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Oct 15
2009

Washington mistakes Wall Street for Main on derivatives

Posted by Ron F in RiskRegulationcredit default swapCreditBanks

Ron F

One of the more specious arguments made against derivatives regulation at yesterday's hearing of the House Financial Services Committee was that this would hurt companies' ability to get credit and manage their risks.

Several Republicans who made this argument went unchallenged, which prompts me to weigh in with a question: How many non-financial companies use derivatives to hedge?

Not once in my nearly 20 years of covering corporate finance have I come across evidence of their use by an industrial company that isn't a major multinational, and even those companies would stick mostly to currency or interest-rate swaps. Surely only they can afford to pay for customized contracts. And I've never heard of one that uses credit default swaps.

 My experience is borne out in recent data that shows that five large banks hold 95 percent of the credit default swaps written.

If anything, that hurts corporate borrowers, because such swaps give lenders less incentive to restructure loans, as Henry Hu, an academic turned SEC regulator in the Obama administration, pointed out in research published in 2008, and as I wrote about earlier. In fact, CDS provides lenders with an incentive to drive borrowers into Chapter 11.

So tell me exactly how moving standardized swaps onto exchanges or clearinghouses and limiting speculation in those still traded over the counter hurts anyone but banks?

Theoretically, I suppose, they might be less willing to lend as a result of more stringent regulation of credit swaps, but as Hu observes, that's a debatable proposition. And even if he's wrong, then something is more seriously amiss with our financial system. If, that is, banks aren't willing to take on credit risk and manage it by applying traditional lending standards instead of financial gimmickery that invariably leads to public blackmail (i.e., taxpayer bailouts without strings), then what purpose do they serve?

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