I finally learned what these are today. I had thought these were simply insurance policies for corporate bonds; you buy a bond, and then pay someone a percent of the value every year. (For those who don’t know what a bond is: you pay someone, usually a large corporation, a specific amount of money now; the company then promises to pay you back, with interest, at a later date. So a bond has a base value, a time for repayment, and an interest rate.) If the bond issuer defaults (can’t pay you as promised), the person to whom you’ve been paying every year for the credit default swap then pays you the full value of the bond, insuring you against loss of your original purchase amount.
On the face of it, this seems to be a straightforward insurance policy doesn’t it? And indeed, credit default swaps actually do promise to insure against a bond default, that is, promise to pay the purchaser of the swap the full value of the bond if the company issuing the bond defaults, or is unable to pay the bond. So it is similar to an insurance product. For example, when someone insures, say, Betty Grable’s legs or Brett Favre’s arm with Lloyd’s of London, Lloyd’s actually arranges for a specific person to be prepared to cover the loss of function, should that occur. That person, or “name” at Lloyd’s needs to put up a bond of their own with the Lloyd’s consortium, demonstrating they actually have to resources to cover the potential loss. This amounts to private, or self-regulation.
But these credit default swaps have two additional twists which render them something else again. First of all, they are totally unregulated. Neither the government, nor any other official body have any standards or regulations for them, such as how much cash in reserve the “insurer” has to hold in the event of loss. Nor is there any umbrella organization, like a stock exchange or Lloyd’s, to operate within and provide oversight. Second this resembles a gambling casino more than an insurance house like Lloyd’s. In addition to people who actually have bought a bond getting one of these default swaps to insure against an actual loss, there are a lot of other people who are, in essence, betting that the bond issuer will default on the bond. That is, they buy a credit default swap, but don’t actually own, nor do they ever intend to purchase, the bond they are seeking to insure. They are basically playing in a casino, and putting down a small amount of money – that percent-of-value-per-year – in hopes of getting a large amount of money – the value of the bond they don’t actually own.
The amazing thing about this phenomenon is that there were actually people, investment banks and individual investors, who were willing to play the bank, or casino in this scenario. Not amazing that they would do it, but amazing that they would do it at the levels they did. Consider this: for every dollar of actual bond being insured, the “casinos” were insuring against the loss of ten dollars. All told? $5,000,000,000,000 (that’s trillions) worth of bonds were being insured against, and $50,000,000,000,000 worth of credit default swaps were sold. And sold, and resold, like hot potatoes or musical (financial) chairs. Once it looked like more than ten percent of the outstanding bonds might default, then – BOOM – the whole house of cards was ready to crash, as no one wanted to be left holding the bag.
The bankruptcy of two key players, Lehman brothers and AIG, were the trigger for melting this quivering mass of barely congealed Jell-o. In stock trading terms, the short sellers were caught with their pants down.
Things wouldn’t have been so bad if the sellers of the credit default swaps had been required to maintain actual assets equal to a reasonable percentage of the bonds they were insuring. But with no regulators and no rules, ANYONE could be a seller. And those buying the “insurance” in many cases did little to nothing to verify that those selling were actually capable to covering any losses that might occur.
So what are the lessons here? First, financial traders – people who buy and sell money and promises of money – are very clever at designing and marketing products, which seem like something real, but are actually nothing more than a glorified bet. Second, even a gambling casino needs some oversight, like a gaming commission or a Securities and Exchange Commission, to make sure there are some rules, and that players follow the rules.
This is a lot like the problems the internet posed for copyright holders in books, music, films, or TV. When copyright laws were written, no one envisioned VCRs, DVD players, the internet, or file sharing servers. So people were able to trade, or sell, copyrighted products, with no oversight. We are seeing once again how technology and human imagination will always race ahead of any specific laws. We need a more sophisticated approach to financial regulation, one that covers not specific activities or products, but the general function of buying and selling money and promises of money. To the extent that finance resembles the Wild West, or Internet Piracy, we ALL stand to lose value – our house, our stock portfolio, our wage, our job.
I sincerely hope that Obama’s administration develops a more nuanced approach to this financial crisis than the one FDR rushed into place 75 years ago. While that worked for a pre-computer era, it assumed on a static system of financial products. Regulators will never be smart enough to be able to predict what capital creators will attempt, so the laws must cover the concept, not the specific products.