Financial toxic waste removal 101
Are Credit default swaps actually insurance against default?
By Jon Fernquest |
America's shadow banking industry is much like a zoo of strange and exotic financial instruments.
Perhaps the most exotic and also most frightening animal found in this zoo is the so-called Credit Default Swap (CDS), frightening due to the sheer size of the market and its flimsy status as "insurance."
Credit-default swaps are like insurance contracts that protect holders of bonds and loans from the risk that their money will not be paid back to them (default).
The only problem is that they have become a favorite tool of speculators who use them to bet that a certain company will fail.
And guess what? When people want you to fail, you are more likely to fail. This is the heart of the problem explained below.
The sheer size of the market
In mid-2007 the CDS market amounted to $45 trillion which was twice the size of the US stock market and dwarfed other markets such as the $7.1 trillion US mortgage market, the $4.4 trillion U.S. treasuries market, and the comparatively tiny $700 billion US Treasury rescue plan.
The CDS market ballooned to a peak of $62 trillion at the end of 2007 and then receded to $54.6 trillion as of June 30.
Recently, the US public started taking a closer look at Credit Default Swaps when the gigantic global insurer AIG needed to be bailed out because its balance sheet was loaded with them (See US Sixty Minutes TV Special).
(See photo on right of the classic time bomb, a bundle of dynamite sticks with a wind-up alarm clock as timer)
Traditional banking: Close monitoring and oversight of borrowers
In the way that banking traditionally worked banks were uniquely well-positioned to monitor and oversee a company's financial health.
In the good old days, banks had a close long-term relationship with the companies they lent money to. Bank loan officers, responsible for this relationship, demanded details about a company's finances and business. This "loan documentation" was standardized and well-understood. This detailed information was then used to decide how much money to lend. This bank monitoring and oversight was especially important in times of bad company health:
In the standard account of banks' role in corporate governance, particularly as the borrower's fortunes deteriorate, banks are the muscular superheroes who step in and take charge to right the troubled ship. They might insist that board members resign or that the company bring in a new chief restructuring officer, and if the company does file for bankruptcy they might use their loan agreement and their ability to meter the company's access to cash to dictate the course of the restructuring process (Source: The Promise and Perils of Credit Derivatives, 7-8, link).
CDS default insurance encourages more loans
In the US, Credit Default Swaps (CDSs) and the securitization of home loans (mortgage-backed securities) encouraged banks to make more loans:
In the three decades since Fannie Mae first began purchasing mortgages from banks, and selling interests in portfolios of mortgages, mortgage lending has soared. The ability to sell a mortgage after the bank makes a loan sharply reduces a bank's risk, which encourages banks to make more loans...Because [Credit Default] swaps limit the bank's downside risk (and pass it on to other parties, such as insurance companies and pension funds), banks are willing to lend much more money to many more businesses.
More money available to borrow (credit) was considered a good thing.
More loans with less default risk for banks meant less incentive for banks to monitor and oversee these loans, a bad thing.
CDS default insurance encourages less monitoring and oversight
During the Enron Crisis of 2001-2002 Credit default Swaps protected Enron from getting hurt along with Enron:
JP Morgan Chase, Citigroup, and several other banks lent had billions of dollars to Enron, but they appeared to have provided very little oversight, either while Enron was thought to be healthy or after its fortunes began to deteriorate. There no doubt were many reasons that the banks were missing in action, but surely one of them was credit derivatives. The banks that financed Enron had used massive amounts of credit derivatives to limit their exposure in the event Enron defaulted – by one estimate, they used more than 800 swaps to lay off $8 billion of Enron risk.
This was a good thing according to Fed Chairman Alan Greenspan:
Alan Greenspan and others have argued that credit derivatives served as a shock absorber during the corporate crisis of 2001 and 2002. Because many of the lenders to companies like Enron and WorldCom had hedged their risk, the corporate scandals did not spread to the banking industry. By limiting their exposure, banks averted what could have been a parallel wave of banking failures. These systemic benefits are so important, in Greenspan's view, that Congress should eschew regulation so that the market will remain unfettered and continue to grow.
However, if banks had not been so protected from Enron's failure, banks might have been more actively involved in helping Enron to survive:
The banks would have preferred that Enron survive, even after buying all this protection. After all, a healthy Enron meant the ability to keep making loans to Enron and to continue pocketing the fees. But the prospect of Enron’s decline meant much less to Enron's banks than if their loans were fully exposed
Credit Default Swaps provide a way for speculators to place bets that a firm will fail.
This may actually make it more likely that companies fail.
Kind of like turning off the oxygen on a patient in the critical care ward of a hospital:
In 2004, Tower Automotive, which supplies truck frames to the auto industry, borrowed roughly $580 million under a pair of loans arranged by J.P. Morgan Chase and Morgan Stanley.31 As its financial condition deteriorated, Tower began looking for an additional loan to improve its cash position. The new loan would have required that Tower’s existing lenders free up a portion of their collateral and adjust the terms of their interest payments. J.P. Morgan and the banks that had participated in the earlier loan were willing to make the concessions, on the view that the new loan might enable Tower to avert bankruptcy. The hedge fund participants, on the other hand, would have none of it, which meant no concessions under the existing loans and therefore no new loan. Two months later, Tower filed for Chapter 11.
Credit Default Swaps also magnify systemic risk and may make financial contagions more likely. More on this later.
(Source: The Promise and Perils of Credit Derivatives, 7-8, link)
Vocabulary:
shadow banking industry or system - unregulated non-bank financial institutions that have played an important role in the credit expansion in the US and Europe over the last decade, these institutions include hedge funds, special investment vehicles, and until last week investment banks, they employ money investment vehicles such as structured investment vehicles (SIVs) and collateralised debt obligations (CDOs) and credit derivative instruments that allow them to evade banking regulations, they are blamed for contributing to the 2007 subprime mortgage crisis and helping to transform it into a global credit crunch (See Wikipedia)
a Credit Default Swap (CDS) - a credit default swap - a transfer of credit risk through a derivative instrument, insurance against loan default (See Wikipedia)
flimsy - weak, not strong, falls apart easily
status - an official description that says what category of thing something belongs to
default - fail to pay a lona back on time
In the good old days,... - what happened in the past,...(which was much better than now)
monitoring - check regularly on something to see if everything is going smoothly and there are no problems
oversight, oversee - ensuring that something works well
corporate governance - the setting of high level policy for a corporation by a board of directors
borrower's fortunes deteriorate - the borrower has even more bad luck (making it less likely to stay in business)
right the troubled ship - take a ship that is sinking and leaning to the side and make it stand up and sail again
file for bankruptcy - officially and legally declare that your business cannot continue in operation
filed for Chapter 11 - instead of ending the business and selling off its assets, the business is allowed to reorganize and try doing business again
meter the company's access to cash - control and measure how much cash the company is getting
dictate the course of - determine what happens in a series of events
securitization - bundling many separate assets into one security
mortgage-backed securities (MBS) - an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans (See Wikipedia)
limit the bank's downside risk - limit the risk of losing a lot of money (or even failing)
credit - loans
Enron Crisis of 2001-2002 - a financial scandal involving Enron Corporation and its accounting firm Arthur Andersen that was revealed in late 2001, after a series of revelations involving irregular accounting procedures conducted throughout the 1990s Enron was on the verge of bankruptcy by November of 2001, Enron filed for bankruptcy on December 2, 2001 (See Wikipedia)
missing in action (MIA) - when a soldier goes missing during a war
limit their exposure - limit their risk
a shock absorber - reduce the amount a car jumps when it goes over a bump
hedged their risk - took steps to reduce risk and protect themselves from some danger
averted - avoided, go around (a problem)
a parallel wave of banking failures - another series of bank failures happening at the same time
systemic - affecting the whole system
systemic benefits - benefits for the whole system
systemic risk - risk from the whole system (for example, the whole system fails at the same time)
magnify systemic risk - make risk from the whole system even greater
eschew - avoid doing something
eschew regulation - avoid making rules for something
unfettered - not restricted or bound
critical care ward - the area of a hospital were people in very bad condition who need special treatment and care are kept
