Obama moves to regulate complex financial instruments

McClatchy NewspapersMay 13, 2009 

WASHINGTON — The Obama administration on Wednesday unveiled a plan for strong new regulation over the complex financial instruments that helped spark today's global financial crisis.

The surprise announcement represented one of the first steps in an expected comprehensive and controversial rewrite of federal financial oversight.

"This financial crisis was caused by, in part, significant gaps in the basic framework of oversight over critical institutions and markets," Treasury Secretary Timothy Geithner said. "We are committed to putting in place . . . a series of comprehensive reforms to create a stronger system, less vulnerable to crisis, (and) stronger protection for consumers and investors."

The Treasury Department seeks to give the Commodity Futures Trading Commission expanded powers to impose limits on traders in all commodities instead of the current practice of having limits only in regulated markets.

The administration is trying to shine light in so-called "dark markets," where two private parties can enter into complex contracts about the prices of future deliveries of oil or other commodities. These bets are called over-the-counter swaps or derivatives. They collectively amount to trillions of dollars of activity — but happen outside any regulatory framework.

"It is long past time to start regulating derivatives. Right now, trillions of dollars in derivative transactions known as swaps are going full bore with virtually no oversight, because federal regulators are prohibited by law from regulating them," said Sen. Carl Levin, D-Mich., the chairman of the Senate Permanent Subcommittee on Investigations.

The Commodity Futures Modernization Act of 2000, passed at the end of the Clinton administration with the help of many members of Geithner's current team, allowed these private contracts to take place outside the view of regulators. Levin has introduced legislation to close the regulatory gaps created by the very people who now are trying to end the financial crisis.

The administration's plan, which depends on congressional approval, seeks to standardize virtually any private contract between two parties in these complex investments. If it can be standardized, it must be settled in a manner similar to the settling of contracts that trade hands for the future delivery of oil, wheat or any number of other commodities that are traded in regulated markets.

Importantly, this process would allow regulators to impose stricter margin requirements, forcing traders to keep more capital in reserve in case of market turmoil. That would reduce the possibility that these complex instruments could again threaten the financial system.

That's what happened last September, when giant insurer American International Group didn't have enough cash in reserve to pay off its partners in credit-default swaps, which are bets on the possibility of loan defaults. AIG was rescued by the Federal Reserve and has since received more than $150 billion in taxpayer bailout money.

The Obama administration also wants traders of these complex transactions, shorthanded as OTC swaps, to be subject to limits in order to prevent their ability to unduly affect prices.

"It prevents them from taking over the price movement of a specific commodity," said Mike Masters, a hedge fund manager whose firm, White Knight Research & Trading, has used government data to show how certain trading activities allegedly drove up oil prices and hurt consumers.

The way Masters reads the Obama administration's plan, regulators not only will be looking at individual positions in a given commodity but also will have the ability to look at investments by big players such as Goldman Sachs, Morgan Stanley and others across a range of products.

"That's a really big deal. That means they're saying we want the CFTC to put position limits across markets," Masters said.

One mystery about the Obama plan is its timing. It was not on Geithner's public agenda, nor was it leaked in advance, as has been common practice. It caught Wall Street and Washington by surprise.

Industry leaders suggested privately that this was meant to deflect attention from the recent bank stress tests, which have been lampooned on "Saturday Night Live" and elsewhere as being too soft on Wall Street. Others on Capitol Hill suggest privately that several nominees for financial posts have been held up while lawmakers waited for proof that Obama would get tough on Wall Street.

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