Obama to correct Phil Gramm's costly mistake on derivatives
May 14th 2009 11:30AM
Updated Dec 4th 2009 11:42AM
One of the greatest benefits to America of John McCain's loss last November was blocking a return to power of Phil Gramm, who helped McCain by pointing out that Americans are "whiners." More importantly, he's the economist whose deregulation of the market for derivatives, such as credit default swaps (CDSs), led to the $173 billion bailout of American International Group (AIG). And now your president, Barack H. Obama, will reverse Gramm's grievous mistake.
With help from then-Treasury Secretary (and current Obama economic advisor) Larry Summers, Gramm created a monster. In 1999, he added a 262 page amendment to a government re-authorization bill, that deregulated CDSs. (CDSs are insurance policies that pay if a bond issuer defaults on a bond payment.)
CDSs -- now a $38 trillion market that peaked in 2008 at $62 trillion -- are now so dangerous because Gramm's legislation made it possible for the same bond to be insured hundreds of times without requiring each insurer to maintain reserves in case of a claim or to report their contracts to anyone. Last September, a credit downgrade of AIG triggered a $14.5 billion margin call related to the CDSs on the books of AIG's financial products group. Since it couldn't pay, the U.S. bailed AIG out to the tune of $173 billion. Such margin calls also led to the collapse of Lehman Brothers, Fannie Mae, and Freddie Mac.
Now Obama wants to regulate the $680 trillion derivatives market -- this notional amount includes the value of derivatives' underlying assets -- so we don't have a repeat of this financial catastrophe. Treasury Secretary Tim Geithner announced that the U.S. wants to require CDSs, interest rate swaps and other types of derivatives to be traded on exchanges and backed by capital reserves -- basic rules that Gramm worked so hard to block. The result will be a more open derivatives market in which there is less casual speculation and more manageable risk.
While it is too bad that it took a financial catastrophe to reverse Gramm's work, thanks to the November defeat of John McCain we can stop whining and continue to fix the problems that Gramm and his allies foisted on our country.
Peter Cohan is president of Peter S. Cohan & Associates. He also teaches management at Babson College. His eighth book is You Can't Order Change: Lessons from Jim McNerney's Turnaround at Boeing. He owns AIG shares.