Committee on Banking, Housing and Urban Affairs : Statement by Christopher Whalen; United States Senate; June 22, 2009

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One of the additional concerns that the Congress must address and which strongly argue in favor of outlawing the use of OTC CDS contracts entirely, is the question of fairness to investors, specifically the use of these instruments for changing the appearance but not the financial substance, of other banks and companies. The AIG collapse illustrates how CDS and similar insurance products may be used to misrepresent the financial statements of public companies and financial institutions.

In the case of AIG, the insurer was effectively renting its credit rating to other firms, and even its own affiliates, in return for making these counterparties look more sound financially than their true financial situation justified.

The use of CDS and finite insurance to window dress the financial statements of public companies is an urgent issue that deserves considerable time from the Congress to build an adequate understanding of this practice and create a public record sufficient to support legislation to ban this practice forever. For further background on the use of CDS and insurance products at AIG to commit securities fraud, see “AIG: Before Credit Default Swaps, There Was Reinsurance,“ The Institutional Risk Analyst, April 2, 2009

Q & A

Below are my responses to the Committee's written questions.

1) How can the Congress best modernize oversight of the over-the-counter derivatives markets to increase transparency and reduce risks?

The Congress should think of modernizing the oversight of OTC derivatives in terms of restoring the existing norms of disclosure, transparency, prudential risk controls and fairness that prevail in organized, regulated markets in the US, markets such as the NYSE or CME. The existing structure of OTC derivatives is not “innovative“ but rather is retrograde for the reasons suggested in the general points above regarding bank business models and the nature of the credit derivatives markets. Consider the fact, for example, that even today, market participants, regulators and the public still have no access to close-of-day prices for CDS and complex structured assets because the large dealers such as JPM and GS refuse to make this information available to the public.

In order to address this situation, Congress should take immediate action to immediately start to limit the risks posed by the operation of OTC markets. Specifically:

Congress should subject all OTC contracts to The Commodity Exchange Act (CEA) and instruct the CFTC to begin the systematic review and rule making process to either conform OTC markets to minimum standards of disclosure, collateral and transparency, or require that the contracts be migrated onto organized, bilateral exchanges. It is time for the Congress to right the wrong done over a decade ago to Commissioner Brooksley Born and her colleagues at the CFTC. This wrong was committed in part by the Congress and in part by then-Treasury Secretary Larry Summers, then-Fed Chairman Alan Greenspan, and former Treasury Secretary Robert Rubin, among others, who all worked together to effectively block action that would have subjected OTC contracts to the full supervision of the CFTC.

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