Securities and Exchange Commission (SEC) Chairman Christopher Cox called Tuesday for regulation of certain credit derivative products, saying the market was overrun by fraud that contributed to the housing crisis.

At a Senate Banking Committee hearing, Cox said the SEC is investigating the market.
"Legislation has expressly excluded CDS from regulation, even of the most modest kind — even disclosure," Cox testified. "We have a big regulatory hole around CDS … . It's vitally important that we regulate this so we can have disclosure, we can have transparency."

Committee Chairman Chris Dodd asked other witnesses, including Treasury Secretary Henry Paulson, whether giving the SEC power to regulate credit default swaps should be included in the troubled-asset bailout package Congress is working to pass this week.

Paulson advised against it.

"We can't deal with this immediately," he said, saying the credit default market was too big to risk disrupting with an emergency regulation.

Cox said the issue required "urgent" attention but said he was not seeking to add provisions to the bailout bill.

Still, in response to Sen. Elizabeth Dole, R-N.C., who linked the problem to the collapses of American International Group (AIG) and Lehman Brothers,  Paulson acknowledged that the lack of transparency in the CDS market was a "big problem." Federal Reserve Board Chairman Ben Bernanke, noting that CDS contracts had proliferated quickly, assured her, "We are working to address your concern."

The SEC chief's call escalated a debate about whether to regulate credit-default swaps, which are contracts designed to hedge the risk of asset-backed securities such as collateralized loan obligations.

Cox asked lawmakers for authority to regulate "naked" CDS, contracts in which one party pays another a regular premium against the possibility of default of an asset-backed security that it does not actually own, with the second party paying the first the security's nominal value if it defaults.

"It's a very pleasant surprise," said Michael Greenberger, a professor at the University of Maryland Law School who was director of the trading division at the Commodity Futures Trading Commission. "This represents an internal desire by SEC staff to have regulatory responsibility for CDS, and I think the meltdown immediately leading up to the need for a bailout has given the SEC the intestinal fortitude to express its internal positions publicly."
But others saw the request for authority as unrealizable.

"It's utterly ridiculous," said Anthony Clemente, the CEO of the New York-based asset manager, Canaras Capital Management. Though swaps contracts generally follow a standard set by the International Swaps and Derivatives Association (ISDA), each is customized.

"It's part of this whole network of private investment activity that really lacks the standardization you see in securities markets," he explained, adding that it would be much more practical to regulate banks' exposure to CDS contracts rather than the instruments themselves.

Lynn Turner, a former SEC chief accountant and a managing director at GlassLewis, said those opposing federal oversight had plenty of time to improve voluntarily. A commission led by former New York Fed President Gerry Corrigan earlier this decade urged the industry to adopt standardization and transparency measures.

"They were all given chances to avoid regulation and didn't," Turner said.

New York Gov. David Patterson backed Cox on Tuesday, a day after his insurance commission issued a proposal to regulate "covered" CDS contracts — those in which the first party pays the second a premium against the possibility of default of an asset-backed security it does own.
"Chairman Cox and I agree that this action is paramount if we are to stabilize this market," he said in a statement. "The absence of regulatory oversight is the principle cause of the Wall Street meltdown we are currently witnessing."

Patterson said his banking department also is working with the New York Fed to create a central clearing facility for credit-default swaps to address counterparty risk and establish margin requirements.

But ISDA executive director Robert Pickel said the insurance commission's plan "may ultimately cause more harm than good." Though the insurance regulator may monitor insurance companies' own swaps, he said, "going beyond this common sense approach threatens to disrupt global derivatives markets which have continued to function amidst the current turmoil."

Regarding  Cox's testimony, Greg Zerzan, ISDA's head of global public policy, said the derivatives markets have functioned "very well under the current regulatory regime, which regulates institutions such as banks and broker-dealers on an institutional level but does not extend ill-suited regulation to privately negotiated derivatives contracts."

The CDS market is estimated to be worth roughly $60 trillion. During the structured products boom, investors entered into agreements with each other designed to hedge the risk to which they had exposed themselves by buying slices of collateralized debt obligations, many of which were made up of subprime mortgages. An investor who bought part of a CDO would hedge the risk by paying another party a regular premium in exchange for the ability to collect the nominal value of the CDO from that party if the security defaulted.

Other investors bought CDS contracts even though they did not own a CDO, taking the view that the security on which they were writing the contract was likely to fail and they would receive a payout for its nominal value.

"They were selling CDS for people who didn't have any risk — it was a bet on whether people would pay off on their subprime loans," said Greenberger, the Maryland law professor.

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