I dislike the ‘both parties are at fault’ argument. Strikes me as lazy, a way to avoid really thinking about an issue. Unfortunately, I found a good example of the ‘both sides’ argument in the debate over what went wrong in the financial crisis.
The issue is deregulation. Actually that’s the problem. What’s thought of as ‘deregulation’ really has two components. Deregulation occurs when existing regulations are removed. If there are financial instruments which have never been covered by regulatory laws, that properly understood, is not ‘deregulation.’ That is a lack of regulation or no regulation. The reasons for no regulation may be philosophical, insufficient political will or just a lack of understanding about how to regulate effectively.
In the current crisis, when ‘deregulation’ is blamed, defenders–like Peter Wallison from Bloomberg.com–point out the following:
- There has been a great deal of deregulation in our economy over the last 30 years, but none of it has been in the financial sector or has had anything to do with the current crisis.
- The repeal of portions of the Glass-Steagall Act in 1999 — often cited by people who know nothing about that law — has no relevance whatsoever to the financial crisis, with one major exception: it permitted banks to be affiliated with firms that underwrite securities.
A 60 Minutes segment on Oct 5th did a very good job of highlighting the difference. The lack of regulation which existed at the highest end of the financial sector, specifically with credit default swaps [CDS], is shocking to hear described. Michael Greenberger, former director of trading and markets at the Commodity Futures Trading Commission [CFTC], defines the financial instrument:
A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails.
It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ‘swap,’ which by virtue of federal law is deregulated.
The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late ’90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and [Clinton] Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. Republican Senator Phil Gramm crowed that the new law “protects financial institutions from over-regulation and it guarantees that the US will maintain its global dominance of financial markets.” Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives “financial weapons of mass destruction.”
Another perspective from a Dow Jones newswire:
Putting regulation of credit-default swaps on the table a decade ago led to the idea being shot down. In May 1998, the CFTC issued a so-called concept release asking what kind of regulation might be appropriate. The release didn’t suggest that such swaps be traded on exchanges, but outlined alternatives that would provide authority to combat fraud and manipulation, and set standards for capital adequacy of those backing the swaps.
A backlash to the proposal quickly came from Alan Greenspan, then the Fed chairman, [Clinton] Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt, and from Congress. After, it was never formally taken up by the CFTC.
Finally, in reading up on this stuff I came across 2 incredible items:
- The Daily Kos – a popular left-wing blog – comes to the same conclusion that “not regulating, as opposed to deregulating” is the real problem.
- The amount of outstanding credit derivatives is $16.4 trillion at the end of March 2008. For reference and perspective, the US GDP for 2007 was $13.8 trillion, while the world’s GDP for 2007 was estimated at $54.3 trillion. [Insert incredulous noises here].
A Look At Wall Street’s Shadow Market
Oct. 5, 2008(CBS) On Friday Congress finally passed – and President Bush signed into law – a financial rescue package in which the taxpayers will buy up Wall Street’s bad investments.
The numbers are staggering, but they don’t begin to explain the greed and incompetence that created this mess.
It began with a terrible bet that was magnified by reckless borrowing, complex securities, and a vast, unregulated shadow market worth nearly $60 trillion that hid the risks until it was too late to do anything about them.
And as correspondent Steve Kroft reports, it’s far from being over.
It started out 16 months ago as a mortgage crisis, and then slowly evolved into a credit crisis. Now it’s something entirely different and much more serious.
What kind of crisis it is today?
“This is a full-blown financial storm and one that comes around perhaps once every 50 or 100 years. This is the real thing,” says Jim Grant, the editor of “Grant’s Interest Rate Observer.”
Grant is one of the country’s foremost experts on credit markets. He says it didn’t have to happen, that this disaster was created entirely by Wall Street itself, during a time of relative prosperity. And they did it by placing a trillion dollar bet, with mostly borrowed money, that the riskiest mortgages in the country could be turned into gold-plated investments.
“If you look at how this started with the subprime crisis, it doesn’t seem to be a good bet to put your money behind the idea that people with the lowest income and the poorest credit ratings are gonna be able to pay off their mortgages,” Kroft points out.
“The idea that you could lend money to someone who couldn’t pay it back is not an inherently attractive idea to the layman, right. However, it seemed to fly with people who were making $10 million a year,” Grant says.
With its clients clamoring for safe investments with above average return, the big Wall Street investment houses bought up millions of the least dependable mortgages, chopped them up into tiny bits and pieces, and repackaged them as exotic investment securities that hardly anyone could understand.
60 Minutes looked at one of the selling documents of such a security with Frank Partnoy, a former derivatives broker and corporate securities attorney, who now teaches law at the University of San Diego.
“It’s hundreds and hundreds of pages of very small print, a lot of detail here,” Partnoy explains.
Asked if he thinks anyone ever reads all this fine-print, Partnoy says, “I doubt many people read it.”
These complex financial instruments were actually designed by mathematicians and physicists, who used algorithms and computer models to reconstitute the unreliable loans in a way that was supposed to eliminate most of the risk.
“Obviously they turned out to be wrong,” Partnoy says.
Asked why, he says, “Because you can’t model human behavior with math.”
“How much of this catastrophe had to do with the instruments that Wall Street created and chose to buy…and sell?” Kroft asks Jim Grant.
“The instruments themselves are at the heart of this mess,” Grant says. “They are complex, in effect, mortgage science projects devised by these Nobel-tracked physicists who came to work on Wall Street for the very purpose of creating complex instruments with all manner of detailed protocols, and who gets paid when and how much. And the complexity of the structures is at the very center of the crisis of credit today.”
“People don’t know what they’re made up of, how they’re gonna behave,” Kroft remarks.
“Right,” Grant replies.
But it didn’t stop ratings agencies, like Standard & Poor’s and Moody’s, from certifying the dodgy securities investment grade, and it didn’t stop Wall Street from making billions of dollars selling them to banks, pension funds, and other institutional investors all over the world. But that was just the beginning of the crisis.
What most people outside of Wall Street and Washington don’t know is that a lot of people who bought these risky mortgage securities also went out and bought even more arcane investments that Wall Street was peddling called “credit default swaps.” And they have turned out to be a much bigger problem.
They are private and largely undisclosed contracts that mortgage investors entered into to protect themselves against losses if the investments went bad. And they are part of a huge unregulated market that has already helped bring down three of the largest firms on Wall Street, and still threaten the ones that are left.
Before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they are much simpler than they sound. “A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution, or a financial instrument, fails,” he explains.
“It is an insurance contract, but they’ve been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a ‘swap,’ which by virtue of federal law is deregulated,” Greenberger adds.
“So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy?” Kroft asks.
“A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument,” Greenberger says.
But he says there was a big problem. “The problem was that if it were insurance, or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap, and not insurance, there was no requirement that adequate capital reserves be put to the side.”
“Now, who was selling these credit default swaps?” Kroft asks.
“Bear Sterns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them,” Greenberger says.
“These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?” Kroft asks.
“Well, it made it easier to sell the terrible investments if you could convince the buyer that not only were they gonna get the investment, but insurance,” Greenberger explains.
But when homeowners began defaulting on their mortgages, and Wall Street’s high-risk mortgage backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn’t set aside the money they needed to pay off their obligations.
Bear Stearns was the first to go under, selling itself to J.P. Morgan for pennies on the dollar. Then, Lehman Brothers declared bankruptcy. And when AIG, the nation’s largest insurer, couldn’t cover its bad debts, the government stepped in with an $85 billion rescue.
Asked what role the credit default swaps play in this financial disaster, Frank Partnoy tells Kroft, “They were the centerpiece, really. That’s why the banks lost all the money. They lost all the money based on those side bets, based on the mortgages.”
How big is the market for credit default swaps?
Says Partnoy, “Well, we really don’t know. There’s this voluntary survey that claims that the market is in the range of 50 to 60 or so trillion dollars. It’s sort of alarming that, in a market that big, we don’t even know how big it is to within, say, $10 trillion.”
“Sixty trillion dollars. I know it seems incredible. It’s four times the size of the U.S. debt. But that’s the size of the market according to these voluntary reports,” says Partnoy.
He says this market is almost entirely unregulated.
The result is a huge shadow market that may control our financial destiny, and yet the details of these private insurance contracts are hidden from the public, from stockholders and federal regulators. No one knows what they cover, who owns them, and whether or not they have the money to pay them off.
One of the few sources of information is the International Swaps and Derivatives Association (ISDA), a trade organization made up the largest financial institutions in the world. Many of them are the very same companies that created the vast shadow market, lobbied to keep it unregulated, and are now drowning because of unanticipated risks.
ISDA’s CEO, Robert Pickel, says there is nothing wrong with credit default swaps, and that the problem was with underlying mortgage securities.
“Well, there’s clearly something wrong with the system if all of these leveraged bets, hidden leveraged bets, caused a collapse in the financial system,” Kroft remarks.
“It is something that we all need to look at and learn lessons from. And we all need to work together to understand that and design a structure in the future that works more effectively,” Pickel says.
“My point is, the people that made these mistakes are the people you represent in your organization. And many of them sit on the board. I mean, if they didn’t get it right, who would?” Kroft asks.
“These people understand the nature of these products. They understand the risks,” Pickel replies.
“Well…they didn’t or they wouldn’t have bought them. They wouldn’t have used them,” Kroft says.
“These are very useful transactions. And the people do understand the nature of the risk that they’re entering into…but I’m not sure that…,” Pickel says.
“Useful?” Kroft interrupts. “How come they brought down the financial system?”
“Because, perhaps they didn’t understand the underlying risk, and nobody really saw the effects that were going to flow through from the subprime lending situation,” Pickel says.
That chapter is not over, and there is much suspense and fear on Wall Street that there are other big losses out there that have yet to be disclosed
They already dwarf what has been lost on those original risky mortgages. As bad as the mortgage crisis has been, 94 percent of all Americans are still paying off their loans. The problem is Wall Street placed its huge bets and side bets with all of those fancy securities on the 6 percent who are not.
“We wouldn’t be in any of this trouble right now if we had just had underlying investments in mortgages. We wouldn’t be in any trouble right now,” says Partnoy.
He says it’s the side bets.
“You got Wall Street firms, Bear Stearns, Lehman Brothers. You got insurance companies like AIG. Merrill lost a ton of money on this,” Kroft says. “Everybody’s lost a ton of money. They’re supposed to be the smartest investors in the world. And they did it themselves.”
“They did it all on their own,” Partnoy agrees. “That’s the most incredible thing about this crisis is that they pushed the button themselves. They blew themselves up.”
Asked how much of this was incompetence on the part of Wall Street and the people who ran it, Jim Grant tells Kroft, “The truth is that on Wall Street, a lot of people just weren’t very good at their jobs. It’s as simple as that.”
“These people were being paid $50 to $100 million a year. Some of them, the guys that were running the places,” Kroft remarks.
“There is no defending,” Grant replies. “A trainee making 45,000 a year would have had the common sense not to bet the firm on mortgage contraptions that no one in the firm actually understood. That is not a deep point to comprehend. Somehow, through, I will call it a criminal neglect and incompetence, the people at the top of these firms chose to look away, to take more risk, to enrich themselves and to put the shareholders and, indeed, the country, itself, ultimately, the country’s economy at risk. And it is truly not only a shame, it’s a crime.”
60 Minutes requested interviews with top executives at Bear Stearns, Lehman Brothers, Merrill Lynch , Morgan Stanley, Goldman Sachs, and AIG. They all declined.
Unregulated swaps seen as big factor in Wall Street collapse
By John Dunbar
The Associated Press
Sunday, October 12, 2008
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WASHINGTON — It can be a fine line between investing and gambling, but in Las Vegas, you know the odds.
On Wall Street that’s not always the case, especially when it comes to the $62 trillion market in arcane financial contracts known as “credit default swaps.”
“Moreover,” added Michael Greenberger, former director of trading and markets for the Commodity Futures Trading Commission, “Las Vegas is regulated.”
These swaps are increasingly being blamed for the near-collapse of insurance giant American International Group Inc., the bankruptcy of investment bank Lehman Brothers, and the downfall of other investment houses and financial institutions.
Members of the House Oversight and Government Reform Committee on Tuesday accused AIG of opening “a casino in London” when it began dealing in these complex derivative contracts. The Federal Reserve came to AIG’s rescue three weeks ago with an $85 billion line of credit; so far, the company has tapped it for $61 billion.
The swaps are a form of insurance, but they aren’t regulated that way.
Say a big investor buys a bond from a company, but is worried about the company’s ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit default swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it.
The issuer doesn’t write this insurance for free. It gets a fee, usually a percentage of the value of the bond.
False sense of security
The transactions are made “over the counter,” not regulated by any public exchange, and since the contracts are not considered “insurance,” Greenberger said, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.
The swaps have given those invested in all manner of debt, including mortgage-backed securities, a false sense of security.
“Everyone walked around saying, We’re insured,'” said Greenberger, a law professor at the University of Maryland.
As housing prices rose and more people could get mortgages despite questionable credit records, mortgage-backed securities were an attractive place for pension funds and other investors to park money.
“Were it not for that insurance, it certainly wouldn’t have reached this manic state of growth,” Greenberger said.
Mortgage-backed securities have turned sour with plummeting home prices and increasing default rates. The securities have clogged the credit market, prompting the Bush administration and Congress to put taxpayers on the hook buying them up.
As the government buys mortgage-backed securities from teetering financial institutions at less than face value prices, issuers of the credit default swaps could be liable for the difference.
That’s troublesome enough, but it actually gets worse.
Buyers of credit default swap insurance are not required to own the underlying securities they are insuring.
In other words, the investor can buy insurance on a mortgage-backed security without having to buy the security itself. When that security turns sour, whoever is holding the credit default contract — whether they actually own the security or not — can demand payment for the face value of the security.
This has created a market in which speculators actually are betting that mortgage-backed securities will lose their value.
Because the market is unregulated, the size of the credit default market is difficult to estimate.
The International Swaps and Derivatives Association, a trade group, estimates that its “notional value” for year-end 2007 at $62.2 trillion — roughly five times the entire U.S. production of goods and services last year. The total represents how much sellers of the protection would have to pay if every one of the securities were to default, an unlikely scenario to be sure.
But even this is a rough estimate. Participation in the survey was voluntary. What is helping drive the panic in these contracts is that little is known about who owes what to whom.
The $55 trillion question
The financial crisis has put a spotlight on the obscure world of credit default swaps – which trade in a vast, unregulated market that most people haven’t heard of and even fewer understand. Will this be the next disaster?
By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter
Last Updated: September 30, 2008: 12:28 PM ET
(Fortune Magazine) — As Congress wrestles with another bailout bill to try to contain the financial contagion, there’s a potential killer bug out there whose next movement can’t be predicted: the Credit Default Swap.
In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they’ve played a critical role in the unfolding financial crisis. First, by ostensibly providing “insurance” on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.
“If CDS had been taken out of play, companies would’ve said, ‘I can’t get this [risk] off my books,'” says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. “If they couldn’t keep passing the risk down the line, those guys would’ve been stopped in their tracks. The ultimate assurance for issuing all this stuff was, ‘It’s insured.'”
Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies – all linked to one another by CDS and other instruments – was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see “Hank’s Last Stand”).
And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we’ll see, two fundamental aspects of the CDS market – that it is unregulated, and that almost nothing is disclosed publicly – may be about to change. That adds even more uncertainty to the equation.
“The big problem is that here are all these public companies – banks and corporations – and no one really knows what exposure they’ve got from the CDS contracts,” says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. “The really scary part is that we don’t have a clue.” Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: “This has become essentially the dark matter of the financial universe.”
AT FIRST GLANCE, credit default swaps don’t look all that scary. A CDS is just a contract: The “buyer” plunks down something that resembles a premium, and the “seller” agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you’re holding bonds and you’re worried that the issuer won’t be able to pay, buying CDS should cover your loss. “CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk,” argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.
Because they’re contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you’ve got yourself a $5 million – or a $100 million – contract.
And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace’s hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)
You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it’s released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.
Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and “netted” all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.
The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year – and the market has only worsened since. CDS contracts on widely held debt, such as General Motors’ (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. (“There’s nothing to do but watch Bernanke on TV,” one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.
ONE REASON THE MARKET TOOK OFF is that you don’t have to own a bond to buy a CDS on it – anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people’s debt. That’s why it’s possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.
“It’s sort of like I think you’re a bad driver and you’re going to crash your car,” says Greenberger, formerly of the CFTC. “So I go to an insurance company and get collision insurance on your car because I think it’ll crash and I’ll collect on it.” That’s precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors’ subprime mortgage bonds would default.
So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, “To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract.”
There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late ’90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm – most recently in the news when he stepped down as John McCain’s campaign co-chair this summer after calling people who talk about a recession “whiners” – crowed that the new law “protects financial institutions from over-regulation … and it guarantees that the United States will maintain its global dominance of financial markets.” (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would “supersede and preempt the application of any state or local law that prohibits gaming …”) Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives “financial weapons of mass destruction.”
THERE’S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you’re pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. “People have been insuring risks that they can’t insure,” says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. “Let’s say you’re writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there’s a huge fire and they all burn down. What do you do? You just close up shop.”