Out of the Shadows and Into the Harsh Light By FLOYD NORRIS

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September 27, 2008
Off the Charts
Out of the Shadows and Into the Harsh Light By FLOYD NORRIS

THE credit default swaps market — a market that for years was kept out of view and away from any regulation — has suddenly turned into a political hot potato in Washington.

The chairman of the Securities and Exchange Commission said this week that regulation was needed immediately, while the secretary of the Treasury said efforts were already under way to get things under control, and urged caution.

Such swaps, which enable lenders to a company to purchase what amounts to insurance that will protect them if the company defaults on its debts, have grown exponentially in recent years, with the nominal amount of debt guaranteed rising to more than $62 trillion at the end of last year from $631 billion in mid-2001.

The sudden interest in the market stems from two separate but related developments. The collapse of a major firm in the market could set off a chain of problems, a fact that has scared the Treasury Department this year.

In addition, speculators who think a financial firm will fail can buy credit-default swaps. They will profit if they are right. But even if the firm is not in trouble, an increase in the price of those swaps may scare other investors, and send the company’s stock down. That prospect has alarmed the S.E.C. As the political debate was growing, the International Swaps and Derivatives Association, a trade group, reported that the amount of outstanding credit-default swaps declined in the first half of 2008, something that had never happened before.

The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be insured. The huge total reflects the way the market is structured, as well as the fact that someone does not need to actually be owed money by a company to be able to buy a credit-default swap. In that case, the buyer is betting that the company will go broke.

Within that huge market, many contracts offset one another — assuming that all parties honor their commitments. But if one major firm goes broke, the effect could snowball as others are unable to meet their commitments.

In regulated futures markets, contracts are centrally cleared. If you buy an oil futures contract on Monday, and sell it on Wednesday, you have made your profit (or taken your loss) and you no longer have any stake in whether oil prices rise or fall. But if you buy a credit-default swap on Monday from one firm, and sell an identical swap on Wednesday to another firm, you still face the potential of risk if the party that sold the swap to you is unable to pay when a default occurs, perhaps years later.

“One of the major reasons that the government helped out in the Bear Stearns situation,” Treasury Secretary Henry M. Paulson Jr. testified at a Senate hearing this week, “was to avoid throwing it into bankruptcy with all the credit-default swaps.”

Mr. Paulson said the Federal Reserve Bank of New York was working to develop protocols for that market to deal with a failure of a big player, and indicated that he did not see a need for legislation.

But Christopher Cox, the S.E.C. chairman, said Congress should act. “Neither the S.E.C. nor any regulator has authority over the C.D.S. market, even to require minimum disclosure to the market,” he testified. “The market is ripe for fraud and manipulation,” he added.

The S.E.C. is investigating possible fraud, although no charges have been brought, and is looking for cases where someone may have purchased credit-default swaps to drive up their price and persuade others that a company was in trouble.

The swaps market has been exempt from regulation since it began to grow, thanks to legislation the industry sought. The industry argued that regulation would drive business overseas, and that no regulation was needed because ordinary investors did not trade in the market.

In announcing the decline in the amount of swaps outstanding, Robert Pickel, the chief executive of the trade group, said it reflected industry efforts “to reduce risk by tearing up economically offsetting transactions, and demonstrates the industry’s ongoing commitment to reduce risk and enhance operational efficiency.”

The accompanying charts show the growth of the amount of credit-default swaps outstanding, and show how those totals compare with the total amount of outstanding loans from banks and others to corporations and foreign governments. Even with the decline, the swaps volume is more than three times the debt total.

Floyd Norris comments on finance and economics in his blog at norris.blogs.nytimes.com.