By now you have memorized those three ugly words, “subprime mortgage mess.” Get ready for three more: “credit default swap,” called CDS on Wall Street but barely known on Main Street, where it may well spread financial disease as lethal as subprime and sundry exotic mortgages. The sagacious financial expert who almost alone has warned of such looming woes for more than a decade is Frank Partnoy, professor of law at the University of San Diego.
In its simplest form, a credit default swap is essentially insurance against default or some other calamity on a debt instrument, such as a bond or a loan. For example, a bank holds a bond and wants to be sure it gets its steady interest payments and its principal when the bond matures. So the bank buys a contract from a third party — say, a hedge fund, insurance company, pension fund — which promises that the bond will be paid off in full. In return, the bank pays the third party a regular premium. The calamity for which the bank gets insurance might be bankruptcy of the bond issuer, failure to pay interest or principal, and the like. Call this bond protection.
The vehicle by which this quasi-insurance is carried out is a derivative — a financial instrument whose value is derived from some other security, such as a stock, bond, or commodity. Most derivatives are bewilderingly complex — often created by Harvard and MIT mathematics PhDs. Sometimes both the buyers and sellers of derivatives don’t understand them. After all, the essence of white-collar fraud is contrived complexity. The investment banking world is expert at creating such mares’ nests. Trouble is, the firms are often not smart enough to unravel their own self-made messes. A low-level trader cost the second-biggest French bank $7.2 billion by making trades the bank had not detected. The U.S. can’t be smug: big Wall Street houses such as Merrill Lynch and Citigroup have lost billions of dollars in mortgage-related products, and the chief executives raking in $60 million or more a year in salary had no idea what was going on.
Now some financial experts are asking if the credit default swap phenomenon is a protection racket — or a Ponzi scheme. People are wondering what happens when the third party promising protection doesn’t have the money to pay off. This could cause a chain reaction. Protection sellers could default. Protection buyers, which had wrongly assumed they were covered for calamities, would find themselves in deep doo-doo. Worrisomely, public disclosure of swap deals is very slim. There is a stark lack of information. The swaps are sold over the counter, not traded on an exchange, and are largely outside the scrutiny of regulators.
Bill Gross, managing director of Newport Beach–based PIMCO, which runs the world’s largest bond fund, recently pointed out that through use of derivatives, hidden off the balance sheet, America’s banks evade the reserve requirements that once backed up the system to prevent runs. Gross’s January report put it in stark words: “Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage [debt], based in many cases on no reserve cushion whatsoever. Financial derivates of all descriptions are involved, but credit default swaps are perhaps the most egregious offenders.” If something goes wrong in the economy — and a national recession looks increasingly likely — the banks may well not have adequate reserves. There are $45 trillion of swaps and $500 trillion of all kinds of mysterious derivatives floating around the world, often undetected.
Gross says that in the course of the coming (perhaps underway) economic woes, swaps could account for $250 billion of losses — the same as subprime mortgages. “Casualties and shipwrecks are the inevitable consequence,” says Gross.
University of San Diego law professor Partnoy sold derivatives on Wall Street for two years. In 1997, his book F.I.A.S.C.O.: Blood in the Water on Wall Street warned of coming problems with derivatives. His 2003 book, Infectious Greed: How Deceit and Risk Corrupted the Financial Markets, specifically zeroed in on swaps. He showed how they were critical in the Enron and WorldCom frauds. “Banks had done an estimated $10 billion of credit default swaps related to WorldCom,” wrote Partnoy. When WorldCom collapsed, the banks were owed billions in the bankruptcy, but they didn’t worry: they had sold the risk to somebody else. There were 800 swaps amounting to $8 billion of bets on Enron, wrote Partnoy. Then–Federal Reserve chairman Alan Greenspan applauded this risk-shifting, saying it took pressure off U.S. banks. But because the swap market was “opaque and unregulated,” wrote Partnoy, “no one could be sure where the risk had gone.” Property, casualty, and reinsurance companies took hits, as did pension funds and hedge funds.
But, noted Partnoy, just as banks used derivatives to skirt reserve requirements, insurance companies used them to avoid legal rules that blocked them from taking on too much risk. Banks were dodging regulation by shifting risk to less regulated insurance companies, which were also doing illegal gambling. Because of the swap boom, the world financial system might be creating instability, not reducing it. Banks are in the best position to monitor a loan; they have access to data that the third parties don’t have. An insurance company — especially one based offshore, as so many are — can only look at public documents. It doesn’t have the inside scoop, as banks supposedly have.
Now the chickens are coming home to roost. Consider Ambac Assurance and the Municipal Bond Insurance Association (MBIA). They had done very well insuring tax-free municipal bonds. (For example, Ambac insured the San Diego ballpark bonds.) Ambac and MBIA had the highest AAA ratings — ergo, so did the municipal bonds they guaranteed. But then they got greedy. They decided to insure debt instruments that were loaded up with mortgages that turned out to be kinky. These bonds are collapsing. There is a question of whether Ambac and MBIA have the money to provide the protection they promised. The stock prices of Ambac and MBIA have dropped precipitously, oscillating on rumors. There is talk of a bailout of these companies by big banks (themselves lacking funds) or even the federal government.