Standardize derivatives and spread the wealth

The biggest economic reforms of the year will occur when Asia, Europe and the U.S. overhaul the way over-the-counter derivatives are traded. The leaders of the largest economies committed themselves to change last November, but some officials are already going soft.

U.S. Treasury Secretary Timothy Geithner is pushing for partial reform. He asked the Senate to write legislation requiring standardized derivatives to be traded on open exchanges. Credit default swaps — derivatives that act as a form of insurance to credit bondholders — are starting to be settled on a daily basis by an independent party that requires trading partners to post capital in case of default. Already this has added greater transparency to the market. Europe and Asia are following suit.

The reform of credit default swaps was badly needed. U.S. taxpayers spent $170 billion to bail out AIG after it issued credit default swaps on collateralized debt obligation (CDOs) and did not have adequate cash to cover them.

But Geithner has excluded non-standardized derivatives from having to be traded on an open exchange. CDOs based on consumer loans are non-standardized derivatives that enabled the profligate lending that overwhelmed U.S. consumers with more money than they could repay. Half the credit created in the past five to seven years came from unregulated instruments such as CDOs.

This market died last fall, but the Treasury Department is trying to bring it back to life again with the Term Asset-Backed Securities Loan Facility (TALF). Under TALF, the government created $200 billion in collateralized debt obligations based on student loans, credit card loans, student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA). The rationale was to jumpstart the credit markets which had become frozen, so lending could begin again. These securities are now coming to market.

Consumer-based CDOs are not inherently bad. The advantage of securitizing mortgages and car loans is that they transfer risk from the lenders to the investors of the securities. The loan originators sell the loans, are able to make more loans and earn more fees regardless of their deposits because they don’t hold the loans’ risk. Securitization lowers borrowing costs and enables greater distribution of loans to consumers.

The problem with excluding CDOs from standardization is that banks will again sell their loans to be pooled, sliced up, securitized and sold to investors who will find it difficult to evaluate their risk, even after reading through hundreds of pages of information. Too much credit will drown consumers all over again.

According to Rohan Douglas, editor of the book “Credit Derivative Strategies,” the United States is one of the few places where consumer-based CDOs are created, because of its structured lending system and size. “The scale of the U.S. is large and the mortgage market is the largest fixed income market in the world,” he said.

Since the loans emerge from a regulated market, the securitization of the loans could become a regulated market. If CDOs were standardized, those who securitize them, rate them and invest in them would better understand how the CDOs perform in good and bad economic periods. In addition, standardized CDOs, if adopted by other countries, could help balance the way credit is generated throughout the global economy.

The world economy is not flat — it’s lopsided. Some parts of the globe have little access to credit, while others have too much. CDOs based on consumer loans, which enabled U.S. consumers to be awash in cash, could potentially help balance the way credit is spread throughout the global economy. Citizens of other countries should also be allowed to benefit from the easy credit that CDOs enable.

Instead of worrying about protecting the hefty fees they receive for creating CDOs, the banks should look at the advantages they would gain from standardizing them. Those international banks too-big-to-fail just might be able to create CDOs from consumer loans in the other countries where they operate. Spread the wealth.

Ten years ago, financial companies fought the regulation of credit default swaps. Now they are moving to standardized contracts and open exchanges. If that would have been done earlier, at least part of the collapse of the financial industry could have been avoided.

Democratic Sen. Tom Harkin said he is committed to the regulation of all derivatives. In the coming weeks, we will see if other senators share his determination to shape CDOs into investments that pose less risk for investors and consumers. We will see whether the U.S. is able to cure the financial contagion that it helped create.

Susan E. Reed has covered business and international affairs in 34 countries for CBS News, The New York Times, The New Republic and other news organizations.

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