Credit default swaps are blamed for instigating the nation’s financial crisis, helping to bring companies like American International Group (AIG) to its knees after it could no longer pay the many claims it owed on the swaps contracts. Nearly three years after the fact, credit default swaps and other complex derivative instruments are still a booming fixture on Wall Street and, unexplainably, largely untouched by financial reform efforts.
This irony is the subject of Gretchen Morgenson’s Feb. 28 column in the New York Times. In the article, she writes that Congressional reform plans for credit default swaps are “full of loopholes,” a fact that almost guarantees “that another derivatives-fueled financial crisis” is right around the corner.
According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009.
Morgenson’s article includes comments from Martin Mayer, a guest scholar at the Brookings Institution and a noted author on banking and finance-related issues. On the subject of credit default swaps, Martin says the following:
“Credit default swaps are a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent… They were not well-motivated.
Mayer’s criticism of credit default swaps dates back several years. On May 20, 1999, he penned an Op-Ed piece in the Wall Street Journal, titled The Dangers of Derivatives. Some of his selected comments include the following:
“These over-the-counter derivatives – created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing – are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real life, as Justice Oliver Wendell Holmes wrote, “certainty generally is an illusion.” The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.
“Meanwhile the rules of this game – adopted and enforced by the world’s banking supervisors – further shrink what are already low time horizons in the financial markets. Measuring their positions every day through the algorithms of “value at risk” analysis, players must make constant adjustments of hedges and options to control the losses they may suffer from unanticipated volatility of market prices. In real markets, often enough, you can’t do that.
“The current [plat du jour] – the credit derivative – is the most dangerous instrument yet, and neither the risk controllers at the big banks nor the bank examiners seem to have any good ideas about how to handle it. A vehicle by which banks can swap loans with each other apparently gives everybody a win – banks can diversify their portfolios geographically and by category with the click of a mouse.
“But the system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries – their knowledge of their borrowers, and their incentive to police the status of the loan.
“When a loan is securitized, nobody has the credit watch. Researchers at the Federal Reserve Bank of New York concluded that in the presence of moral hazard – the likelihood that sloughing the bad loans into a swap will be profitable – the growth of a market for default risks could lead to bank insolvencies.”
Fast forward to 2008 and 2009 and Mayer’s predictions became reality. Morgenson contacted Mayer for her Feb. 28 column, asking for his thoughts on solutions to the problems that credit default swaps have produced. Among his recommendations:
- Companies that trade in credit default swaps should be required to put up more capital to back them, Mayer says. That way, if a client asks for payment, the issuer actually has the funds available to make good on the payment.
- Increased regulatory oversight of credit default swaps needs to become the rule, according to Mayer. In addition, he suggests that credit default swaps must be exchange-traded so that their risks are more transparent.
“The insistence that you mustn’t slow the pace of innovation is just childish,” Mayer said in the NYT’s article. “Innovation has now cost us $7 trillion,” a price tag that refers to the loss in household wealth resulting from the financial crisis. “That’s a pretty high price to pay for innovation.”