DHinMI's diary last night highlighted a plan to recover the AIG bonus money through taxation. Not a bad idea, but there's something more important we could be doing: tax the credit default swaps that are at the heart of the mess. Even after the government bailout began, last fall, AIG has continued to enter into swap contracts, and is using taxpayer money to be able to do that. Maybe these contracts are worthwhile, maybe they're not, but they're almost completely unregulated and hidden from oversight. That needs to stop!
Credit Default Swaps were exempted from regulation in the US by Phil Gramm's "Commodity Futures Modernization Act of 2000"; by the fall of last year they had grown to over $60 trillion. As a form of insurance they don't pay out unless the underlying entity loses its value, which doesn't happen all that often, so the actual total monetary value that would ever be paid is considerably less than this - but a small fraction of $60 trillion is still an awful lot of money, as the AIG bailout has proved. Some of the swaps essentially cancel one another out (bets in opposite directions) which reduces the real volume further. The various shocks and actions of recent months seem to have reduced total swap volume to about $30 trillion at present.
About a week ago, Intercontinental Exchange (ICE) started a new clearinghouse for CDS's in the US, under Federal Reserve and SEC approval. A similar clearinghouse or exchange is expected to open in Europe later this year, and several other competing exchanges may be set up as well.
The exchanges provide more openness and transparency and assurance of consistency in these contracts, but they are no substitute for actual regulatory oversight. For one thing, private parties arranging these contracts don't have to use the exchanges if they don't want to, so they can keep their transactions hidden for now. For another, the original purpose of these swaps was to provide insurance on underlying bonds held by one party to the swap. But the total value of the swaps is many times larger than the total value of the underlying securities now, indicating the extent to which most of the use of swaps is for speculation, rather than insurance purposes.
So two simple regulatory steps would be to require all swaps to go through exchanges (and therefore to be out in the open), and to require the counterparty to hold the bond or security being insured by the swap.
A simpler alternative to that second regulatory approach, but one that could have significant other benefits (raising a lot of money for the federal government, in particular), is to impose a financial transactions tax - either generally or restricted to the new CDS exchanges. This sort of tax discourages wanton speculation by adding some friction to the markets, but legitimate insurance needs are not harmed by a small additional fee of this sort.
A third approach is to realize that, if the federal government is acting (as in AIG's case) to re-insure these contracts to prevent defaults, then holders of these contracts should be subject to insurance payments to the federal government, similar to the payments banks make to the FDIC for their deposit insurance. Companies holding CDS's without having made such insurance payments would not be bailed out. At $30 trillion, even a 1% per year insurance fee would raise some $300 billion for the government.
Congress needs to step in here. Much more urgent than taxing extravagant bonuses, we need to reverse Phil Gramm's 2000 law and bring these securities under regulatory oversight, and preferably include some sort of taxation change that helps pay for the bailouts the American taxpayer has already been forced into.