Traders Sowing Seeds of Destruction Prompt Crackdown

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Credid Derivatives

Sept. 24 (Bloomberg) -- The $62 trillion market for credit- default swaps, created to protect banks from loan losses, helped fuel a near-meltdown in the financial system and now may be regulated for the first time.

The derivatives precipitated plunges in the shares and debt of Wall Street firms, accelerating the collapse of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc., the biggest U.S. insurer. Now, regulators want to bring oversight to a part of the credit market that may be more susceptible to manipulation than selling stocks short, according to U.S. Securities and Exchange Commission Chairman Christopher Cox.

{xtypo_quote_right} "The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing," Paterson said in a statement Sept. 22. {/xtypo_quote_right}

Banks "are suffering the consequences of their own actions," said Thomas Priore, chief executive officer of Institutional Credit Partners, LLC, a New York-based hedge fund with $13 billion in assets. "They created a mechanism through default swaps to reflect a view on credit that has taken on a life of its own."

The swaps became one-way bets on the demise of financial institutions as traders hedged the risk that their partners might implode, said Gary Kelly, a strategist at broker Tradition Asiel Securities Inc. in New York. The wagers sent distorted signals about credit risk, he said.

The resulting run on shares of financial companies prompted Cox yesterday to seek enforcement powers over the market. New York State will also start regulating some sales of the derivatives, according to Governor David Paterson.