Still no action by Congress on credit default swaps

Sunday, January 31, 2010

By Josh Bill and Dr. Hamner Hill

"Every civilization," Swiss historian Jacob Burkhardt once wrote, "carries within itself the seeds of its own destruction." We believe the financial crisis of 2008 exposes a seed that can destroy Western-style free-market capitalism. The name of that seed is the credit default swap, or CDS.

A CDS is an investment tool for managing risk. Generally speaking, return varies inversely with risk. Riskier investments pay higher returns. An investor who makes a risky investment can reduce the risk (hedge the bet) through a CDS that promises, for a small fee, to pay the investor should the original investment go bad. Let's be honest and call a CDS as what it is: insurance.

We rarely think about it, but insurance is a highly regulated industry, and for good reason. For instance, the administrator of a hospice-care facility would not be allowed to buy life insurance on its residents. A surgeon could not take out a life policy on a patient he or she was about to operate on. You could not take out a fire policy on a home you did not own, and you could not take out more than one policy on a home you did own.

The term in the industry is "insurable interest." You cannot insure someone or something when you have no financial connection to them or it, and you can only buy enough insurance to cover that interest, or to make you whole, in case of a loss. That's how that system works, and it's the only way it can survive.

On the other side of the issue, insurers are required to hold a specified percentage of their total potential liabilities as capital reserves so that they can pay off when catastrophe strikes one of the insured parties.

Unregulated insurance

Understanding those limits in regular insurance -- and that a CDS is an insurance policy in the financial markets -- explains much or most of their abuse by Wall Street. There are no such limitations on either side of the issue with CDSs. And that is precisely what caused the problem.

It was, and still is, possible to buy an unlimited number of CDSs against any financial instrument, whether one owns that instrument or not. Imagine someone taking out 20 fire policies on his neighbor's home. Common sense tells you the odds just went up that that house is going to burn, and you have just created a perverse appetite for the homes most likely to burn.

The riskier, the better

The distortion of markets caused by CDSs is clearest in the secondary mortgage markets. Soon after CDSs became legal in 2000, Wall Street firms began paying more for subprime mortgages with poor or no documentation of a family's ability to pay them back than for those with traditional proof of income and ability to repay. Why? Because the riskier, and even riskiest, subprime mortgages offered a greater likelihood that the borrowers would default. Since the very firms that sought out these bad mortgages had taken out multiple insurance policies that they would fail (getting paid 100:1 on each of those bets), that's where the real money was to be made.

Eventually, the highest risk mortgages were repackaged as collateralized debt obligations (CDOs) vouched for by large Wall Street firms thus earning totally unjustified AAA bond ratings.

The total amount of subprime mortgages written soon rose to $2 trillion. The total value of the CDSs written against CDOs rose to $65 trillion. That's right: $65 trillion of insurance against $2 trillion worth of high-risk mortgages.

Those who profited the most sought out the worst of the worst mortgages to bet against. One big winner was a hedge fund manager named John Paulson. In 2006, Paulson convinced Goldman Sachs and Deutsche Bank to create extremely high-risk CDOs and sell them to others, so both he and they could bet against them. Paulson picked the mortgages. He made $15 billion. His friend George Soros (who later said "I'm having a very good crisis") made $5 billion. Deutsche Bank made $25 billion doing this. Goldman Sachs made much, much more.

In 2006, Goldman Sachs and Deutsche Bank underwrote 352 fraudulent mortgages in Sikeston, Mo. In 2009, Goldman Sachs paid Massachusetts $60 million to close an investigation into its role in creating "mortgages designed to fail at the inception."

Since CDSs are totally unregulated, the companies offering the insurance had nowhere near the funds necessary to pay off when the real estate bubble burst. There were many sellers of CDSs, but AIG was the largest. By October 2008, AIG had written $2.7 trillion worth of CDSs, and it couldn't pay. Congress bailed out AIG with $180 billion of taxpayer money so it could pay off these bets. Taxpayer money ended up in the pockets of Goldman Sachs and Deutsche Bank because they bought CDS side-bets from AIG against the very CDOs they created.

Indifference? Corruption?

To date -- either as a sign of incompetence, indifference or corruption -- Congress has done nothing since writing bailout checks in 2008. Each and every law that allowed this to happen is still on the books. When Illinois Sen. Dick Durbin said of Congress, "The big banks own this place," it may have been more than hyperbole.

This is not a conservative versus liberal issue. It's not a Republican versus Democrat issue (we are one of each). This is not populism. It's a matter of right and wrong.

We hope the Massachusetts message of outrage will be repeated from all over the country, but on this specific issue we hope it will read: "It's the credit default swaps, stupid!"

Josh Bill is a former chief of staff to the late U.S. Rep. Bill Emerson, a former official in the Reagan administration and a former mayor of Sikeston.

Dr. Hamner Hill is the chairperson of the Department of Political Science, Philosophy and Religion at Southeast Missouri State University.

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