April 24, 2008 1:25PM

Can Wall Street’s Clean Up Plan Work?

By Elizabeth MacDonald

Big guns in the stock market are trying to dodge the thunderbolts thrown down from Mount Washington DC over Wall Street’s creation and handling of the credit crisis.

They’ve come up with a new central clearinghouse that would oversee for the very first time credit derivatives, beginning with credit default swaps. This is yet another historic move arising from the Great Credit Crunch. Credit derivatives right now are cleared through a central clearinghouse, and they also tend to fly under the regulatory radar.  

But investors now ought to ask, will a new clearinghouse for these credit derivatives be enough? What does this mean for investors? Are the stars in correct constellation for a new Wall Street order? And can Wall Street regulate itself?

While market historians can give you a list of Wall Street’s botched attempts at self-regulation longer than your arm, a growing chorus of them say it’s about time for this new modus operandi.

But a big obstacle to the new clearinghouse is the fear by the Street that it could cut into trading profits–never mind the outsized costs of the Street’s mismanagement to investors and taxpayers. And as Wall Street tries to heal itself without government intervention, doing so doesn’t come without other obstacles that the industry itself is erecting.  

The new clearinghouse for credit default swaps comes about as banks and investment houses have written off a total of about $215b to date in degraded inventory from bad derivatives, with tens of billions of dollars more in writedowns expected. Goldman Sachs (GS) says the amount will top out at a desolating $460b, and the fire engine red alarm is already clanging in Washington, as lawmakers watch with accelerating alarm.

The idea for a new clearinghouse for credit derivatives is an issue we’ve been reporting about since December at Fox Business (”What Congress Must Ask the Federal Clean-up Crew,” “The Reality Check that Bounced,” “How Congress Can Fix the Crisis”).

It’s a call for change that has gotten louder after the near collapse of investment bank Bear Stearns (BSC). The plans for a central mechanism for credit default swaps come as fears have grown that there are still more ailing counterparties beyond Bear Stearns that could create shocks to the system, at a time when the thinly regulated $45t credit default swap market alone is larger than the US government bond and housing markets combined.

The hope is that by dragging these credit derivatives out of the shadows and into the sunlight, that doing so will sharply curtail any future writedowns that have rocked Wall Street and shaken Washington.

The thinking goes that the move will bring better and more timely pricing, more transparency, greater capital efficiency, and reduced risk in the trades of these opaque securities.

A new clearinghouse might, just might, stop dead in its tracks another expensive rescue of Wall Street by the Federal Reserve, as the central bank has made costly moves to revivify the financials deadened by Frankenstein securities.

Dragging all derivatives out from the shadows could also prevent embarrassing hat in hand visits to get money from sovereign wealth funds as well as screaming investors at shareholder meetings, as executives’ once sparkling reputations have been seweraged. Wall Street hopes that coming up with this move ostensibly on its own would stop pesky Congressional scrutiny, which the Street loathes.

Here’s the deal. A group of large Wall Street firms now plan to start offering a central counterparty clearinghouse for these credit derivatives later this year. The plan is for an over-the-counter clearing house run by the Chicago-based Clearing Corp., which would be regulated by the Commodities Futures Trading Commission. The Clearing Corp. is backed by Credit Suisse (CS), Goldman Sachs Group (GS), Citigroup (C), J.P. Morgan Chase (JPM) and Deutsche Bank (DB). The CME group, which runs the biggest futures exchange, has already moved toward a similar plan for interest rate swaps.

Only companies with solid capital and dependable trading histories in clearing trades would be allowed to do business with this new central counterparty and get protected from the risk of a trader or investor failing to meet a trade. The new clearinghouse would guarantee payment on the trades it executes, and in turn reduce counterparty risk. And since it would be the counterparty, the banks’ exposure would have zero risk weighting. 

But obstacles are on the rise.

The credit derivatives industry already is fighting any regulation. Historically, over-the-counter trading in these securities has been private. 

Wall Street talk is that the dealers with big positions in these trades will either ignore or fight the move because they don’t want to be regulated. Insiders like to keep these trades in the shadows because they can charge colossal fees from deals they can rig themselves without any meddling. A new clearinghouse could cut into those fees.

Another obstacle to standardizing trading in these derivatives is the very nature of the securities themselves. Take bond derivatives. They are more esoteric than straightforward stocks. More so credit default swaps.

Also these complex securities tend to trade in bigger lots, they come in a much wider variety than regular stocks, plus historically they tend to have less liquidity. And past attempts to trade credit derivatives on other exchanges have failed.

The bottom line is, if the market doesn’t bring all derivatives trading into the sunlight, the regulators will force them to do so. And if they don’t, they should.