-- Congress should approve federal oversight of credit-default swaps, an unregulated, $62 trillion market of investment contracts that have been cited as a factor in the nation's financial crisis, the nation's top securities regulator said Tuesday.
Testifying at a Senate Banking Committee hearing, Securities and Exchange Commission Chairman Christopher Cox described the lack of oversight as a potentially costly mistake Washington should address "to enhance investor protection."
Credit-default swaps are insurance-like contracts issued to cover potential losses on corporate debt, municipal bonds or mortgage securities. Typically sold by banks and hedge funds, they are designed to provide protection against any defaults.
The nation's commercial banks held $180.3 trillion in derivative contracts during the first quarter of 2008, with more than half that total in credit-default swaps, according to data from the federal Comptroller of the Currency.
Cox warned that investors in the fast-growing market are tantamount to short sellers of the municipal or corporate bonds covered by credit-default swaps, because the investors profit if the bonds default.
Over the last decade, speculators have increasingly used credit-default swaps to place investment bets on a given company's failure.
Moreover, investors aren't required to own the bonds upon which credit-default swaps are based. This has led to widespread buying by speculative investors in so-called naked swaps, or naked shorts — bets on bond defaults.
"This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern," said Cox, who urged Congress to act on the issue after action on the proposed $700 billion bailout of the U.S. financial industry.
Cox's recommendation, echoed by Treasury Secretary Henry Paulson, came one day after New York Gov. David Paterson announced that his state's insurance department would regulate credit-default swaps starting Jan. 1.
The International Swaps and Derivatives Association, however, said it opposes government oversight apart from efforts to guard against manipulation of the credit-defaults swap market.
"Proposals which would seek to treat privately negotiated contracts as securities, or otherwise apply ill-fitting regulatory regimes to these agreements, are likely to deter healthy economic activity," Robert Pickel, the association's executive director and chief executive officer, said in a statement Tuesday.
But Tano Santos, a finance professor at the Columbia University Graduate School of Business, said the current "opaque" market makes it difficult to determine a given company's financial risk from credit-default swaps.
"It is precisely because of the decentralization of this market that we have seen this (financial industry) distress," said Santos.