The plan won't apply to credit default swaps purchased by speculators, i.e. swap owners who are trying to profit from an increase/decrease in a borrower's creditworthiness, New York Governor David Paterson told Bloomberg News. Paterson also urged the federal government to follow New York's lead and regulate the rest of the credit default swap market.
Credit default swaps are contracts designed to protect against or speculate on default. CDSs pay the buyer face value if a company fails to adhere to its debt. Hedgers typically use them to guard against bond losses. However, speculators use them as an active investing/trading tool in an attempt to profit from a company's / issuer's credit worthiness.
Economist David H. Wang told BloggingStocks there's an upside and a downside to increased regulation of the $62 trillion CDS market.
"On the one hand, we do need a central regulator in the United States to verify that those selling credit default swaps can in fact pay the swap holder if there is a default claim," Wang said. "The system for swaps was jeopardized when AIG could not pay all claims, and could have resulted in contagion, which prompted the federal government's loan."
"On the other hand, I don't know if New York state is equipped to handle the tens of thousands of swap insurers at this juncture," Wang said. "A better reform would involve Congress establishing a national credit default swap agency to avoid a quilt-like regulatory system that could occur if it's left to the states."
Is there a chance credit default swaps could remain unregulated, in Wang's interpretation? "That's not likely. It is now clear that a failure of a large credit default swap issuer, for liquidity or solvency reasons, can pose systemic risk, and that is an unacceptable framework. Long-term, non-regulation of swaps is untenable," Wang said.
Bond Market / Economic Analysis: Look for the various swaps/derivatives and trading associations/groups to lobby against the proposed new regulations, but the view from here is that their argument has been philosophically undercut by the events of the past two weeks. An unregulated swap/derivative market no longer occupies the moral high ground because the market has demonstrated that it cannot discipline participants. In an unregulated market, a rogue or reckless entity can cause the bond and credit markets to freeze up or propel another financial crisis -- a needless and unacceptable risk that advanced industrialized economies should and will regulate out of the realm of possibility.
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Chasing Value: Ten stocks for 2010 -- Part 2
