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Business & Technology

Treasury secretary says power, risks of explosive derivatives market blindsided the government

July 10th, 2009 12:00 am by Associated Press

WASHINGTON (AP) -- The huge amount of money tied up in complex derivative transactions helped cripple the economy, Treasury Secretary Timothy Geithner told lawmakers Friday as he laid out a case for greater government control over a generally unregulated sector of the financial markets.


"Establishing a comprehensive framework of oversight is crucial," Geithner said in his opening remarks to a joint hearing by the House agriculture and financial services committees.


Despite apprehension among Republicans, the effort to add government restrictions to these more freewheeling financial instruments has gained support within the Democratic-controlled Congress.


"Clearly, we're going to be significantly expanding regulation of derivatives," said Rep. Barney Frank, the chairman of the Financial Services Committee.


Derivatives are financial instruments whose value derives from something else, such as a mortgage-backed security or a commodity like oil. The allure of the over-the-counter derivative, as opposed to those swapped on exchanges, is that it can be individually negotiated and tailored to meet the specific needs of the buyer.


Geithner said the ease with which derivatives were bought and sold in an era of easy credit encouraged financial institutions and investors to take on too much risk. At the same time, government regulators weren't given the proper tools to mitigate those risks and protect the American consumer, he said.


"The complexity of the instruments overwhelmed the checks and balances of risk management and supervision," he said.


The administration's proposal, part of a broader overhaul package, has run up against much of the financial industry, which says it would raise costs and squash innovation.


Some lawmakers and federal regulators say they are skeptical, too.


"My fear is that the administration is going down the path of shifting risk not to the investors and the dealers, but ultimately to the taxpayers," said Rep. Spencer Bachus of Alabama, the top Republican on the Financial Services committee.


Under the administration's broader plan, which requires Congress' blessing, the Federal Reserve would be put in charge of keeping large, influential institutions in check. A new consumer protection agency also would be created.


Additionally, Obama wants to regulate for the first time derivatives that are being privately traded "over the counter," or away from an exchange.


The influence that derivatives can have on the financial sector was most evident when American International Group Inc. sold so-called credit-default swaps to protect investors against potential losses on mortgage-backed securities. When the housing market collapsed, AIG was unable to make good on its promises and took a $182 billion government bailout to keep from collapsing.


But Geithner said many investors used the instruments to evade regulation, exploit regulatory loopholes or minimize taxes.


Over-the-counter derivatives "grew explosively" in the past decade, with the face value of outstanding transactions rising sixfold to almost $700 trillion in 2008, he added.

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