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Financial Weapons of Mass Destruction

Image has not been found. URL: /wp-content/uploads/2008/09/buffet.jpgWarren Buffet (Mark Hirschey)

Warren Buffet calls credit derivatives “financial weapons of mass destruction.” When his company, Berkshire-Hathaway, Inc., took over an insurance company in 2002, it took him four years to unwind its portfolio of credit derivatives — at a cost of $400 million. Buffet didn’t entirely follow his own advice, however, because in the first quarter this year Berkshire-Hathaway took another $500 million loss on credit derivatives.

Why worry about credit derivatives? One reason is that the “notional value” of the most important credit derivatives, credit default swaps, or CDS, is now $62 trillion. That’s trillion, with a “‘T,” and it is more than the whole world’s gross domestic product. Numbers that big automatically make people nervous, especially when they see the canniest investors like Buffet taking losses.

Debt-150x150_709.jpg
Debt-150x150_709.jpg

Illustration by: Matt Mahurin

CDS are the fastest-growing financial instrument of all time, because they fill a real need. Stock markets have long had efficient methods of re-balancing risk. For example, if you have a large stock position, and are worried that it will fall, you can buy options that will limit your possible losses, without the expense of actually selling the shares.

But bond markets, other than Treasuries, are primitive compared to stocks. There are no options markets for corporate bonds. So if you were worried about your holdings, your only recourse was to sell them. Markets in mortgages and bank loans are even less developed.

Enter CDS, often called “credit insurance.” Suppose a bank, or pension fund, is worried about its exposure on a portfolio of bonds. It can enter into a CDS with another investor to shift the risk of defaults. The bond owner makes a regular stream of payments to the protection seller over the life of the swap; in consideration for the payments, the protection seller promises to make good the losses to the bond owner if the bonds default.

The beauty of the CDS is that if the payments are calculated correctly, the protection seller is in the same position as if he actually bought the bonds, but without putting up the cash. The payments he receives will mirror the bonds’ interest coupons and market risk premium, and he will profit as their market price rises and falls. (If the value of the bonds rises, the cost of protection will drop. So he can eliminate his risk by buying protection on the same bonds and pocketing the difference between the premium he pays and those he receives.) If the bonds actually default, of course, he’s out the principal value of the bonds, less any expected recoveries, just as if he owned them.

So CDS are a wonderful invention. They make it possible to create “synthetic” bond portfolios quickly and cheaply. The extra efficiency should increase liquidity and lower interest costs. A win-win, it sounds like, all around.

The scary parts are in the gritty details. To begin with, the payoffs from a winning CDS tend to be large. If you’ve sold protection on a $10 million portfolio of bond X, and X defaults, you owe your counterparty the full principal of the bond less the likely recovery. In normal times, recovery rates might be 50 percent, but in recessions, they can drop to 20 percent. In any case, protection sellers will be on the hook for lots of cash.

And for a market involving such huge amounts of money, it is still very informal — with deals getting done by email and fax, often with shaky documentation. Big banks play the role of dealers, matching up trading parties, but from that point the details are left to the counterparties.

Until recently, swap parties could sell off their positions without informing their counterparties. Since swaps might be traded many times, someone who thought she had protection might not be able to track down her counterparty when it was time to collect. Deal terms can also be complex. At least three large recent defaults are in court, because protection sellers refused to pay, on the grounds of alleged contract violations by their counterparties. As defaults spiral up, CDS close-out disputes could become a litigation goldmine.

The biggest problem, however, is so-called “counterparty” risk. Most financial instruments of CDS scale, like Treasury futures, are traded on exchanges, like the Chicago Merc. Once brokers match a Treasury future trade, the Merc steps in as the counterparty for both the buyer and the seller. The exchange insists on daily collateral-postings. If you make a loss because you sold a future that’s rising in price, you have to post additional collateral; if the future price drops the next day, you get that portion of your collateral back. In short, iron-clad procedures ensure that the exchange always has enough cash to settle up with the parties when contracts close out.

CDS, however, trade “over the counter,” without a central exchange. While most counterparties insist on some initial collateral, the arrangements are inconsistent, and updating of positions is haphazard. Perhaps a third of the ‘long’ players, or protection sellers, moreover, are hedge funds, typically very highly leveraged. While they love selling protection for the cash income, if they are faced with a spate of default payouts, they could easily default themselves.

The biggest banks are now cooperating to set up a central CDS clearing system, but many suspect it is just a tease. The murkiness of the current system allows them to extract an estimated $10 billion in annual brokerage fees, which would surely be at risk in an efficient, transparent trading environment.

It was fear of just such a falling-domino cascade of CDS failures that forced the Federal Reserve to intervene so vigorously to prevent a collapse at Bear Stearns. The firm’s end-of-year SEC reports show that it was a guarantor on $2.5 trillion in “credit derivatives,”’ most of them, presumably, CDS.

If Bear had gone under, all those guarantees would have immediately defaulted. The price of default swaps would have increased across the board, and banks would have started making collateral calls on hedge funds with positions like Bear’s. Hedge funds that didn’t have sufficient collateral would have joined the domino cascade. Panicky brokers scrambling to liquidate their most exposed positions could have crashed the fragile CDS trading machinery.

There was a real risk of a global financial thrombosis that could have taken weeks to unravel. The potential losses are incalculable. Nor are the rescues necessarily over. Lehman Bros. is on many people’s short lists of the next to go.

That is what’s scary about CDS markets. So the Fed probably had no choice but to intervene in the Bear case to forestall a possible catastrophe. What is not forgivable is that the major global regulatory bodies have allowed things to come to this point, and that the Fed even had a policy of cheering it on.

But more unforgivable yet would be the lack of a strong regulatory response to ensure that it doesn’t happen again.

Charles R. Morris, a lawyer and former banker, is the author of “The Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash.” His other books include “The Tycoons: How Andrew Carnegie, John D. Rockefeller, Jay Gould and J.P. Morgan Invented the American Supereconomy” and “Money, Greed, and Risk: Why Financial Crises and Crashes Happen.”

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