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:
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.