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Credit Default Swaps; The real financial WMD October 30, 2008

Posted by shaferfinancial in Uncategorized.
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Its been bugging me for a while. How could these investment banks and AIG go belly up? The numbers weren’t making sense to me. Certainly, mortgage backed securities caused some real losses, but the foreclosure rates weren’t high enough and the devaluation of real estate not uniform enough to destroy all that capital. Probably some tranches of MBSs were filled with sub-prime loans, but most had a majority of conforming loans where the foreclosure rate is high but well under 2%. Countrywide, IndyMac and other banks that loaned predominately in the sub-prime, alt-a, and option arm market were destined to go bankrupt, but AIG, the investment banks that were simply pass throughs for the majority of these MBSs?

Then I started to read about the credit default swaps and the light went on for me. I had never heard of this before last year and now I know why. Credit default swaps are simply side bets on US mortgages in the form of insurance. Folks could go out and buy insurance on mortgages that they don’t own. This is what a derivative is. Imagine you are betting on a football game. You don’t own the football teams, you don’t get a salary based on how well you perform for a football team, you don’t have any formal relationship to the teams. But you can bet on them. This is what a derivative is. A credit default swap is a derivative based on mortgage performance. Now these swaps were totally unregulated so the investment houses and banks that sold them didn’t have to increase reserves for potential losses from them. Since there was no formal trading center, no one knew how much of these were being sold. Turns out trillions of dollars! From a CBS Interactive report we find out how come we know so little about these. Turns out they were illegal until 2000!

In the early part of the 20th century, the streets of New York and other large cities were lined with gaming establishments called "bucket shops," where people could place wagers on whether the price of stocks would go up or down without actually buying them. This unfettered speculation contributed to the panic and stock market crash of 1907, and state laws all over the country were enacted to ban them.
"Big headlines, huge type. This is the front page of the New York Times," Dinallo explains, holding up a headline that reads "No bucket shops for new law to hit.” "So they'd already closed up 'cause the law was coming. Here's a picture of one of them. And they were like parlors. See,"Dinallo says. "Betting parlors. It was a felony? Well, it was a felony when a law came into effect because it had brought down the market in 1907. And they said, 'We're not gonna let this happen again.' And then 100 years later in 2000, we rolled them [laws] all back."
The vehicle for doing this was an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000. And the bill was a big favorite of the financial industry it would eventually help destroy. It not only removed derivatives and credit default swaps from the purview of federal oversight, on page 262 of the legislation, Congress pre-empted the states from enforcing existing gambling and bucket shop laws against Wall Street.

So that is the story, Greenspan, the Clinton White House, and the Congress (all of them, both Democrats and Republicans) made this fatal error praying to the god of deregulation!  This on the back of the repeal of the Glass-Steagal Act under the auspices of the Gramm-Leach-Bliley Act of 1999 drove the dagger in the heart of regulation on the books since the great depression.  And now we are all paying for it! 😦

Without these credit default swaps, AIG and the investment banks survive. Banks are healthier and all but a few who were primarily originating sub-prime and option arm loans survive.

Oh, since all this money was lost, where did it go?  Into the pockets of some now incredibly wealthy folks. One hedge fund who was heavy into buying these returned 600% in one year!!!! The manager of this hedge fund pocketed $3.7 billion that year.

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Comments»

1. Sean Purcell - October 30, 2008

David,

As always, a very detailed look at a difficult problem. Personally, I am torn over the whole CDS debacle. (I was going to write a whole “gun vs shooting rampages” analogy here, but it just felt too violent.)

Here’s my problem: Credit Default Swaps serve a very legitimate and important purpose. The fact that people paint derivatives as gambling at all frustrates me. Derivatives are a must in the market place and here’s why: they allow one to hedge risk. The ability to hedge risk is an extremely important aspect of our markets as you are well aware. Without equities would be lower, rates would be higher and capital would move more slowly. Derivatives are NOT some bastardized form of gambling that should be outlawed the way 60 Minutes implied.

I’ll give you an example using the derivatives called options, which were my area of specialty): ABC company insures the debt of XYZ company, allowing XYZ company to borrow desperately needed funds for expansion, research and other job creating endeavors from a large pension fund that would not otherwise have bought XYZ’s bonds (lent them the money). In turn, ABC company short sales XYZ’s stock, thus hedging their risk. That way, if XYZ does default on their debt obligations and ABC has to pay the pension fund themselves, they recoup much of their losses in the profits made from shorting XYZ’s stock (which has obviously tanked after defaulting on their debts). This, by the way, is what made the ban on short sales so laughable a month ago. Congress, in all its ignorance, tries to help companies find liquidity by removing one of the mechanisms that allows them get liquid. But I digress.

Let’s go back to our example and let’s say that ABC company does not want to short the stock. There are many reasons for this: the cost of carry is too high, shorting the stock may send the wrong sell signals to the market at a time when XYZ is trying to grow and ABC is insuring that growth and so on. So how does ABC hedge their risk? They buy puts in the options market (a derivatives market). Again, this “derivative” that is so maligned has been instrumental in helping a comany to grow and adding jobs to the economy.

With that understanding of the possible good to come from a derivative, take a look at credit default swaps. These were basically isurance policies written by one company to “insure” or raise the credit rating of another company so that they could borrow money. Very reminescent of our previous example. The difference being that instead of shorting stock to hedge risk, they were simply carrying the risk. Ahhh, that is a big difference and their is a large problem arising from this difference: with no regulation there is no minimum reseves required as there would be a formal insurance company. There was no way to know if the insuring company – the one trading on their AAA credit rating – could in fact handle a claim (never mind multiple claims). So what was supposed to be the regulating aspect of this market? Once again we get to point our tired fingers at the Credit Rating Agencies. FAILED AGAIN. If they had been doing their job (insteading of just collecting a fee) they would look at a company that was over extended (didn’t have the reserves to justify the default swaps they had done) and lower their rating (geez, there’s a novel idea). That would have ended the transaction on the spot. But, none of this happened and the press has not looked into it and other than appearing before a Congressional hearing a couple of days ago there have been no repurcussoins for those ratings agencies that were asleep at the wheel while the whole train barreled down the tracks.

One last thought, an easier way to fix this problem than counting on the ratings agencies who have shown themselves to be completely untrustworthy, there should be an open exchange for these products. Again, regulation does not solve the problem nearly so cleanly or simply as just putting these transactions out in the open. The Chicago Board Options Exchange (their’s my bias again) is made up of open outcry option pits. Every trade is thrown out for anyone to do and every transaction is posted and recorded. No specialist system (like the NYSE) to create legalized theft and no back room shenanigans such as existed so far. In an open exchange a company over-extending themselves would be seen immediately and – just as the ratings agencies would have done had they continued their responsibilities instead of settling for bribery – the credit default swaps would not have grown beyoned its natural limit.

I apologize for the length of this. I believe I will have no choice but to post it as well. I will, of course, reference this site as its origin and I trust you don’t mind David. I do enjoy out exchanges. 🙂

2. Credit Default Swaps Are Not The Bad Guys | BloodhoundBlog: National real estate marketing and technology blog | Realtors and real estate, mortgages, lending, investments - October 30, 2008

[…] he has to say.  He recently posted an interesting and (typically) well written article entitled Credit Default Swaps; The real financial WMD.  You can imagine from the title his take on these instruments.  Part of the article quotes from […]

3. shaferfinancial - October 31, 2008

Sean, thanks for the great comment. I tend to agree with you that a central marketplace for CDSs would solve most of the problems. As you point out there was no reserve requirements for selling these instruments and that is what got them in trouble. Why not combine a central marketplace (so everyone will know how much liability is out there) and a reserve requirement. Wouldn’t this allow the good factors of CDSs and derivatives in general and add some protection to the stockholders? Warren Buffett I believe holds the entire possible derivative losses on the books as a liability.

4. Credit Default Swaps are Not the Bad Guys « Life That POPs - November 6, 2008

[…] what he has to say. He recently posted an interesting and (typically) well written article entitled Credit Default Swaps; The real financial WMD. You can imagine from the title his take on these instruments. Part of the article quotes from a […]

5. Teresa - February 17, 2009

HI David – I would recommend (if you haven’t already) read Satyajit Das. He wrote the “book” on swaps..


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