Dinallo Has Common Sense Solutions on CDS and Regulatory Issues

Eric Dinallo was on Bloomberg recently, talking about CDS and other regulatory issues. This clip is worth watching: he is the only politician or regulator who understands the dangers posed by CDS and inadequate regulation and is willing to talk about realistic solutions.

Dinallo, as former NY State Superintendent of Insurance has first hand knowledge of the issues involved, due to the problems he dealt with on AIG, MBIA (MBI), Ambac (ABK) and other financial guarantors. He and NY Governor Paterson attempted to bring the CDS issue to a head by offering to regulate them as insurance, if the Federal government did not step in and do something. At the time, it seemed that Congress would be doing something, but more than a year later CDS regulation is still being debated and in the process whatever we get is going to be too watered down to resolve the issues. Dinallo makes some excellent points:

CDS should be regulated - as either insurance products or gambling products. Approximately 20% of CDS are supported by an insurable interest: they should be regulated as insurance with requirements for adequate capital. The other 80% of CDS are gambling contracts and should be regulated as such.

These views are in sharp distinction from those we see in Congress, where there is considerable weight given to the input from Goldman Sachs (GS), Bank of America (BAC), Morgan Stanley (MS), JP Morgan (JPM) and CItigroup (C). All of these "banks" make good money trading and steadfastly resist any efforts to regulate CDS in such a way as to prevent a recurrence of the debacle that required their rescue on the backs of over-burdened taxpayers.

CFMA, Graham-Leach-Bliley, Glass-Steagall - CFMA was the legislation that exempted CDS from regulation by either the CFTC or the SEC. Glass-Steagall enforced the separation of banks from other financial activities such as insurance, and Graham-Leach Bliley removed these important protections from the regulatory arsenal.

Dinallo's common sense analysis: depositary institutions must not be permitted to indulge in leveraged financial bets. That would include insurance companies such as AIG. Basically we need to repeal CFMA and Graham-Leach-Bliley, restoring the legal basis for adequate regulation of financial firms.

Compensation for TARP recipients - After noting that Wall St. seems to have trouble grasping the implications of the compensation issue, Dinallo adds that it's not just about the top executives. There are many operating employees (traders) making the big bucks. Obviously their compensation schemes motivate extreme risk taking, inappropriate with taxpayer support.

But he sees the solution as being improved regulation, not setting arbitrary limits on compensation. If CDS are limited to their proper function as insurance, issued by institutions that have adequate capital, the problem of excessive compensation will go away. If banks and insurance companies that are entrusted with people's savings and financial security are prohibited from gambling, the high rollers will go elsewhere, where they can't endanger the system, and their compensation will be paid by their gambling adversaries rather than taxpayers.

NY Attorney General - Dinallo is a candidate for this position. Noting that Elliot Spitzer was able to act as the "Sheriff of Wall Street" while serving as NY Attorney General, and that Dinallo makes sense on a lot of regulatory issues, there is potential for some reduction in Wild West capitalism.

Disclosure - No position in the firms mentioned.

Comments

[Tom Armistead:]

Disclosure correction, I am long MBI

Oct 25 09:34 AM

[lower98th:]

>Basically we need to repeal CFMA and Graham-Leach-Bliley, restoring the legal basis for adequate regulation of financial firms.<

The polls and congressional email tallies should make this a no-brainer. Will Congress ever get this right?

Oct 25 09:49 AM

[apppro:]

ALL I know is, is that while Bill Ackman was screwing over MBIA and Ambac through his relentless rumormongering & Naked shorting back in 2007 Dinallo did nothing. Best he could do was to go on CNBC and say we need the muni's to survive. Lot of good that did! Not once did he scream to Wilbur Ross or Buffett to help out and stop the insane naked shorting and mindless manipulation of ABK's CDS's thru M2M. Even when Buffett made that ridiculous offer to buy ONLY the muni's and leave MBIA & ABK with the subprime - Dinallo did squat. He had no solution then and believe me he has none now either. He let everyone hang out to dry because he was afraid of Spitzer back in 2007 and has no one to back him up now.

Cramer named it the other night when he screamed that the short sellers who brought the system down are getting away with it, and this time he is sure right about something.

Oct 25 05:38 PM

[CaptainJJack:]

The Credit Default Swap is not an insurance contract. There is no way to pool the risk.

It is a risk transfer product, just like a futures contract or an interest rate swap contract.

The issue is "contagion" , and it is why you do not see insurance contracts written on investment risk, generally. The environment that creates a problem for one creates the problem in many.

The correct way to regulate these is in an exchange, like other investment derivatives. They should be subject to the standard rules on market manipulation and clearing, in cash, everyday, at market.

There is no need for an insurable interest anymore than there is a need for an insurable interest in an interest rate swap or a grain futures contract.

Finally, I could not agree more that the repeal of Glass Steagall was the single biggest cause of this crisis. The Fed and the FDIC were formed in recognition that commercial banks were historically not regionally diversified, and often when a town or region went down, so did the banks.

However, the Fed requires that these banks hold much greater capital, with leverage at roughly 10 times, and the FDIC requires that the commercial banks fund the losses. Given the margins in this business, these banks achieve high ROEs even with the low leverage.

The Fed And FDIC were never designed to backstop an investment bank. The investment banks primary strategy is to borrow money and trade, and there is almost no way they can survive long term without 30+ leverage, the margins are far to thin.

As long as the one type of bank can own the other, we will see bad outcomes.

Oct 26 11:21 AM