All Commentary
Wednesday, April 1, 2009

Too Big to Succeed

One widely cited culprit for the 2008 financial crisis was a supposed decision by the U.S. government not to regulate a relatively new type of financial instrument known as a credit default swap (CDS). In fact, this so-called “failure to regulate” refers to regulations that prohibited public trading of these instruments, concentrated risk in a small number of large firms, and massively increased the probability of a financial disaster. To add to the irony, one of the government officials most responsible for these interventions, then-Federal Reserve Chairman Alan Greenspan, recently apologized for having had too much faith in the free market when he should have apologized for not having had enough.

In 1999 Brooksley Born, head of the Commodity Futures Trading Commission (CFTC), tried to bring CDSs under the regulatory umbrella of her agency. Born was stymied by Greenspan, Treasury Secretary Robert Rubin, and Securities and Exchange Commission Chairman Arthur Levitt. She eventually resigned and the dispute was effectively settled in 2000 by the passage of the Commodity Futures Modernization Act (CFMA), which prohibited the CFTC from any further examination of CDSs. Details of the dispute can be found in an October 15, 2008 Washington Post article titled “What Went Wrong,” by Anthony Faiola, Ellen Nakashima, and Jill Drew. But the article itself went wrong when it saw only deregulation and free markets in a fiasco caused by regulation and central planning. It failed to consider the full implications of the CFMA itself, nor did it address the disastrous side effects of an international agreement known as the Basel Accord, both of which made credit default swaps anything but a free-market failure.

Who’s in Charge?

As neat and tidy as it might be to portray Born as the advocate of regulation and Greenspan, Rubin, and Levitt as opponents, it was actually a dispute among government officials over which of them should be in charge. The confusion derives from the nature of CDSs themselves.

When someone borrows money the lender is always concerned about the possibility that the borrower will not repay the loan. There are various ways for the lender to protect against that risk. The lender can sell the loan to someone else, who assumes both the right to collect the payments and the risk that the borrower will fail to make them. The lender can require the borrower to find someone willing to guarantee the loan—that is, someone who agrees to pay if the borrower defaults. Or the lender can make a separate contract with an unrelated third party who, in exchange for a premium paid by the lender, agrees to make the same guarantee to pay the lender if the borrower defaults.

A CDS is an example of the third option. The party paying the premium—the lender in this example—is considered the buyer of the CDS. The seller of the CDS is essentially providing default insurance, so a CDS can be viewed as an insurance contract and might be subject to regulation by government officials who oversee the insurance industry.

It is also, however, a form of derivative—a contract that derives its value from another asset or contract (in this case, the actual loan), but which can be settled separately by a payment of cash or some other highly liquid asset. In fact the parties to a CDS don’t actually need to have any relation to the loan: You and I can enter into a CDS in which I pay you a premium and you promise to pay me money in the event General Motors defaults on bonds that neither you nor I own. In this case, you and I are both speculating (or gambling) on a possible future event and neither one of us can be described as insuring the other against risk. Thus a CDS may be viewed as a form of futures contract and might be subject to regulation by government officials who oversee the futures industry.

Many of the biggest players in the CDS market turned out to be banks. Only about 40 of the more than 5,000 banks in the United States traded CDS contracts, with three of them—J.P. Morgan Chase, Bank of America, and Citigroup—trading more of them than all other banks combined. Commercial banks ended up as major buyers of packages of loans known as mortgage-backed securities that were protected by credit default swaps, and many investment banks were involved in these transactions. Thus a CDS may be viewed as a product supporting banking and lending and might therefore be subject to regulation by government officials who oversee the banking industry.

Finally, since an overwhelming percentage of credit default swaps are associated with either publicly traded bonds or publicly traded mortgage-backed securities, a case could be made for classifying a CDS as a form of investment security, which might be subject to regulation by the government officials who oversee the securities industry.

Despite the Post’s portrayal, Born may actually have come the closest to advocating a free-market policy. Although she was never able to get far enough to develop her ideas in detail, as head of the CFTC she likely would have had the authority to regulate CDS contracts that were traded on public commodity futures markets. The three men opposing her prevented these contracts from being publicly traded at all. As a result, credit default swaps could only be traded privately, keeping this market in the hands of a relatively small group of big players whose subsequent missteps might have been prevented or their impact minimized by such public trading.

Private Versus Public Trading

The distinction between private and public trading is important. Private contracts are those resulting from one party directly contacting another and negotiating a mutually acceptable agreement. While government courts claim jurisdiction over the enforcement of these contracts, the content of the contracts is generally up to the two parties.

Starting with the Securities Act of 1933, however, the federal government defined certain financial transactions as public matters and claimed the authority to regulate or prohibit them. Any contract that results from advertising or general solicitation, any use of an exchange that makes it possible for buyers and sellers to be matched up without knowing each other, or even the mere fact that one of the parties is an individual with a net worth under $1 million and an annual net income under $200,000 can be sufficient to claim the contract is a public matter.

The Commodity Futures Modernization Act, by prohibiting the CFTC from regulating credit default swaps, prevented it from authorizing public trading of CDSs on futures exchanges. In other words, the CFMA regulated public trading in the severest manner possible: It forbade it.

With only private trading permitted, the general public was effectively excluded. Furthermore, remember that private contracts must result from direct negotiations and that there is a prohibition on providing any public information about them that might be deemed advertising or general solicitation. This provided an overwhelming edge to the biggest players who traded them the most, as the high costs of contacting potential counterparties, negotiating contracts individually, and compiling private information created enormous economies of scale. Thus the federal government didn’t merely declare credit default swaps off-limits to the CFTC; it also effectively created a trading cartel for the largest banks, insurance companies, and hedge funds catering to wealthy investors.

Credit default swaps were invented by a team led by Blythe Masters of J.P. Morgan in 1997 as a tool for hedging the risk of default on loans. In a truly free market, regulated exclusively and severely by Messrs. Profit and Loss, she would today be hailed for this great invention. Prices are information, and the cost of a freely traded credit default swap provides a far better estimate of the risk on a debt instrument than the opinion of a credit rating agency that doesn’t personally suffer from a default and expresses its opinion in the form of letters. The meaning of a AAA or BB rating is vague and debatable, while a CDS priced at 1.08 percent on an 8 percent bond indicates that it is the equivalent of a risk-free 6.92 percent bond.

Furthermore, making the risk tradable would allow virtually all of us to choose, if we wished, to include small amounts of CDSs in our diversified investment portfolios. We could increase our personal investment returns modestly in exchange for sharing in a tiny portion of the total risk associated with lending. We wouldn’t all need to become experts in them. Mutual funds could put together diversified portfolios of CDS contracts and develop track records to draw our investments, and asset managers would have the incentive to become more informed in order to serve clients better. As a personal financial adviser, I would love to have that option for the client portfolios I manage.

Finally, the widespread trading of CDS contracts would help minimize counterparty risk—the danger that the party with whom we’ve contracted will not honor his obligations. With many people able to trade them, the portion held by any one player could be reduced and those who overexposed themselves to risk would have a ready market to hedge their own activities.

How Government Made the CDS a WMD

Unfortunately, government intervention helped make credit default swaps toxic. The explosion in the use of CDSs was not a free-market phenomenon. In 1988 the Basel Committee on Banking Supervision, an international body made up of representatives from all the major central banks, produced the Basel Accord, which went into effect in 1992 in the United States and most other participating countries. The accord set capital requirements for all banks that weighted assets based on their risk. The Basel II Accord was signed in 2004 to refine the requirements.

Under the Basel Accords the lowest capital requirements for a bank were not for the loans they personally originated and understood best but for AAA-rated securities. The safest direct loans are home mortgage loans to borrowers with excellent credit whose loan amounts don’t exceed 80 percent of the property value. These loans to “prime” borrowers have a risk weighting of 35 percent under Basel II. But if such loans are packaged into a mortgage-backed security rated AAA, the risk weighting is only 20 percent, reducing the amount of capital the bank must keep on hand and increasing its profits. Thus a bank has the incentive to sell the loans it has originated and replace them with AAA securities. Indeed, Basel II virtually mandated that banks sell their loans if they wanted to be competitive. The biggest buyers, Fannie Mae and Freddie Mac, two government-sponsored enterprises operating as profit-making businesses, benefited enormously from this regulation-inspired activity.

Not all loans are to prime borrowers with large down payments, however. Because of various government mandates, such as the Community Reinvestment Act, incentives were created to lend to less creditworthy borrowers with low or no down payments. Although most of these loans were not made by banks, they too were packaged into mortgage-backed securities, and many of them found their way to banks as AAA-rated securities.

How so? Why would a package of loans to subprime borrowers get the same high rating as a package of loans to prime borrowers? Through the magic of a CDS. Although the loans themselves might have a high risk of default they were protected by credit default swaps sold by entities that were themselves rated AAA, such as AIG Insurance, and CDSs were given AAA ratings as a result. A package of subprime loans might be rated BB (below investment grade), getting a prohibitive 350 percent risk weighting under Basel II, but that would be reduced to 20 percent weighting as a CDS-protected AAA security.

This was an international phenomenon. In September a report of the Center for European Policy Studies described the bailout of AIG Insurance by the Federal Reserve as a bailout of the European banking system. AIG was exposed to nearly a half-trillion dollars in credit default swaps, $300 billion of it to provide regulatory capital relief to European banks subject to Basel II. On September 15, 2008, the credit-rating agencies Standard & Poor’s and Moody’s downgraded AIG’s debt rating. Ironically, the price of credit default swaps on AIG itself had been rising for months, demonstrating the superiority of CDS pricing to credit ratings in the timely identification of borrower difficulties. This triggered contractual obligations for AIG to post tens of billions in additional collateral to guarantee its own ability to perform on the CDS contracts it had sold. There was some evidence that AIG could have arranged financing through various hedge funds or American banks but it apparently didn’t like the terms of these loans. It obtained a better deal from the Fed, even though the central bank has no oversight authority with respect to insurance companies. Had AIG not been able to post the additional collateral, the CDS protection it offered would no longer have preserved the AAA ratings of the securities in the European bank portfolios it was insuring, and capital requirements would have increased by as many as 161?2 times for some of the assets held by these banks.

Jury Still Out

So how significant were credit default swaps in the financial meltdown of 2008? For the firms that went bankrupt, such as Lehman Brothers, or those that were taken over, such as Bear Stearns, or those that had to cede significant control in exchange for government bailouts, such as AIG, very. They were big players in the CDS market who made some bad bets and failed to hedge their own risks.

It is not nearly as clear that there is any systemic problem with credit default swaps. In a November 15, 2008 article, “The Meltdown That Wasn’t,” the Wall Street Journal noted, “Lehman Brothers was supposed to be exhibit A. The firm was on one end of roughly $5 trillion in CDS contracts, according to Moody’s, and Lehman was itself the subject of $72 billion in CDS, in which other investors were betting on Lehman’s success or failure. Here was the doomsday scenario, with a major player in CDS going bankrupt. It turned out to be the meltdown that never melted.”

Lehman failed and the government let it fail. There is no evidence the liquidation had anything to do with problems for any other player. Businesses go bankrupt all the time, and it is best for the long-term health of an economy that incompetent managers cease to manage.

Credit default swaps didn’t melt down at all. The market for them continued to function smoothly even as the traditional credit markets were struggling. There were many causes for the housing boom and bust that played the biggest role in the financial panic of 2008, and it is quite plausible to wonder if CDS contracts are being scapegoated to distract from other, more likely villains. The role of CDSs in satisfying regulatory capital requirements appears to have been a major reason for the explosion in their use. If there is any failure there, it is in the unforeseen consequences of the regulations that came from the Basel Accords. They should be modified or repealed.

The Born Supremacy

Still, had Born gotten her way in 1999, many good consequences might have come from it:

1) Publicly traded CDS contracts almost certainly would have priced the risk of various debt instruments more accurately than the credit-rating agencies have done. As mentioned, CDS prices showed AIG was in trouble before the rating agencies acknowledged it.

2) Large players in the CDS market would have had a convenient way to hedge excessive risk exposure without being limited to hedge funds, big banks, insurance companies, and the federal government.

3) The inefficiencies in pricing that have allowed players such as J.P. Morgan Chase to make large profits on the basis of superior information would have been replaced with a more efficient market and level playing field.

4) Individual investors would be able to diversify portfolios more and earn some of the returns available in this market instead of being available only as taxpayers to bail out the incompetent.

5) Counterparty risk would be massively reduced by the much greater number of participants in the market.

Born may be getting the last laugh. In October 2008 the Chicago Mercantile Exchange announced plans to establish exchange trading of credit default swaps. In spite of the posturing of some politicians there is enough recognition of the benefits of derivatives to ensure that the markets for them will be expanding rather than disappearing. While we can only hope exchange regulation will be limited to the enforcement of contracts, regulated public trading is better than none at all.

The democratization of credit default swaps has begun. Greenspan, Rubin, and Levitt may have meant well in trying to limit CDS trading to big players, figuring that the public wasn’t ready to assume the risks associated with new financial instruments. Unfortunately the massive taxpayer-financed bailouts have shown that the public was going to bear the cost of failure in any event, and the primary result of their elitist attitude was to concentrate risk unnecessarily within a handful of firms whose exposure made them too big to succeed.