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Shields: Implementing regulatory safeguards

03/31/09 7:55AM By Jeff Shields
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(HOST) It seems that every day there is fresh outrage about the AIG bonuses.  And with good reason. But commentator Geoff Shields hopes that we aren't losing sight of the forest for the trees.  

(SHIELDS) While the bonuses are significant, the much bigger problem is the systematic unraveling of the safeguards which might have prevented AIG from getting into financial difficulty in the first place.  

Earlier in the decade, AIG recognized the opportunity to make a lot of money by selling bond default insurance.  They carefully structured these arrangements to get around insurance regulations.  Essentially, what AIG did was offer to sell insurance to the holders of bonds but called the instruments "credit default swaps" instead of "insurance."  

Besides agreeing to pay defaulted principal and interest, AIG further agreed that they would provide collateral to the insured party in the event that certain problems arose either with AIG or with the company whose bonds were insured. As the economy has worsened, there has been a rash of collateral calls on AIG.

The root of these problems has to do with extremely lax regulation.  The lax regulation was not an accident, but rather the result of vigorous lobbying by AIG and other buyers and sellers of credit default insurance.  That lobbying focused on keeping these insurance products unregulated, by insurance commissioners, the SEC, the Federal Reserve Board and other federal regulators. Those lobbying efforts also extended to avoiding reserve requirements which might have been imposed.  

Insurance companies normally have to keep assets as reserves to back their insurance policies.  However, there are no reserve requirements for credit default insurance.  

Congress agreed not to impose disclosure requirements, which would have made transparent the growing risks that AIG was taking, and which might have triggered intervention.  And Congress failed to impose requirements for reserves.

Indeed, not only were the lobbyists successful in avoiding new regulation, but they also were able to undo the existing regulation, particularly the Glass-Stiegel Act which required insurance, banking, and investment banking services to be conducted by separate companies.

During the Clinton administration, the Glass-Stiegel Act was repealed, and during both the Clinton and Bush administrations, Congress repeatedly voted down efforts to regulate credit default insurance.  It's important that Congress and the executive branch now react to the AIG debacle by implementing regulatory safeguards.  

The first step would be to re-impose the Glass-Stiegel act requirements for separation of banking, investment banking and insurance business.  Following that, we should impose significant reserve requirements for credit default insurance products. And finally, we should impose vigorous disclosure requirements with regard to financial institution investments including hedge funds and credit default swaps.   

We should not just be mad about bonuses; we should insist on adopting regulations which will prevent AIG-type abuses in the future.
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