WASHINGTON -- Treasury Secretary Timothy Geithner is telling lawmakers the U.S. economy stumbled last year in part because the power and risks of an explosive derivatives market blindsided the government.
In congressional testimony prepared for delivery Friday, Geithner said the ease with which derivatives were bought and sold in an era of easy credit encouraged financial institutions and investors to take on too much risk.
At the same time, government regulators weren't given the proper tools to mitigate those risks and protect the American consumer, he said.
The federal regulatory system "failed in its most basic responsibility to produce a stable and resilient system for providing credit and protecting consumers and investors," he said.
Geithner was to appear before the House Financial Services Committee and the House Agriculture Committee, which share jurisdiction of derivatives. It will be his first appearance in the House since President Barack Obama laid out his plan to overhaul the regulatory framework governing the financial system. Geithner testified before the Senate Banking Committee in June.
Since then, the proposal has run up against much of the financial industry, which says it would raise costs and squash innovation.
Some lawmakers and federal regulators say they are skeptical, too. They question whether Obama wants to give too much power to the Federal Reserve.
Under the plan, which requires Congress' blessing, the Fed would be put in charge of keeping large, influential institutions in check. A new consumer protection agency also would be created.
Additionally, Obama wants to regulate for the first time derivatives that are being privately traded "over the counter," or away from an exchange.
Derivatives are financial instruments whose value are derived from something else, such as a mortgage-backed security or a commodity like oil.
In one infamous example, American International Group Inc. sold so-called credit-default swaps to protect investors against potential losses on mortgage-backed securities. When the housing market collapsed, AIG was unable to make good on its promises and took a $182 billion government bailout to keep from collapsing.
The allure of the over-the-counter derivative, as opposed to those swapped on exchanges, is that it can be individually negotiated and tailored to meet the specific needs of the buyer.
But Geithner said many investors used the instruments to evade regulation, exploit regulatory loopholes or minimize taxes.
Over-the-counter derivatives "grew explosively" in the past decade, with the face value of outstanding transactions rising sixfold to almost $700 trillion in 2008, he added.
"The apparent ease with which derivatives permitted risk to be transferred and managed during a period of global expansion and ample liquidity led financial institutions and investors to take on larger amounts of risk than was prudent," he said.
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