Andrew Teasdale of Toronto-based Tamris Consultancy says when he heard about the bailout of AIG and Lehman Brothers’ bankruptcy, he felt the way he did during the 9/11 terrorist attacks.

A clearing house would help sort out the mess on Wall Street, believes Diane Urquhart, a Mississauga, Ont.-based independent financial analyst, following the recent decision by the U.S. government to pump $700 billion into the financial markets to bail out the current mortgage mess.

Not to mention, it’d make life easier on accountants.

“A clearing house would provide a daily netting process for identifying who holds what investments, who owes money, the outstanding amounts owed and paid between and among market participants,” says Urquhart. “It would make it simpler for accountants to prepare financial statements because the information they use would be based on actual audited records outlining the contractual obligations and ownership history.”

Having background data is vital because derivative contracts are often bought and sold to a daisy chain of different owners far removed from the original counterparty. According to Urquhart, although such contracts are drawn up by lawyers according to a standard International Swaps & Derivatives Association format, sometimes important elements such the creditworthiness of earlier owners and their conformity with contract terms are not fully noted or up to date.

“So, if you are Buyer F and the contract is in arrears, you start suing those previous owners with deeper pockets up the line,” she says. “And those owners then counter sue. The clearing house netting-out reports would help reduce litigation because they would reveal such details so each new owner would know the details of the contract.”

In many ways, this is similar to potential home buyers checking out the ownership history of the property they want to purchase at the land registry office to find out if there are any outstanding liens against it.

Moreover, according to Walid Busaba, professor of finance at the University of Western Ontario in London, such clearing house consolidations will also facilitate mark-to-market valuations of derivative contracts. Currently, the trading in such investments can be very thin because the market for them is small, so holders of such commercial paper must resort to using exotic formulas and references to composite indexes to come up with valuations.

And conventional securities regulation alone may not be enough to do the job. “The root cause of the market meltdown was lax lending practices that resulted in bad loans and mortgages in the U.S. housing market,” says Busaba. “The solution for the problem lies in greater investor prudence and market transparency. I am not sure that legislation can increase investor prudence.”

Market transparency can show up in at least two different formats. The more difficult one is having conventional securities exchanges handle credit default swaps (CDSs) and other esoteric financial derivatives. These products provide counter-party risk coverage to backstop the risk of possible defaults of commercial paper for which lenders securitize loans, mortgages and other debt instruments. Currently such complex transactions trade in an unregulated, over-the-counter (OTC) marketplace.

Five years ago, billionaire investor Warren Buffett called CDSs a “time bomb” and “financial weapons of mass destruction” and directed the insurance arm of his Berkshire Hathaway Inc. to stop handling them.

“When I heard about the bankruptcy of Lehman Brothers and the bailout of AIG, I recalled how I felt when I saw the airliners crashing into the twin towers,” says Andrew Teasdale, Toronto-based president of investment consulting firm Tamris Consultancy.

“If all credit derivatives related to off-balance sheet securitized debt and all off-balance sheet securitized debt had been traded on exchanges, the mess on Wall Street would not have occurred. That’s because the market would have realized that most of the assets underlying these investments were crap.”

However, exchanges have not been actively seeking to add derivatives to their product line.

In addition, Teasdale also points out that there is little incentive for current issuers to simplify such contracts in ways that have made conventional stocks and bonds easy to trade. That’s because CDSs as bilateral, tailor-made investments yield higher margins. To standardize them for sale to mainstream rather than sophisticated investors would turn them into less profitable, commodity-like commercial paper.

However, establishing a centralized, derivative trading clearing house is seen as a more effective way of boosting the transparency and accountability of such transactions. In fact, such a clearing house was a key recommendation from the August report of the Wall Street, blue-chip Counterparty Risk Management Policy Group III.

That proposal is gaining traction since The Clearing Corporation of Chicago has already taken steps to get the project rolling. Says company spokesperson Andy Merrill: “The Clearing Corporation and its clearing participants have been moving aggressively to prepare the CDS platform for launch as soon as the appropriate regulatory approvals are achieved. Testing is already underway and the results so far have validated our platform design.”

Since derivatives trade over-the-counter, they are not subject to an end-of-day statistical totalling of transactions by participant, number of trades and dollar value.

The derivative trading clearing house idea is alive and well in Canada. In fact, one is currently in place. At the Montreal Exchange (MX), the Canadian Derivatives Clearing Corporation provides central counterparty clearing services. The annual volume of the derivatives traded on the MX is about $70 million – a miniscule amount compared to the multi-billions worth of various derivative contracts traded OTC every day. However, the MX does not trade CDSs. It handles only interest rate, index, equity and currency derivatives.

But that footprint could expand because the Expert Panel on Securities Regulation in Canada recently received submissions from the Bank of Canada and others proposing the establishment of a national derivatives trading clearing house.

Still, the existence of a U.S. clearing house would not likely have prevented the market emergency. Nevertheless, increased transparency of derivatives trading patterns could have raised red flags earlier to regulators and others. For example, since exchanges have position limits for members regarding the maximum number of say, forward contracts they can hold, access to such risk exposure by firm could alert exchange monitors to those members who are overexposed in certain sectors, in violation of trading rules. According to Busaba, this would force companies to limit their risk by diversifying their positions.

Similarly, proposed regulations requiring banks and others to bring off-balance sheet assets onto their balance sheets would likely result in additional work for accountants. “Such rules are very hard to enforce,” says Busaba. “Even if these assets were brought on to the balance sheet that would only provide transparency about the position the firm holds without any indication of the related risk.

“Auditors would still need to scrutinize such items more closely to assess their true value and risk level because of the potential impact that any subsequent changes to these assets would have on the firm’s balance sheet and income statement.”

But Toronto-based forensic accountant Al Rosen remains sceptical that any real change would occur. “Many auditors have no interest in digging deeper into the underlying assets to determine what level of risk they might have,” he says. “In our practice, we meet lots of accountants who are simply willing to rubber stamp anything you put in front of them.

“To prevent a market meltdown from happening again, you need leadership and a change in attitude to fix the underlying problems.”

Should American taxpayers be worried about bearing the burden of the U.S. $700 billion debt load resulting from proposed to bail-out plan? “Not really,” says Busaba. “This arrangement is similar to the Resolution Trust Corp. set up in the late 1980s to handle distressed assets from the savings and loan crisis. Many of the recent underlying properties will turn out to have real value as long as the government can wait for the housing market to turn around so they can avoid selling them at ‘fire-sale’ prices.

“The same is true with many of AIG’s businesses, some of them are highly profitable. The difficult part will be unwinding the thousands of CDSs and other derivative contracts that got them into trouble.”