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SEC's Cox is Shocked, Shocked to Discover Gambling in Credit Derivatives

Largely unregulated derivatives known as "credit default swaps" are emerging as a primary villain in the mortgage-based financial meltdown. And SEC Chairman Christopher Cox has apparently just discovered them.

At an SEC roundtable discussion earlier today, Cox singled out the swaps as dangerous instruments because they are negotiated over-the-counter, they're ripe for manipulation and their accounting is so dodgy that the total value of outstanding swaps far exceeds the total value of what the swaps are meant to insure.

"No one has regulatory authority over credit default swaps," Cox declared. "Their invisibility undermines confidence." Since the only regulatory power today's SEC has against the swaps involves anti-fraud cases, he added, fixing the problem "requires immediate legislative action."

Given that the swaps came into existence about a decade ago, I wasn't sure if I was listening to Cox or Captain Renault, the venal Casablanca police chief who proclaimed he was "shocked, shocked" to find gambling in Rick's Cafe. (No one turned up with any winnings for Cox, though, which sort of spoiled the moment.)

Credit default swaps involve contracts between a "buyer" who pays periodic payments to a "seller" for rights to a payoff if there is a default on a debt. Intended as insurance against poor debts, the swaps grew into a major tool for speculation after Congress banned their regulation in 2000. Since then, the worldwide market for the swaps has ballooned to a whopping $62.2 trillion, according to the New York Times. Cox placed their value at $58 trillion and said they are so popular that their value doubled in the past two years.Since swaps are off-the-books deals traded over the counter, many financial institutions didn't really keep track of them. There was no central data base that recorded the deals and who owed what, Cox said. So when the financial system began to unravel at stunning speed last month, the swaps acted as little understood and largely invisible time bombs that made the crisis much worse.

The SEC has taken some encouraging steps toward modernizing its disclosure system recently. For instance, Cox and the commission have pushed forward with interactive data, which is a much faster and more flexible system for corporate data than the venerable but clunky EDGAR system that's been around since the 1980s. With the new system, anyone will be able to pull out exactly the data they want and be able to do so instantly with similar firms to get comparisons.

The problem, as panelists noted, is that a lot of what caused the current financial crisis wouldn't have been tracked anyway, so no matter what kind of shiny new system the SEC comes up with for corporate info retrieval, it's useless if it doesn't track deals made off the books. The biggest single problem areas in this case are derivatives, off the balance sheet accounting and determining fair value in such an accounting swamp, said Paul Haaga Jr., a panelist and vice chairman for Capital Research and Management.
Cox suggested that new exchanges be formed to register and trade credit default swaps. Those could demystify the swaps and make trading more transparent so firms would have a better idea of what kind of trouble they might cause. The Chicago Mercantile Exchange Group has already said it will team up with Citadel Investment Group to create an electronic trading system for the swaps. That, coupled with new legislation from Congress, could help.

One wonders, however, where Cox has been the last three years that he's headed the SEC. True, the swaps were deregulated before his tenure, but he must have known about the potential problems they can create. But then, Cox was picked for the SEC job precisely because he is not an ardent regulator.

He's right about doing something even if, as a Congressman in 2000, he supported legislation to leave the swaps uregulated. But it's a little too late to start a beautiful friendship with the pro-regulation crowd.

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