Why are we still not regulating credit default swaps?

In the news this weekend, among many other (some related) topics, has been AIG's revelation that much of the "bailout" money they received from the US government has gone to a small collection of banks, foreign and domestic. I am no expert on the various derivative contracts at issue - nor apparently are most of the financial press. However two rather interesting, perhaps disturbing, issues occur to me from reading the actual statements involved:

  • These don't appear to be actually payments to the banks in question, but rather "collateral postings" by AIG, at the request of the banks.
  • These contracts were purchased after the date of the initial government rescue in September 2008!

Why is AIG still selling these CDS contracts? What possible useful purpose can these unregulated contracts now serve, when provided from a company that is essentially bankrupt due to its previous over-selling of such contracts? Clearly the sales only make sense given the US government's "bailout" of AIG, and the assumption by the counterparties that AIG would continue to be sound - on the other hand, they still required the above-mentioned "collateral postings" to give some assurance of payment on the contracts so apparently they don't fully trust the US to continue the bailouts here.

We need CDS's and related contracts to be brought under complete and open regulatory control now. I realize government wheels take a while to turn, but this has to be a top priority. How would you force such regulation on them now?

Let me suggest one way. Why not introduce law to consider unregulated CDS's after a certain date to be a form of illicit gambling, governed by RICO or other relevant statutes? Parties and counterparties would have the option of converting an unregulated CDS to a regulated one through a registration process, preferably with a government-imposed fee equal to something like 1% of the total potential payout under the contract. Any unregulated CDS not converted would be considered null and void - no payout necessary, no further "insurance" payments needed by the counterparty.

This would have two salutory effects:
(1) Speculative CDS contracts would be greatly reduced through the imposition of the fee, and parties like AIG that have foolishly over-extended themselves in such promises would have a way out of their bad contracts
(2) The fee would raise a considerable amount of money for the government, to close that hole in the budget brought on by the bailout.

But I'm no expert here - can anybody tell me the adverse consequences of such a step?

I think it could be the only step that makes sense. We need to get these contracts regulated ASAP.

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I am new to reading this

I am new to reading this blog. The opinions expressed are interesting. I am curious about the author.

apsmith writes: "But I'm no expert here..."

No offense intended, but what is your background? Elsewhere on the blog I read the statement that :

"Arthur Smith started adult life as a physicist, but now spends his days developing software and telling a few other people how to do it too (for the American Physical Society)."

That's nice, but that is very little information on which to know whether I should accept you as a credible person. Would you please point me to biographical information that will explain who you are, what is you area of expertise and why I should believe you. Thanks.

Hi Guillermo, I should

Hi Guillermo,

I should probably expand on the bio area on the site here a bit, huh.

I'm apparently not worthy of a wikipedia entry yet, though there are one or two pages that refer to things I've written. You can check my LinkedIn profile here:

http://www.linkedin.com/in/apsmith

but that's a bit limited too. There's my old NSS bio page:

http://www.nss.org/about/bios/smith.html

though I now have 4 children, not 3 (which is largely why I'm not doing much with NSS any more). While I was working in research I published around 2 dozen papers on the theory of metal and semiconductor surfaces, quasicrystals, buckyballs, organic superconductors, and various other systems of interest at the time. You can look me up in Google Scholar though my name's a little tough to narrow - this search seems to catch a few of my papers though, or search PROLA for author: A P Smith since most of my publications were there...

If that helps. Obviously none of that has anything to do with finance. A number of my friends from grad school did go on to become quantitative analysts on Wall Street though, but I claim no expertise by proxy through them!