Credit Default Swaps: Why Washington Ignored Our Warning

By Martin Hutchinson

Three years ago, I told you that Wall Street's newest invention - credit default swaps - would cause a major financial crash.

Now, I'll concede that credit default swaps (CDS) weren't the only cause of the financial meltdown that brought about the collapse of Lehman Brothers Holdings (OTC: LEHMQ) and nearly brought down American International Group Inc. (NYSE: AIG). But these financial derivatives were a major exacerbating factor - which is why I also warned that credit default swaps should be banned.

Just three years later, we're embroiled in yet another financial crisis. But the stakes have grown: This time around we're talking about entire countries - and not just banks - defaulting on their debt. Not surprisingly, credit default swaps are once again at center stage.

Just yesterday (Monday), in fact, the possibility of a Greek-debt default drove spreads on Western European credit default swaps up to record levels, providing even more profits for those speculating against the overall health of the Western financial system. Those profits for speculators increase the overall losses in the world financial system whenever something goes wrong, creating the possibility that even moderate "credit events" could collapse the whole shaky edifice.

If Washington had heeded my warnings back before the first global financial crisis, you and I would be much better off today.

Three Options Washington Missed

Despite their clearly dangerous tendencies, credit default swaps have displayed an unparalleled ability to survive - and were largely unaffected by the 2,000 pages of regulatory legislation in the Dodd-Frank Wall Street Reform and Consumer Protection Act and several years of additional regulation.

That's a travesty, since Dodd-Frank - the Wall Street "overhaul" signed into law almost exactly one year ago by U.S. President Barack Obama - represented the best chance to blunt the hefty influence of these derivative financial instruments.

As daunting as this sounds, I assure you that there would have been three very clear ways of achieving this goal:

• Ban the things altogether - a proposal that features the virtue of simplicity, and has little economic cost (since credit default swaps don't really do the job they were designed for, as I'll show you in a moment).
• Ban the sale of a "naked" credit default swap - meaning one in which the party doesn't own the underlying debt (since it would bring the CDS market in line with the insurance market, where it has since 1774 been illegal to buy a life insurance policy on a stranger - ostensibly because the chance of an "accident" is too great).
• Or require banks to assess the full value of their CDS obligations as loans, and count the appropriate percentage of them against capital, making it difficult for huge volumes of CDS trading to develop (since it would become hugely expensive for banks to write them).

As originally designed, credit default swaps were a form of "insurance" that protected the lender in the event of a loan default. In fact, when a lender buys a CDS from an insurance company, the loan turns into an "asset" that can be "swapped" for cash if the borrower defaults.

As we've seen, however, credit default swaps have largely been used as vehicles of speculation - and dangerous ones, at that. Credit default swaps aren't traded on any sort of formal exchange, and there's not any kind of requirement to report the transactions to a regulatory agency.

This lack of transparency - coupled with the CDS market's huge size (the market for credit default swaps is believed to have soared from $900 billion in 2000 to an estimated peak of $60 trillion in 2008) - had regulaors conceding that credit default swaps could pose a "systemic risk" to the overall economy.

A Failed Experiment

I ran a modest derivatives desk from 1982-87. Even back then we were looking at ways to design derivatives that revolved around credit events. There was an obvious market for shifting credit from banks to such entities as insurance companies and pension funds. You see, banks were good at originating loans, but had limited balance sheets. Insurance companies and pension funds, by contrast, had a very limited ability to source loan assets, but had plenty of appetite for properly remunerated credit risk.

The problem was that there was no fair way to calculate the payoff on bankruptcy, nor was there a watertight way to adjudicate in the innumerable situations that were not quite formal bankruptcies.

The upshot: We decided the technical problems of determining payoffs were just too great to get around.

It was another 10 years - in 1995, to be exact - when the first credit-default-swap agreements were finally carried out. That surprisingly late date indicates the shakiness of the structure.

By 1995, the profitability of all kinds of derivatives operations - assisted by the "funny money" that then-U.S. Federal Reserve Chairman Alan Greenspan was just beginning to create - made derivatives traders simply ignore the problems.

They put in place a mock auction procedure to determine the payoff on bankruptcies, one that was infinitely easy to "game," because it allowed an auction of a few millions of obligations to determine payoffs on billions of dollars of debt. This also led to complex and essentially unworkable rules to determine when a bankruptcy had occurred.

The bottom line was that the entire process was nothing but a sophisticated scam. That was clearly the case with AIG, where credit default swaps on the insurance giant paid off spectacularly at the same time as AIG was paying all its creditors in full - and using our money (as U.S. taxpayers) to do so.

Sophisticated operators such as Goldman Sachs Group Inc. (NYSE: GS) were thus able to get paid twice - once from the government on their AIG debt and then a second time through their holdings of AIG credit default swaps.

What's more, the problems with the actual credit default swaps that we've detailed here weren't the only problems that needed addressing: It's also clear in hindsight that banks grossly underestimated their risk.

The problem here is that - unlike with a currency position or a bond - the potential loss from a credit default swap if something goes wrong may be 100-times the premium received for selling the CDS instrument.

Thus the fluctuations in CDS prices in normal times are a tiny fraction of the potential loss on a default event.

At any point in time, if the maturity of one credit default swaps is the same as another, then the swap associated with the firm or country with the higher CDS "spread" is viewed by the market as being more likely to default. That's because a higher fee is charged to protect against this happening. But that's only if everything else is equal, and that isn't always the case.

Since Wall Street's risk management looks at normal price fluctuations and then assesses the maximum possible risk as a modest multiple of the daily fluctuation, it was completely inadequate in measuring the risk of a CDS book. That, in a nutshell, is why AIG went bust and had to be bailed out with $170 billion of taxpayer money.

After the dust cleared, it became clear that the CDS market bore a large part of the responsibility for the disaster. Credit problems were multiplied through them, so that when losses occurred they rippled through the entire banking system, rather than being confined to just those with a direct business relationship with the defaulter.

Credit Default Swaps: The Greek Connection

Given all of their flaws, credit default swaps clearly do not accurately hedge against the risk of loss from a loan default, so they differ very little from straight gambling contracts. Since we, as taxpayers, are forced to underwrite the losses of the banking system, we should have the right to shut down this "gambling" element of the CDS market.

Needless to say, since Wall Street lobbied hard to prevent any of its really profitable games from being closed off, last year's Dodd-Frank Act did nothing to shut down the CDS market; indeed it seems to have achieved very little other than adding bureaucratic cost and uncertainty to the financial system. According to the Bank for International Settlements (BIS), CDS volume outstanding had fallen from its $60 trillion peak in 2008 all the way down to $30 trillion at the end of last year.

But this apparent decline is actually spurious; it simply reflects the big dealers being more careful to net off countervailing operations as far as possible, to keep the total "optical" exposure down and prevent calls for further regulation.

In reality, the credit-default-swaps market is as active as ever. Indeed, yesterday's headlines underscore that credit default swaps are playing a major role in the struggle over Greece's possible default.

If Greece defaults, the losses to the banking system will not simply be some fraction of the $100 billion of Greek debt, but also the gamblers' payoffs on the CDS outstanding on Greece - current estimates say we're talking about an additional $100 billion.

Let's face it: A system that doubles the potential loss on a bankruptcy (and probably more than that, because the holders of Greek-debt credit default swaps will manipulate the foolish "auction" system of determining payout) is imposing a huge cost - not a benefit - on the world economy.

U.S. banks had total exposure of $41 billion to Greece by the end of 2010, according to a June 9 report from the BIS. About 83% of that total is tied to "guarantees" that range from protection for sellers of credit-default-swap contracts, to other third-party obligations.

Let's hope that - after we've suffered through a more-severe version of the 2008 financial crisis (something that appears increasingly likely, thanks to the world's foolish cheap-money polices) - governments around the world will finally wise up and get around to banning credit default swaps.

The unfortunate reality is that, as the hard-working taxpayers who shoulder most of the burden in the world's "real" economy, you and I will be considerably poorer by then.

At the end of the day, one thing is abundantly clear: When we sounded the alarm about credit default swaps more than three years ago, it's a damned shame that our feckless leaders in Washington just didn't listen.

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