Tuesday, September 23, 2008

Credit Swaps Must Be Regulated Now, SEC's Cox Says

(Bloomberg) -- U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should grant authority to regulate the credit-default swaps market amid concern the bets are helping fuel the global financial crisis.

Lawmakers should ``provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,'' Cox told the Senate Banking Committee today at a hearing in Washington.

``Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure,'' and that should be addressed ``immediately,'' Cox said in prepared testimony at a hearing to consider the federal government's $700 billion financial rescue plan.

The SEC is concerned investors may seek to profit by spreading false information or making trades designed to drive down financial stocks during the credit crisis that has re- shaped Wall Street. The agency is demanding hedge-fund managers, brokerages and institutional investors describe in sworn statements their bets on the companies, including trades in credit-default swaps, the regulator said Sept. 19.

Separately, New York State said it will start regulating part of the credit-default swaps market. The state will consider contracts sold to investors who own bonds they are trying to protect from default as insurance, Governor David Paterson said in a statement yesterday. The plan won't apply to contracts purchased by speculators who don't own bonds and only want to bet on an increase or decrease in a borrower's creditworthiness.

Calls for greater regulation of the $62 trillion market have grown after the U.S. took over American International Group Inc. Sept. 16 and gave the New York-based insurer an $85 billion loan to cover obligations at a unit that sold protection on securities through credit-default swaps. The AIG subsidiary was required to post collateral against more than $400 billion of contracts after its credit rating was downgraded.

Investors may use credit-default swaps to bet a company's financial condition will worsen. The contracts pay holders face value for the underlying securities or the cash equivalent should a company fail to repay its debt. The swaps' value increases as investor perception of the company's stability deteriorates.

Swaps linked to firms including Goldman Sachs Group Inc. and Morgan Stanley climbed to records last week, with increases preceding or mirroring drops in stock prices. The two companies on Sept. 21 received Federal Reserve approval to become commercial bank holding companies, ending the Wall Street investment-bank model that shaped the financial world for two decades.

Paulson, Bernanke
Cox today said investors who buy swaps without owning the underlying debt may be similar to naked short sellers who sell stocks they don't own or borrow. Such short sales can flood the market and illegally drive down stocks.

Cox testified with Treasury Secretary Henry Paulson and Fed Chairman Ben S. Bernanke, who want Congress to let the government remove $700 billion of illiquid assets from the banking system. Paulson and Bernanke say the rescue plan is necessary to keep the financial crisis from worsening.

Last week, the SEC imposed a temporary ban on short-selling of financial stocks. Cox said the move will ``stabilize the markets'' until Congress approves Paulson's plan.

In a short sale, traders borrow shares from their broker that they then sell. If the price drops, they buy back the stock, return it to their broker and pocket the difference.

Under Fire
Cox has been under fire from lawmakers. Republican presidential candidate John McCain last week called for his firing, saying Wall Street's top regulator failed to head off the crisis in financial markets.

Senator Richard Shelby, an Alabama Republican, criticized the SEC at today's hearing for giving assurances over the past several months that its oversight of the five-biggest U.S. investment banks was adequate.

``Nothing could be further from the truth,'' Shelby said.

The Fed in March orchestrated a sale of Bear Stearns Cos. to prevent its collapse, while agreeing to backstop about $30 billion of the firm's mortgage assets. This month, Lehman Brothers Holdings Inc. declared a record bankruptcy and Merrill Lynch & Co. sold itself to Bank of America Corp.

Cox, a Republican who served in Congress before becoming SEC chairman, deflected blame by arguing that the turmoil on Wall Street was caused by ``a failure of lending standards.'' Banking regulators, not the SEC, are responsible for overseeing mortgage lending.

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