Massive market clean-up looms after election

WASHINGTON (Reuters) - Salvaging order from the Wall Street train wreck will mean years of toil for the next U.S. president and Congress, with an early reform push expected in the high-leverage, low-oversight markets for securitized debt and derivative financial instruments.

Soon after the November 4 elections, lawmakers plan to pursue big changes in credit default swaps, mortgage-backed securities and other complex investment vehicles at the core of a crisis that is costing taxpayers billions of dollars.

"No one has the right to juggle knives on a public bus," Rep. Chris Shays said at a congressional hearing last week.

"High risk ventures that threaten systemic integrity need to be fully capitalized by their private sponsors or prohibited altogether," the Connecticut Republican said.

Whether it's Barack Obama or John McCain in the White House, these once thriving, now troubled markets will be immediate targets for the House of Representatives Financial Services Committee led by Rep. Barney Frank.

Both Frank, a Massachusetts Democrat, and Senate Banking Committee Chairman Christopher Dodd have expressed serious concerns. Last week, Frank urged "new constraints on risk in the era of securitization" and singled out collateralized debt obligations and credit default swaps for criticism.

The shape of reform in these markets -- or what's left of them -- will depend greatly on who wins the White House. Both candidates have proposals to attack the housing crisis and stimulate the economy. They talk about changing Wall Street, but offer few details on securitization and derivatives.

Sen. Obama, the Illinois Democrat, has criticized an "archaic, 20th century regulatory system for 21st century financial markets," while Arizona Republican Sen. McCain has called for "reforms that promote greater transparency and accountability to ensure we never face this problem again."

Whomever is chosen next to head the Treasury Department, the Securities and Exchange Commission and other regulatory agencies will also be crucial, of course. So will whether Democrats make significant gains in Congress.

Regardless of the election outcome, crackdowns look likely on the regulation, transparency and accountability of some of the financial world's most esoteric instruments -- the kinds that are ravaging the balance sheets of banks worldwide.

BETTING ON RATES, DEFAULTS

The $58-trillion credit default swaps (CDS) market allows traders and bankers to place bets on the direction of interest rates and the likelihood of companies defaulting on bonds. CDS aren't standardized and don't trade on exchanges. They are handled over-the-counter in an informal, unregulated market.

Lehman Brothers, the once venerable Wall Street investment bank, was a major CDS dealer. It filed for bankruptcy last month, saddling its CDS transaction partners with big losses.

Remaining dealers -- Bank of America Corp (BAC.N), Citigroup Inc (C.N), Goldman Sachs Group Inc (GS.N), JPMorgan Chase & Co (JPM.N) and others -- are trying to stabilize the CDS market with a clearinghouse and smoother transactions.

But Congress is being urged to put an agency in charge of CDS -- possibly the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC).

Debate about that looks likely to get caught up in a general effort to realign Washington financial regulatory agencies -- a tricky area fraught with bureaucratic turf jealosies that have frustrated past Congresses.

"We expect that issues related to structural regulatory reform will be front and center in the next Congress and the conversations have already started," said Scott DeFife, a senior lobbyist at the Securities Industry and Financial Markets Association, an industry group.

SECURITIZED PLENTY

Both the SEC and CFTC are also being eyed by Congress to crack down on the $10-trillion market for mortgage-backed securities (MBS) and asset-backed securities (ABS).

Spawned by a 1970s-era financial innovation known as securitization, these markets enable banks to lend money to home buyers, then bundle the loans and sell them to investors as securities. The MBS market went along fine for decades while it was dominated by the Federal Housing Administration (FHA).

But a few years ago, private banks got in on the action and began peddling risky subprime mortgages that undercut the FHA. As lending standards slipped, banks also widened securitization of credit card debt, auto loans and student loans for college.

Frank's committee is expected to eye at least two potential securitization reforms. One, known as assignee liability, would open the door to more lawsuits along the securitization chain, prodding lenders and securitizers to be more cautious.

Another potential change could alter the legal agreements underlying MBS so more mortgage modifications could occur.

Regulators and lawmakers are pushing, as well, to make ABS and MBS more transparent and more standardized, possibly through changes to the credit rating agency system.

Targeting unscrupulous lending, Congress in July approved the first national licensing system for mortgage brokers and bank officers that write mortgages. Further restrictions may follow next year as the Federal Reserve writes new rules.

Securitization has eroded banks' lending discipline since they no longer carried many of the loans they made on their books. Former Federal Reserve Chairman Alan Greenspan last week told a House committee that lenders should be made to retain more exposure to the loans they securitize.

Some policy-makers see covered bonds -- debt instruments banks issue backed by loans carried on their books -- as helping, but most see these instruments alone as insufficient.

Finally, decisions loom on Fannie Mae FNM.N and Freddie Mac FRE.N -- the mortgage giants in federal conservatorship. Many lawmakers say the two should either be nationalized or privatized and see no future for them in the middle ground they once occupied as private companies with government charters.