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Global Bi-Partisanship Needed

03/29/2012

Republicans often argue that less regulation is always better.  Democrats are often seen arguing that more regulation is always better.  Sometimes, they are both right!

For years, during the Bush II administration, financial deregulation was a sacred objective.  Not surprisingly, the economy boomed, and the financial sector eventually became 22% of GDP.  Also, not surprisingly, a little deregulation soon became too much, financial deregulation became financial innovation, and we soon had the Crash of 2008.  (The subprime mortgage-backed-securities market would not have been even remotely possible during the 1990s.)

One of the really useful but really dangerous financial innovations was the explosive growth of credit default swaps.  If I loan money to somebody, I might get worried that person will not or cannot repay me.  Rather than risk losing the entire amount I have loaned, I might be willing to pay somebody else to take the risk of default.  So, if the borrower cannot repay me, I will still be repaid by “somebody else.”  He was paid to take the risk that the borrower might default, i.e., the risk of credit default was swapped for a fee.

There have been many minor instances where the lender was repaid by the third party who had accepted the fee.  But, far and away, the biggest instance was the sudden failure of Lehman Brothers in September of 2008.  Credit markets froze up around the globe as a result.

The Republicans are right that the market is self-regulating.  Since then, investment banks and hedge funds have worked closely with the International Swaps & Derivatives Association (ISDA) to create real, legally binding procedures, more clearly defined what is actually a credit event, and written down the rules for settling contracts.  (It is hard to believe these basic rules did not exist prior to 2008!)

Largely because of this increased self-regulation, the credit default of Greece caused minimal problems.  Unlike the sudden Lehman collapse, the long lead-time before the Greek default also gave the swap markets time to prepare. The total of $70 billion was finally netted out to “only” about $3.2 billion.

The Democrats are right that more is needed.  The primary reason the credit markets froze up after Lehman’s collapse was that nobody knew who owed how much to whom.  Would you loan overnight funds to another bank if you had no idea whether or not they were on the hook to pay out billions of dollars in swaps?  Of course not, because you might not get repaid.  Part of the massive Dodd-Frank bill requires all swaps to go through a central clearinghouse, so we will know who is “holding the bag” or the credit risk.  This is a good thing!

The problem is that this must be international.  If we create transparency in the U.S., investment banks and hedge funds will just enter into swap agreements in Europe and elsewhere.  This means we remain vulnerable to the problem of the Lehman collapse or another financial heart attack.  And, we will remain vulnerable until the Republicans and Democrats work together to implement this part of Dodd-Frank world-wide!

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