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Standardize derivatives and spread the wealth

Opinion: How to think about the "D" word.

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.