WASHINGTON -- Derivatives are expected to come under increased congressional scrutiny next year as a result of the Orange County, Calif. bankruptcy -- a financial debacle brought on by use the risky instruments.
In the House, a new subcommittee is being created with explicit jurisdiction over derivatives. And in the Senate, incoming Banking Committee chairman Alfonse M. D'Amato is expected to make hearings on derivatives one of his first priorities.
"Orange County has really changed the parameters of this thing," said one industry lobbyist. "It's not just a bunch of sophisticated investors that are affected now."
The outlook for legislation remains murky, despite the heightened attention following the Orange County bankruptcy.
But if another derivatives debacle affecting public funds arises, it will almost certainly prompt lawmakers to take action, said Karen Shaw, president of ISD/Shaw Inc., which tracks bank regulation and legislation.
"There will be a danger, even with a Republican anti-regulatory climate, that lawmakers will feel they have to stop this," Ms. Shaw said. "The imagery of the next S&L crisis is quite powerful."
Rising interest rates caused the $7.8 billion Orange County fund to take a $1.5 billion paper loss, announced earlier this month.
As of March 31 this year, onequarter of the fund's portfolio consisted of derivatives, financial contract with returns tied to the performance of underlying stocks, bonds or other assets.
After learning of the Orange County losses, Sen. D'Amato said he continues to believe that legislation increasing the regulation of derivatives is not warranted.
However, he added that he will conduct hearings on derivatives, including the use of the instruments in certain investment funds, early next year.
During the last Congress, Rep. Jim Leach, R-Iowa, co-sponsored the Derivatives Safety and Soundness Supervision Act of 1994, which would have directed bank regulators to establish guidelines for oversight of derivatives activities.
Rep. Leach, who will chair the House Banking Committee next year, would also have authorized regulators to require financial institutions to disclose derivatives activities information in their call reports.
Although the measure, whcih was not enacted, focused on insured financial institutions, many of the issues arising from the Orange County losses were addressed by the Iowa Republican's bill, Ms. Shaw said.
"The suitability issue is a perfect example," Ms. Shaw said, noting that the Leach bill addresses that issue.
Federal banking regulators have argued that they have sufficient authority to oversee derivatives, and that legislation is not necessary.
At a Joint Economic Committee hearing last week, Federal Reserve Board Chairman Alan Greenspan described the Orange County losses as a "necessary price we have to pay for what is a valuable addition to our financial system."
However, Margery Waxman, a partner with the Washington law office of Greenberg, Traurig, Hoffman, Lipoff, Rosen & Quentel, said comprehensive derivatives legislation is a must.
"Because derivatives products cut across the jurisdictional boundaries of the financial regulators, ... no one agency has the authority to enact comprehensive standards of conduct to govern the sales practices, accounting systems, and management controls for assessing risk in the derivatives market," wrote Ms. Waxman.
Congress is the only policymaking body that can appreciate that the losses suffered by Orange County could ultimately be felt by the taxpayer, Ms. Waxman, a former Treasury Department official, added in a letter to the two incoming banking committee chairmen.
The most important lesson to be taken from the Orange County loss is the need for more direct supervision, according to Heinz Binggeli, managing director at Emcor Risk Management, an Irvington, N.Y. consulting firm.
"The loss is not as dramatic as it sounds, but it happened because there was not sufficient supervision," said Mr. Binggeli.
"The Orange County supervisors should have had a mechanism in place to know what was in the portfolio and to measure the risk in the portfolio."
And this is not a problem that will be easily remedied by legislation, according to Edward Furash, president of Furash & Co., a bank management consulting firm.
"It looks as if the free market is going to be able to solve this, but the critical problem in this case was that rates rose faster than the securities firms and the banks and investors could unwind their position. You can't legislate that," Mr. Furash said.