short selling
- unregulated financial markets (OTC derivative)
- unregulated entities (hedge funds)

The SEC has granted a large number of fund cancellations

On December 3rd, the SEC will, maybe, talk about credit rating agency regulation

Corporation Finance has issued guidance for issuers replacing shelf registrations

Erik Sirri updated the House Ag Committee on the progress toward central clearing for credit default swaps

SEC General Counsel Brian Cartwright will resign

New York Delays Derivatives Regulation

The Corporate Counsel Blog reports that the New York State Insurance Department is delaying its proposed regulation of credit default swaps because federal agencies have stepped in with a more comprehensive plan for regulating all OTC derivatives.

BNA Recap - CDS Clearinghouse, TARP Warrant Treatment

The November tenth issue of the BNA Securities Regulation Law Report summarizes, from an internal SEC document, the SEC's work on the recently announced central clearinghouse for credit default swaps. (40 SRLR 1860)

The same issue contains an interview with FASB member Leslie Seidman about accounting treatment of the warrants issued to Treasury through the TARP equity purchase program. FASB's letter to Treasury about accounting treatment of TARP warrants can be found here. (40 SRLR 1860)

Did Someone Say "Party?"

Today, the President's Working Group on Financial Markets announced a Memorandum of Understanding (MOU) between the Federal Reserve, the SEC and the CFTC. The three agencies agreed to work together to create central counterparties for credit default swaps (CDS). A central counterparty (CCP) is a third wheel who stands between the parties to a contract. Because the CCP would have to be a party to every CDS agreement, the CCP would know the size and the value of the market.

The MOU is the first salvo in the push to bring some regulation to the market in OTC traded derivatives contracts (more here). It is vaguely worded and full of caveats. Sections 2 - 7 are about what the MOU does not do. Section 8 says that the signatories will "take into account" the Group of Ten report: "Recommendation for Central Counterparties."

Experts on the Future of the SEC, Part 5

4. Regulate OTC derivatives!

According to Hazen, “the relevant regulatory failure was the failure to regulate over-the-counter derivatives.” These markets were, in his words, “an accident waiting to happen.” Fried agrees that there should be “more transparency in that market.”

In 1999 Congress passed, and President Clinton signed, the Commodity Futures Modernization Act of 2000 (PL 106-554, 7 USCA 7a-1 et seq). The CFMA, implementing recommedations made by the President's Working Group on Financial Markets, contained provisions exempting certain derivatives, including credit default swaps, from regulation by the SEC or the CFTC. As Chairman Cox put it: in this “regulatory black hole” grew a market larger than, “the GDP of every nation on earth.” The Depository Trust & Clearing Corporation (DTCC) argues that the OTC derivatives market is only half the size Cox claims it is because he counts each transaction twice, but even using the DTCC's math we're talking about a 35 trillion dollar market.

The black hole is beginning to fill with band aids. The State of New York would classify credit default swaps as insurance and regulate the piece of the market written by New York-chartered insurers (approximately 60%). DTCC recently announced the creation of a central clearing facility for OTC derivatives and a database containing information about the largest transactions. Professor Hazen called central clearing of OTC derivatives the “minimum” regulation necessary.

DTCC may be trying to address Senator Tom Harkin's stated intention (Bond Buyer, 10/16/08, 2008 WLNR 19639053) to create a CFTC-regulated exchange for OTC derivatives.

New York Will Regulate Credit Default Swaps

New York's Insurance Department has issued a Circular (NY Circular Letter No. 2008-19) titled "Best Practices for Financial Guaranty Insurers." It is the first salvo in the state's campaign to regulate credit default swaps (CDS) by classifying them as insurance. Circular 2008-19 replaces a general counsel opinion from 2000 (NY General Counsel Opinion June 16, 2000).

New York's intentions are further illuminated by a press release from Governor Paterson and the testimony of NY Insurance Superintendent Eric Dinallo before the Senate Agriculture Committee. Dinallo focuses on CDS written on other people's securities. He calls such agreements, "a directional bet on a company's credit worthiness," or, as my boss Mark put it, "me buying insurance on your life."

He lays blame for the rise of these products on the Commodity Futures Modernization Act of 2000 (PL 106-554) which exempted many derivatives from state "bucket shop" laws (7 USCA 16(e)(2)). As Dinallo points out, most states outlawed derivatives in the early 20th Century. New York's anti-bucket shop law (of 1909!), for instance, forbids agreements that are, "settled ... upon the basis of the public market quotations of or prices made on any ... exchange or market upon which such commodities or securities are dealt ... without intending a bona fide purchase or sale of the same," (NY GEN BUS § 351).

Crask Explainer 4: The Market for Risk

Can we talk about the old days? Back in the old days, when a bank wrote a mortgage, the bank took a risk. If you didn't make your payments, the bank had to contend with the expensive process of taking your house and reselling it at auction. To avoid that result, the bank did its best to determine your ability and willingness to pay it back.

No longer. Our new world, created by Fannie Mae and apotheosized by Lehman Brothers and Bear Stearns, is a place where consequences become wholly untethered from actions. The risk formerly carried by your mortgage bank is titrated into a kind of default-risk toxic sludge and sold to AIG.

This then, is a brief explanation of how the geniuses on Wall Street unglued the risk from mortgage banking. First, investment banks bought the mortgage portfolios of mortgage banks. Then, the investment banks organized special-purpose corporations (SPVs) and sold the mortgages to them. With the mortgages, the SPVs also acquired the associated default risk.

The SPVs were created as mortgage-backed security conduits (for more on mortgage-backed securities see this post). The SPV-issued securities were multi-tiered, with some tiers backed by riskier mortgages than others. The securities backed by the most stable mortgages were sold to the public. The worst went back to the investment bank; the default risk that started with the mortgage bank was distilled and acquired by the investment bank.

To protect itself from these risky securities, the investment bank bought default insurance. Because this insurance swapped default risk for insurance premiums, it was called a credit default swap. Who was the largest insurer? AIG. Thus, the default risk that originated when you borrowed money to buy a house was shifted onto the policyholders of AIG, and finally, to the taxpayers.