World According to TARP No Laughing Matter for U.S. (Update1)

Oct. 29 (Bloomberg) — The financial crisis exacerbated by credit derivatives is costing so much to fix that speculators are now using those same instruments to bet on governments as the price tag for bailing out banks approaches $3 trillion.

The cost to hedge against losses on $10 million of Treasuries is about $39,000 annually for 10 years, up from $1,000 in the first half of 2007, based on CMA Datavision prices. The equivalent for German bunds has risen to $37,000 from $2,000, while it has jumped to $66,000 from $3,000 for U.K. gilts.

Unlike John Irving’s novel “The World According to Garp,” which provokes laughter from readers, the devastation amplified by derivatives is proving unfunny as taxpayers finance the financial system’s rescue through measures such as the $700 billion Troubled Asset Relief Program, or TARP. Pressure is rising on policy makers to regulate a market that’s moved beyond its origins protecting banks from loan losses to $55 trillion, prompting Warren Buffett to call the contracts a “time bomb.”

“There’s a huge gap in our regulatory system,” former U.S. Securities & Exchange Commission Chairman Harvey Pitt said at an industry conference yesterday, referring to legislation almost a decade ago that excluded the derivatives from government oversight. The regulatory system is “terribly broken,” he said.

The Federal Reserve has given futures exchanges until Oct. 31 to present written plans on how they’ll make the market more transparent, said four people familiar with the request. The Fed called banks and exchanges into three meetings in two weeks, pressing them to agree on a clearinghouse that would require dealers to post collateral and pay into a fund that would absorb losses if one of them were to fail.

Calls for Regulation

Turmoil triggered by credit-default swaps prompted calls from SEC Chairman Christopher Cox, Commodity Futures Trading Commissioner Bart Chilton and lawmakers including Senator Tom Harkin, a Democrat from Iowa, for Congress to authorize governing bodies to regulate the market.

New York Governor David Paterson said in a Sept. 22 statement that “the absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing.” New York officials proposed rules that would treat some of the contracts as insurance after the government was forced to bail out American International Group Inc.

`Absolutely Urgent’

“It’s absolutely urgent that we bring disclosure to this corner of the market, that we let the market see where the risk is and price accordingly,” the SEC’s Cox told the House Committee on Oversight and Government Reform on Oct. 23.

Derivatives are contracts whose value is derived from assets including stocks, bonds, currencies and commodities, or from events such as the weather or changes in interest rates.

Credit-default swaps trade over-the-counter, leaving each party exposed to the risk the other won’t fulfill the terms of the contract. The International Swaps and Derivatives Association, the industry group that has been setting the rules and acting as a self-regulator of the market, cited estimates that there were as much as $400 billion of contracts tied to Lehman Brothers Holdings Inc., even though the company only had $162.8 billion of debt, according to Bank of America Corp. analysts.

The Depository Trust & Clearing Corp., which runs a central registry for trades, placed the amount at about $72 billion.

The contracts, which aren’t issued by the companies they are linked to, pay the holder the face value of the amount protected in exchange for the underlying securities if a borrower fails to adhere to debt agreements. A basis point on a credit-default swap contract protecting $10 million of sovereign debt from default for 10 years is equivalent to $1,000 a year.

AIG’s $440 Billion

New York-based AIG amassed bets of more than $440 billion on U.S. home loans, corporate bonds and other assets by selling protection against default via the derivatives.

After ratings firms downgraded the insurer in September because of potential losses from the trades, AIG had to accept an $85 billion loan from the government and turn over majority control because of more than $10 billion in collateral it was required to post on the trades.

Lehman was one of the 10 biggest dealers in the credit- default swap market before it failed. New York-based Primus Guaranty Ltd. which managed $24.2 billion of credit-default swaps and sold guarantees on companies including Lehman and bankrupt Washington Mutual Inc. of Seattle, has tumbled 94 percent this year on the New York Stock Exchange to 40 cents a share.

CDX Index

Banks are now driving the cost of debt protection to new records as they seek to guard against losses on contracts bought from money-losing hedge funds. The Markit CDX North America Investment Grade Index, linked to the bonds of 125 companies in the U.S. and Canada, reached a record 240 basis points on Oct. 24, before falling back to 213 yesterday, according to Phoenix Partners Group. Europe’s benchmark index reached a record 193 basis points before falling back to 163, according to JPMorgan Chase & Co. prices at 8:02 a.m. in London.

Buffett, called “the world’s greatest investor” by biographer Robert Hagstrom, described derivatives in an annual report to shareholders of his Omaha, Nebraska-based Berkshire Hathaway Inc. as “financial weapons of mass destruction.”

“The range of derivatives contracts is limited only by the imagination of man or sometimes, so it seems, madmen,” Buffett said in the 2003 letter to shareholders.

Credit-default swaps are just a tool available to investors to hedge against losses, said Robert Pickel, head of the International Swaps and Derivatives Association in New York.

“To say that CDS were the cause, or even a large contributor, to that turmoil is inaccurate and reflects an understandable confusion of the various financial products that have been developed in recent years,” Pickel told a House committee on Oct. 14.

Competing Proposal

Four groups are vying to operate clearing operations, including a partnership between Chicago-based CME Group Inc. and Citadel Investment Group LLC and a team consisting of dealer- owned Clearing Corp., Atlanta-based Intercontinental Exchange Inc. and credit-default swap index owner Markit Group Ltd. Eurex AG, the world’s biggest futures exchange, and NYSE Euronext have also submitted proposals.

The push to make the industry more transparent may finally let exchange-traded derivatives gain traction after years of failing to compete with banks. Eurex, the world’s biggest futures exchange, opened the first market for exchange-traded credit derivatives in March 2007, beating Chicago Mercantile Holdings Inc. and Euronext, though dealers resisted moving to their platforms because it threatened their profits.

“The CDS market is going to go to exchanges,” Emmanuel Roman, co-chief executive officer of GLG Partners Inc., which manages about $24 billion, said at the Hedge 2008 conference in London on Oct. 23. “That’s a very good development. Not good for the banks but good for everyone else.”

Downgrade Fears

Trading of credit-default swaps on government debt has increased since countries from the U.S. to Germany began pumping cash into their banks to prevent more failures, said Puneet Sharma, head of investment-grade credit strategy at Barclays Capital in London. The expenditures mean the “probability of downgrade has increased,” he said.

Investors are buying protection on countries to speculate on a deterioration of their credit quality and ratings as governments take on risky assets, even if they don’t think there is a chance of default.

Gross issuance of Treasury coupon securities will rise to about $1.15 trillion in the 2009 fiscal year from $724 billion in fiscal 2008, according to Credit Suisse Securities USA LLC, one of the 17 primary dealers of U.S. government securities that are obligated to bid at the Treasury’s auctions.

`Going Down’

“I do not think the U.S. market will blow up,” said Pierre Naim, who bought default protection on Treasuries in January for his Rainbow Global High Yield hedge fund in the Bahamas. “But the quality of U.S. government assets is going down by the day.”

Credit-default swaps on Treasuries have risen nearly 40 percent since TARP was signed into law October 3, and are now about the same as Mexican and Thai government debt before the credit markets began to seize up in June 2007, CMA Datavision prices show. Contracts on bunds soared by 77 percent and gilts by 66 percent over the same period.

The Treasury has allocated an initial $250 billion out of the $700 billion approved by Congress to shore up lenders, and is being pressured by the Financial Services Roundtable, a trade association of the 100 largest banks, securities firms and insurers, to broaden its guidelines so that insurance companies, broker-dealers, automobile companies and institutions controlled by foreign banks could also sell stakes to the government.

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