Senior Ex-Regulator In US Takes Swipe At Derivatives After JP Morgan Loss

Tom Burroughes

21 May 2012

Heavy recently-disclosed losses at JP Morgan reinforce the case to regulate the market for credit default swaps, a widely used form of derivative, more heavily, according to a senior former US regulator Sheila Bair.

JP Morgan recently disclosed that it lost more than $2 billion amid faulty hedging strategies concerning the use of CDS instruments. The problems add to concerns that were expressed after the 2008 financial crisis that such derivatives magnify, rather than disperse, financial risks of defaults. The episode has also highlighted the risks that some say arise when an investment bank sits in the same corporate structure as a private and retail banking operation.

"I'd push them (CDS's) off the planet," Bair, who was head of the Federal Deposit Insurance Corporation for five years before stepping down last summer, told the UK’s Daily Telegraph newspaper. "The CDS market is very volatile and very opaque. From a safety and soundness point of view, I'm uncomfortable with that."

The Dodd-Frank Act that was enacted in 2010 has called for the majority of the derivative market, including CDS, to be traded on exchanges and for transactions to go through clearing houses. The rules have yet to be finalised and enforced.

Bair says that regulators need to go further to stop the explosive growth in the instruments that have become popular because they allow traders and investors to buy insurance without having to own the underlying asset. (This is a practice different from, say, household insurance, where the insurance contract purchaser has to have a material interest in the underlying asset being insured.)

"People shouldn't be able to buy this stuff unless than they a tangible economic interest in the underlying asset," said Bair. "People are just playing the market," she said.