Financial WMD made simple

This post was inspired by a recent NPR program.

Several years ago, Warren Buffett famously referred to financial derivatives as “financial weapons of mass destruction.” Unfortunately, he, and nearly everyone else, didn’t elaborate. For nearly everyone, “derivatives” remained just a word, vaguely associated with big money and big danger.

This post attempts to explain why one particular type of derivative, “credit default swaps,” caused the financial system to implode.

The layman’s confusion is caused in part by opaque naming. (”Credit default swap?” What the heck does that mean?) But it’s really pretty simple. “Credit default swaps” are bond insurance policies. The buyer of such a policy pays a premium to the insurer, for protection against the default of a bond. If the bond doesn’t default, the insurer just keeps the premium. If the bond does default, the insurer must pay the buyer the face value of the bond.

If it’s a bond insurance policy, why don’t they just call it “bond insurance” instead of CDS? There is a reason, and it stinks. More on that in a moment.

Among other uses, CDS were widely employed to improve the credit rating of mortgage-backed securities. For example, a dicey pile of Countrywide mortgages would be securitized, and might have a fairly risky default rating. To reduce risk, the end buyer might simultaneously buy both the securitized mortgages AND a credit default swap (again, bond insurance) to insure against the risk that the mortgage securities might fail to pay off as agreed.

The obvious problem here was that the mortgages were much dicier than expected, too many of them defaulted, and too many insurers (sellers of credit default swaps) were forced to pay insurance claims.

So far, this is a case of bad risk management, but not bad enough to take down the whole financial system. To see where the dynamite was hidden, let’s return to this mysterious reluctance to call these financial contracts “insurance,” even though that’s clearly what they are.

Insurance is a regulated industry. Insurers are required to maintain capital reserves (e.g. cash and investments), to ensure they can actually pay out claims on the policies they sell. This regulation stabilizes the financial system, but irritates the more aggressive financial types, who could enjoy vastly higher return on capital if they didn’t bother to maintain reserves to actually pay claims.

Their ultimate dream of avarice: an insurance company that has no capital to pay claims. Divide by zero: infinite return on capital. Just write policies, collect premiums, and if a claim rolls in, just declare bankruptcy and start over. Easy money.

In the 1990s, when the idea of securitization was expanding rapidly, prospective sellers of bond insurance, fueled by this utopian vision of infinite return on capital, decided not to call their product “insurance.” Instead, they called it a “credit default swap,” and argued it was not really insurance, but a “forward contract” between two private parties. This clever definition meant that, from a regulatory perspective, these products weren’t insurance, and weren’t listed securities, placing them outside the purview of all regulatory agencies.

This unregulated environment was made explicit in law with Web-Bubble-era legislation led by Phil Gramm (John McCain’s chief economic strategist until a few weeks ago).

Freed from the irritant of capital requirements, a credit default swap (CDS) free-for-all ensued. Increasingly, they were used not by bond holders, but by speculators. For example, you could buy a CDS contract to insure against the default of a bond you didn’t actually own.

To see how strange this speculation is, consider an analogy. Suppose you think your neighbor will default on his mortgage. Imagine if you could buy an insurance policy on your NEIGHBOR’S mortgage. If he defaults, you collect the entire value of his mortgage. Everyone on your street could do it, and would each collect the entire value of the mortgage if your neighbor defaults.

This is exactly what was going on in credit default swaps. Today, for every dollar of mortgage backed securities, there are believed to be about 12 dollars of CDS contracts. This is a form of leverage, in that, if a dollar of MBS defaults, then 12 dollars must be paid out by someone.

Now we start to see how the entire system could fail (but it gets worse — see below). The maximum exposure to MBS is not the total MBS market of $5 trillion, but 12 times that, the entire CDS market, or $60 trillion. This is more than 4 times the entire annual output of the United States.

How could the CDS market be so huge? One reason is that they could be structured, typically by hedge funds, into a seemingly riskless bet, known as “netting.” This trick takes advantage of the simple fact that insurance premiums are higher when a claim is more likely. (For example, it costs more to insure a 16-year-old driving a red Ferrari than to insure a 40-year-old bookkeeper driving a Honda Accord.) Hedge funds took advantage of this fact as follows.

Say you run a hedge fund. You buy a CDS on a bond when the risk of default seems low. The price of such a CDS is low, because the perceived default risk is low. Then, as the mortgage collapse unfolds, you also SELL a CDS on the same bond. In the latter transaction, you, the hedge fund, are acting as the insurer. (Why not? CDS are totally unregulated, so anyone can write a policy.)

Because the mortgage collapse is under way, the underlying bond seems more likely to default than it did before. So you can charge a much higher premium for the insurance you are selling than you paid earlier for the insurance you bought. Your profit is the premium received in the second transaction minus the premium paid in the first transaction.

Superficially, you are taking no risk, because if the bond actually defaults, you collect on the insurance policy you bought, and use that money to pay out on the insurance policy you sold. That nets out to zero (hence the term “netting”), but you still have your profit described in the previous paragraph.

What’s the problem here? Something called counterparty risk. In an actual default, you make your insurance claim and try to collect on the policy you bought (the first transaction above). What if they don’t pay you? For example, what if you bought that policy from Lehman Brothers, and they went broke before you could collect? Now the person to whom you SOLD insurance (the second transaction) comes to collect from you. You can’t pay, because Lehman stiffed you, so you are suddenly insolvent, aka broke.

So many people were netting, and the CDS speculation market had become so large over the years, that everyone was dependent upon the counterparty risk (ability to pay a claim) of everyone else. Everyone had booked profits on netting transactions, but in an actual MBS default, if any link in the chain failed to pay, everyone would go broke. Circle of interdependency. Cascading defaults.

The first link to fail was Lehman. The federal government appears not to have understood until very recently (just the past few weeks) that CDS were mainly used to speculate, not to insure one’s own bonds. As a result, the feds didn’t realize that letting Lehman fail would break the chain of interdependencies on CDS claims, causing everyone else to collapse.

So AIG went down. In addition to their regular insurance business, AIG was dabbling in CDS. Well, more than dabbling: they sold $400 billion of CDS, and in the wake of Lehman, enough of these went south to take down the company.

Belatedly, everyone understands that the CDS market should be regulated either as insurance, or as listed securities, or both.

In the meantime, we face the problem of a money supply collapse. For every dollar of MBS default, 12 dollars vanishes from the money supply. This is why the Fed is massively loosening monetary policy.

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