House panel votes to regulate derivatives

‘There will be no more hidden trades where we don’t know the price,’ said Massachusetts Representative Barney Frank. ‘There will be no more hidden trades where we don’t know the price,’ said Massachusetts Representative Barney Frank.
By Anne Flaherty and Jim Kuhnhenn
Associated Press / October 16, 2009

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WASHINGTON - A House panel voted yesterday to regulate for the first time privately traded derivatives, the kind of exotic financial instruments that helped bring down Lehman Brothers and nearly toppled American International Group.

The 43-to-26 vote by the House Financial Services Committee was a first major step for President Obama’s plans to overhaul federal regulations governing financial institutions.

The mostly party-line vote showed Democrats were prepared to override objections by Republicans and the financial lobby and demand increased oversight of Wall Street.

No Democrat on the panel opposed the measure. One Republican, North Carolina Representative Walter Jones, sided with them to approve it.

Next week, the panel is expected to approve another big piece of Obama regulatory plan that would create a federal agency dedicated to protecting financial consumers. Both measures would still face scrutiny by the full House, as well as the Senate, where business-minded Republicans are likely to wield more influence.

But for now, the administration is hailing yesterday’s vote as a critical step toward throwing sunlight on an opaque and growing $600 trillion global market.

The bill “is absolutely essential to preserving a strong marketplace, preserving transparency, [and] getting incentives right in the system,’’ said Michael Barr, Treasury’s assistant secretary for financial institutions.

AIG sold a form of derivatives, called credit-default swaps, to investors who were looking to protect themselves against losses in the housing market. When home defaults rose, AIG did not have enough resources to make good on all of its promises and required a hefty government bailout to avoid folding.

The government was caught off guard because regulators weren’t monitoring the contracts and could only guess at the size of the derivatives market.

Under the bill, AIG would have to conduct those transactions on a monitored exchange and prove to regulators that it had sufficient reserves.

Democrats included an exemption for companies that use derivatives to protect against risk. The exemption was intended to distinguish between AIG and other financial institutions that use derivatives to make money, and manufacturers that rely on them to protect against a spike in fuel prices or fluctuating exchange rates.

Companies could lose that exemption if regulators see a pattern of activity that places other participants in the transactions at risk. Exempt or not, companies would have to report their trades and the prices.

“There will be no more hidden trades where we don’t know the price,’’ said Representative Barney Frank, the Massachusetts Democrat who chairs the panel.

Federal regulators have argued for a tougher proposal. Gary Gensler, chairman of the Commodity Futures Trading Commission, wants to work with Congress “to complete legislation that covers the entire marketplace without exception and to ensure that regulators have appropriate authorities to protect the public.’’

Before reaching the House floor, the measure would have to be reconciled with a proposal from the House Agriculture Committee.

Republicans said derivative transactions should be disclosed and conducted under great visibility, but they object to trading them in regulated exchanges.

While the derivatives bill is considered more complex, Obama’s proposed Consumer Financial Protection Agency faces a tougher political climb. Republicans oppose the measure, and industry groups have lobbied mightily against it. Moderate Democrats say they will support it but have already pushed to scale it back.

Yesterday, the panel ignored the administration’s wishes and voted to spare the majority of banks and credit unions from agency examinations. These banks would still have to follow the agency’s rules and open their books to other federal regulators monitoring their overall stability.

A remaining sticking point is whether the agency should be allowed to trump state laws.