When House Banking Committee Chairman Henry Gonzalez questioned Freddie Mac President Leland Brendsel about rumors that it was considering buying or issuing exotic mortgage-backed security derivatives Nov. 19, he signaled a growing concern in Congress about the safety and soundness of those instruments.
Brendsel told Gonzalez that Freddie had no such plans. Nevertheless, lawmakers have every intent to press the issue and the ranking Republican on the House Banking Committee kicked it off by urging regulators to develop tougher monitoring of derivatives.
Rep. Jim Leach, R-Iowa, made the recommendation Nov. 22 while releasing a 900-page report written by his staff that includes 30 recommendations to strengthen swaps regulation.
Leach is known in Washington as a quiet but influential member of Congress who is widely respected for his careful analysis of tough financial issues. Many of his colleagues on Capitol Hill with probably follow his lead on the derivatives issue, one of the most technically complex to face banking regulators in many years.
His decision to push for stronger regulation--and possibly legislation next year--is a major blow to derivatives dealers, who have been lobbying for months to minimize any new restrictions from the U.S. government.
The International Swaps and Derivatives Association, a leading association of derivatives traders, expressed disappointment with Leach's report.
The group criticized Leach for "inaccurate characterizations of the derivatives business," which it said "do not reflect the value that derivatives bring to a wide variety of endusers by helping them better manage their financial risks."
But Leach's references to derivatives as "the new wild card in international finance" have been echoed by many in congress, who, like Leach, are worried that in case of a market meltdown, it will be taxpayers and community banks "who will pick up the tab for the mistakes of the few."
Leach also said he was particularly concerned about the fast growth of the derivatives market and the likelihood that new entrants can't manage the risks.
"In the derivatives arena, there is a particular problem of new kids on the block" he said.
"Banking regulators should discourage financial institutions from active trading in the derivatives market unless they can demonstrate both adequate capitalization and the sophisticated technical capacity to be involve in such trading." Leach said.
In a newly released Oct. 4 written response to 24 questions from Leach about OTS derivative policies, OTS acting Director Jonathan Fiechter said, "In contrast to the banking agencies, OTS collects fairly detailed information on derivatives."
Touting the OTS's interest rate risk model, which Flechter said could help serve as a model to international efforts to develop derivatives regulations, Flechter said the OTS "collects information on all major types of off-balance-sheet instruments, including futures, options, swaps, floors, swaptions and various types of commitments.
"Key information is collected for each type of instrument, including a code to identify the type of contract, its notional amount, the time to maturity or expiration and relevant interest rates and margins," he wrote. "Only by estimating the interest rate sensitivity of the portfolio with and without derivatives, can the incremental contribution of derivatives to risk or risk reduction be assessed."
Leach said he would give banking regulators until the year-end to respond to his study.
Although he said he would prefer to see action by regulators than Congress, he warned that if their response is insufficient, "you can expect some possibility of a broad framework bill to be introduced" on derivatives regulation.
Such a bill, he said, would do at least three things: create an inter agency commission to set rules on derivatives, call for "cross-industry" harmonization of derivatives regulations and push the Federal Reserve and the Treasury to lead the way toward international standards. Leach added that his staff are now drafting this legislation.
In heft and depth, Leach's study eclipses reports earlier this year from the Group of 30 and the Commodity Futures Trading Commission. But like those reports, the new study puts heavy emphasis on setting international standards.
Leach said that central bankers from industrialized countries working through the Basel Committee should develop international standards on derivatives.
"It's crucial that other countries have comparable rules and regulations," Leach said. "We're dealing with a common problem."
Leach also urged greater disclosures, including expanded requirements for call reports.
Market risks, concentration of counterparty exposures and risk reductions from netting should be covered on the expanded call reports, he said.
New call reports should also differentiate derivatives used for hedging from those used for trading or speculation and "identify the related impact of each category on bank earnings and balance sheets as well as any deferred hedging losses or gains."