Obama Proposes a First Overhaul of Finance Rules

By STEPHEN LABATON and JACKIE CALMES

Published: May 13, 2009

WASHINGTON — In its first detailed effort to overhaul financial regulations, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades.

Win McNamee/Getty Images

The Treasury secretary, Timothy F. Geithner, at a banking industry meeting on Wednesday. He is seeking new regulations.

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Times Topics: Derivatives

The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group.

The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.

The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them.

“This financial crisis was caused in large part by significant gaps in the oversight of the markets,” Mr. Geithner said in a briefing. He said the proposal was intended to make the trading of derivatives more transparent and give regulators the ability to limit the amount of derivatives that any company can sell, or that any institution can hold.

The initiative was well received by senior Democrats in Congress with jurisdiction over the issue. The proposal had been expected, but some lawmakers, impatient with the pace of the new administration’s efforts, had begun moving ahead themselves.

Hinting at a lobbying campaign to come, Robert Pickel, the chief executive of the International Swaps and Derivatives Association, a trade group, said his organization “looked forward to working with policy makers to ensure these reforms help preserve the widespread availability of swaps and other important risk management tools.”

But some in the financial industry say that regulation is inevitable. “Nobody is in a ‘just say no’ mode,” said Steven A. Elmendorf, a former aide to the House Democratic leadership who represents several major financial institutions and groups. “Everybody understands that we’ve been through a financial crisis and that change has to happen. And the only question is how the change happens.”

The administration is seeking the repeal of major portions of the Commodity Futures Modernization Act, a law adopted in December 2000 that made sure that derivative instruments would remain largely unregulated.

The law came about after heavy lobbying from Wall Street and the financial industry, and was pushed hard by Democrats and Republicans alike. It was endorsed at the time by the Treasury secretary, Lawrence H. Summers, who is now President Obama’s top economic adviser.

At the time, the derivatives market was relatively small. But it soon exploded, and the face value of all derivatives contracts across the world — a measure that counts the value of a derivative’s underlying assets — outstanding at the end of last year totaled more than $680 trillion, according to the Bank for International Settlements in Switzerland. The market for credit-default swaps — a form of insurance that protects debtholders against default — stood around $38 trillion, according to the international swaps group. That represents the total amount of insurance that has been written on various kinds of debt, but the amount that would have to be paid out if the debt went into default is considerably less.

As the credit crisis has unfolded, trading in credit-default swaps has cooled, market participants said. The collapse of A.I.G. took a huge player out of the market and banks, hobbled by losses, have curbed their activities in the market. Still, derivatives trading desks have been profit centers at major banks recently.

The biggest banks and brokerage firms, including JPMorgan Chase, Citigroup and Goldman Sachs, as well as major insurers, are all major players in derivatives.

Derivatives are hard to value. They are virtually hidden from investors, analysts and regulators, even though they are one of Wall Street’s biggest profit engines. They do not trade openly on public exchanges, and financial services firms disclose few details about them. The new rules are meant to change most, but not all, of that opacity.

Used properly, they can reduce or transfer risk, limit the damage from market uncertainty and make global trade easier. Airlines, food companies, insurers, exporters and many other companies use derivatives to protect themselves from sudden and unpredictable changes in financial markets like interest rate or currency movements. Used poorly, derivatives can backfire and spread risk rather than contain it.

The administration plan would not require that custom-made derivative instruments — those with unique characteristics negotiated between companies — be traded on exchanges or through clearinghouses, though standardized ones would. The plan would require the development of timely reports of trades, similar to the system for corporate bonds.

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Times Topics: Derivatives

The letter suggested that the Commodity Futures Trading Commission would play a leading role in the oversight of the market, although it would also leave important elements to the Securities and Exchange Commission. Over the years, the turf battle between those agencies contributed to the neglect of that market by government overseers.

Some lawmakers in the House and Senate have already introduced measures to regulate derivatives. But a number of members have pressed the administration to put out its own plan.

Representative Barney Frank of Massachusetts, the chairman of the House Financial Services Committee that oversees the S.E.C., and Representative Collin C. Peterson of Minnesota, chairman of the House Agriculture Committee with oversight of the commodities trading commission, released a joint statement saying, “we agree there must be strong, comprehensive and consistent regulation” of derivatives. “We will work closely together to achieve that goal,” they added.

While derivatives regulation will be a focus of some market players, of equal concern to many in the financial industry are what the Obama administration and Congress might do to regulate compensation for executives across the board, not just at institutions that have accepted federal bailout money.

The Treasury is acting on two paths. First, it plans as soon as next week to announce revised compensation rules for companies getting assistance, to make those rules conform with a law Congress passed in February that was more stringent than the Treasury’s own guidelines.

Separately, Treasury officials have just begun discussing with the Federal Reserve and the S.E.C. what the government can do industrywide — through incentives, restrictions or a mix of the two — to guard against eye-popping compensation that rewards excessive risk-taking of the sort that contributed to the current crisis.

The fear among many in the industry — and some in the administration — is that whatever limits Mr. Obama proposes, Congress will seek to add even more, in response to public anger.

In addition to the regulatory changes it is seeking, the administration is also continuing to expand its bailout programs for various industries. Mr. Geithner announced on Wednesday that the administration would provide a new round of capital assistance to smaller community banks, and would increase the amount that they can borrow from the program.

Beyond derivatives, he also said that the administration would be presenting a comprehensive proposal to overhaul the regulation of the financial system. He said a central goal would be to eliminate the ability of companies to pick the least onerous regulator.

“We need a much simpler financial oversight structure,” he said. “It’s not going to be comfortable for everybody but it’s important to do.”