Unregulated Credit Default Swaps Led to Weakness

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It's a fair guess that a couple of months ago, few people outside the financial world had even heard the words "credit default swaps." But now the obscure and unregulated financial instruments are shouldering much of the blame for destabilizing the global financial system.

Earlier this month, Congress got its own tutorial on credit default swaps from Eric Dinallo, the New York state insurance superintendent.

"It's where you own a bond. Let's just say you own Ford bonds and you want to hedge your risk that Ford is going to default on those bonds. So you go to a third party and you ask them to essentially insure you against that default," Dinallo said earlier this month at a House Oversight Committee hearing on the bailout for insurance giant AIG.

The government rescued AIG last month to prevent it from going bankrupt because it had promised a lot of money, which it didn't have, to people holding credit default swap agreements with the company.

"From recollection, I don't believe the number got to $500 billion, but it was certainly in totality around $400 billion," says former CEO Martin Sullivan.

One problem for AIG: Many of the people it owed money to had not bought credit default swaps from them for insurance; they'd bought them for speculation.

How Credit Default Swaps Work

Here's how it works. Let's say there's a guy named Frank and he has a life insurance policy. When he dies, the beneficiary gets a million dollars. Now imagine a whole bunch of other people saying, "I want a million dollars if he dies, too." And so they take out life insurance policies on Frank. Now imagine Frank dies, and all those people bought their policies from the same company. That company, more or less, was AIG.

Netting

But the fact that the biggest insurance company in the world was brought down by these unregulated securities might not even be the scariest part. Usually, people who traded credit default swaps did something different from what AIG did — something that was supposed to make them safer, but might possibly have made the whole system more dangerous. They did something called "netting."

Imagine a hedge fund that has assets of $100 million and a hunch that the investment bank Lehman Brothers is going down. It goes to AIG and buys a credit default swap on $1 billion. It pays AIG $20 million a year, and the deal is, if Lehman can't pay its debts, AIG owes it $1 billion.

Now, over the next few months, the hedge fund's hunch starts to look more likely. Lehman starts looking riskier. Its profits go down, say, and unfavorable news comes out about it. When this happens, Lehman becomes, basically, more expensive to insure. Just like the more traffic accidents one has, the higher the insurance premiums, the sicker a company looks, the more it costs to buy a credit default swap protection against it.

And the hedge fund is perfectly poised to take advantage of that. It goes out and starts selling credit default swap protection. But because people are more scared about Lehman, the price is higher. The hedge fund can now sell it for $40 million a year. So it is paying $20 million, but taking in $40 million, a net profit of $20 million a year. And its position is "hedged," or totally safe. If Lehman defaults, the hedge fund will owe its buyer $1 billion, but AIG will owe it $1 billion. The trades net out. And in the meantime, the hedge fund is taking in a cool $20 million a year.

And this situation, in which every trade was matched on the other side with another trade, was much more common. The hedge fund would sell protection to Morgan Stanley, say, and buy it from Goldman Sachs. Goldman Sachs, in turn, would sell protection to a hedge fund, which in turn would buy from another hedge fund, and so on down the line.

Satyajit Das, a risk consultant with nearly 20 years of experience working with credit default swaps, says that netting works fine as long as everyone stays in business.

"If the chain breaks down anywhere where one party does not actually honor their contracts, then the losses multiply rapidly," he says. "It links everybody together in this unholy chain and so what happens is if one party has a problem, then everybody else has a problem."

The Greatest Danger

Jon Zucker, who worked at a credit default swap desk at a major bank for five years until 2007, says if everyone in the chain knew the financial stability of everyone else in the chain, then all this would be fine. The problem, however, is because every deal is private, so they don't know.

"You don't know; it's far from transparent," he says. "You know the notion is that I'm working here at NY Money Center Bank and some small bank in Asia goes down and suddenly it just hits a tipping point and several other banks fail and suddenly it's affecting me.

"I never had a clue."

And this lack of information is what has been causing huge problems. It is one reason credit has been freezing up. Banks have been afraid to trade with one another because they don't know what bets anyone has made.

And this, in turn, was one reason the government felt it had to step in with a bailout — because all the banks are linked through these credit default contracts. If one bank goes down, they all could.

Hindsight

The questions then are: Is it fair for taxpayers to be mad? And who should they be mad at? Is it possible to set up a situation where the mistakes won't affect you?

"There is a lot of 20/20 hindsight review of this, saying people should have caught all this stuff," Zucker says. "I'm not altogether sure of that, but one thing I can say is that in terms of intent, there was no intent to regulate.

"And from that point of view, they should be held accountable for some of these mistakes."

Recently, regulators have started to take action. Earlier this month, Congress held hearings on how best to regulate the credit default swap market. SEC Chairman Christopher Cox, who has been criticized for lax oversight of the financial markets, recently wrote an op-ed in The New York Times, calling for greater regulation of the credit default swaps.

Most people seem to believe the best thing would be to set up a central clearinghouse for credit default swaps, or an exchange, where they could be publicly traded like options, or commodity futures. But everyone says it's a complex world: The people who invent these financial products are making small fortunes, and that regulators will always be playing catch-up.

Alex Blumberg reports for Chicago Public Radio's This American Life. He reported this story along with NPR's Adam Davidson.

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