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Apr 19
2010

Goldman case another sign of need to curb naked swaps

Posted by Ron F in Securities and Exchange CommissionRiskRegulationGoldman Sachsderivativescredit-default swapCDSBanksbank failuresbailoutsAIG

Ron F

It seems as if Goldman Sachs' essential defense in the SEC's fraud case against the bank is that it did nothing differently than other banks typically do in failing to disclose to investors that a hedge fund that wanted to short the securities the bank sold helped design them.

But if the "everybody-does-it" line gets Goldman off the hook, then what does that say about Wall Street? Simon Johnson argues that it means that fraud is now its very basis.

And if that's the case and Goldman walks anyway, Johnson predicts that will improve the prospects for more rigorous bank regulation, especially of derivatives.

Yet we keep hearing from some quarters that all that's necessary is to drive as many swaps as possible to exchanges or clearinghouses (and perhaps head off the big dealers' potential domination of those systems for improving transparency and liquidity).

Count me a skeptic about the sufficiency of exchanges and clearinghouses when it comes to credit default swaps, even if the big dealers don't dominate the market. The Goldman suit is a case in point.

The assets in question were primarily synthetic collateralized debt obligations, which are CDS written against a portfolio of securities, in this case residential mortgage-backed ones. And depending on the outcome of legislation now making its way through Congress, such customized derivatives might continue to be exempt from exchange trading or central clearing.

But if, as analysts such as Robert Litan and Luis Zingales have argued recently, such swaps add liquidity to the market and help it "discover" prices, then why did Goldman need a $12 billion government bailout through AIG?

For his part, Zingales contends that the bubble would have grown even larger and the fall-out would have been even greater without such swaps in place. But it's hard to see how such speculation reduced the amount that the government provided to Goldman through AIG.

Is Zingales saying AIG should have written even more such contracts, because that would have blown things up earlier?

If so, it seems to me that the bubble would simply have grown larger earlier, not that the crisis would have been limited.

It's not as if speculation would be impossible under proposals to curb so-called naked swaps, contrary to Litan's argument against a ban. After all, only one party to an OTC swap would be required to have an actual, insurable interest in the securities of the underlying reference entity. The other party would be free to speculate without such an interest.

I suppose Zingales would argue that a curb would prevent a bubble from bursting. But based at least on the current regulatory structure, or lack thereof, I think it's more likely such a limitiation would help keep it from developing in the first place.

By all means, send as many swaps out of the OTC market as possible and don't let Goldman and the other four big dealers dominate the exchanges or clearinghouses, where they would trade or at least clear with more capital behind them. But for those swaps that are exempted, there's no good reason not to require that at least one party use them to hedge actual business risk.

As the Goldman case shows, naked CDS have not added liquidity to the market but subtracted it, and have done more to obscure prices than clarify them. And if Goldman isn't alone in using naked swaps in this way, as appears to be the case, then that's all the more reason to curb their use.

To be fair, Zingales is arguing against a ban on all credit default swaps. But that's a straw man argument, since no one is calling for that. And Litan also mischaracterizes proposals to the limit the use of naked swaps by interpreting them to mean all possibility of speculation.

Some folks keep muddying the waters over derivatives reform. If nothing else, the Goldman case could help clarify them.

 

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