Moral Hazard And The CDS Exchange

Way back during the Bush Administration, when bailouts were measured in mere billions of dollars, many writers in the economic field warned of the "moral hazard". The idea is that when failure is rewarded, those that have failed will have learned nothing and will continue their failing ways. Evidence of the truth of this argument is now on full display. The Wall St. investment banks are back to raking in billions on the still unregulated, and privately traded, Credit Default Swaps (CDS). A rather lengthy article in Spiegel Online examines the situation world-wide:

...banks are back to behaving the same way they did before the crisis. Even worse, thanks to government guarantees for the financial sector and cheap money from central banks, it has never been easier for banks to make money..."The taxpayer is paying for the chips in the casino," the head of the German operations of an international investment bank says quite openly, but anonymously nevertheless. "It doesn't get any better."

Beyond that, since several large banks have gone away, and smaller banks, who were not bailed out, are unable to compete, there are fewer players.

The survivors of the crisis see the thinned out field of competitors as a historic opportunity, and they are taking advantage of it. "Right now, (Goldman Sachs is) one of only a few people on the beach, so they're getting all the girls," New York finance professor and former Goldman partner Roy Smith told the Wall Street Journal.

To date, congress has passed exactly one banking regulation; a cap on executive salaries with a giant loophole. There is no cap on employee bonuses. In the case of Goldman Sachs, who have made $22 Billion already this year, roughly $11 Billion is set aside for employee bonuses. A more ineffective regulation could hardly be imagined.

There are two ideas currently being debated in the House and Senate, regarding CDS regulations. The first is to form a clearing house for the CDS. It was proposed by Treasury Secretary Geitner and is supported by the nine largest investment banks who have formed the CDS Dealers Conglomerate to lobby for the idea. The clearing house would be regulated by the Federal Reserve Bank of New York. Under this plan, the CDS would still be a private transaction and only the banks and, to a lesser extent the government, would have access to most information.

A much better alternative is being proposed by Iowa Democratic Senator Tom Harkin. His proposal would create a CDS Exchange that would operate much like a futures market. Different futures exchanges could compete for business with the various banks and brokers. It would all be out in the open, with market prices made public, the same set of rules for all concerned, and hopefully, equal enforcement. An added bonus is it would have the effect of lowering prices and enable the smaller banks to compete.

The finance lobby is the wealthiest lobbying group in Washington, with strong ties within the Obama Administration. No doubt a lot of Democrats will be taking the money and voting for the private clearing house. I'm not one to agree with Senator Harkin on much of anything, but he's right on this one. Republicans should get on board Harkin's CDS Exchange. Open markets and transparency is the right thing to do.