Barry Ritholtz of The Big Picture discusses Credit Default Swaps and why they need to be regulated. For more on derivatives, read my overview here. ~ Ilene
Credit default swaps are insurance products. It’s time we regulated them as such.
By Barry Ritholtz, The Big Picture
Last week, Greece officially defaulted on its debt. (Unofficially, it defaulted long ago.) This formal default on about $100 billion triggered payment of $3 billion in credit-default swaps. These are the non-insurance insurance products that pay off in the event of a default.
Let’s take a closer look at the tortured history of the swaps and see why they should be regulated as commercial insurance policies.
Our story thus far: CDS obtained their favored status as unregulated insurance policies courtesy of the Commodity Futures Modernization Act of 2000. It was sponsored by then-Sen. Phil Gramm (R-Tex.) — and benefited Enron, where his wife, Wendy, was a director on the board. The energy company had discovered the fast profit of trading energy derivatives, which was much easier to achieve without those pesky regulations. Late in the year, the CFMA was rushed through Congress. Passed unanimously in the Senate and overwhelmingly in the House, it was mostly unread by Congress or its staffers. On the advice of then-Treasury secretary Lawrence H. Summers, the bill was signed into law by Bill Clinton.
No one associated with this awful legislation has yet to be rebuked for it. Anyone who actually read this debacle and recommended it should be banned for life from having anything to do with public policy or economics.
Why? The act was a radical deregulation of derivatives. It was an example of the now widely discredited belief that banks and markets could self-regulate without problems. Management would never do anything that put the franchise at risk, and if it did, it would be suitably punished by the shareholders.
It didn’t quite work out that way. Across Wall Street, nearly all senior management involved escaped with their bonuses and stock options intact. Lehman chief executive Dick Fuld lost hundreds of millions of dollars and now must scrape by on the mere $500 million or so he squirreled away.
The act did more than change the way derivatives were regulated. It annihilated all relevant regulations. First, it modified the Commodity Exchange Act of 1936 (CEA) by exempting derivative transactions from all regulations as either “futures” (under the CEA) or “securities” (under federal securities laws). Further, the CFMA specifically exempted credit-defaults swaps and other derivatives from regulation by any state insurance board or regulator.
Hence, the law created a unique class of financial instruments that was neither fish nor fowl: It trades like a financial product but is not a security; it is designed to hedge future prices but is not a futures contract; it pays off in the event of a specific loss-causing event but is not an insurance policy.
Given these enormous exemptions from the usual rules that govern financial products, you can guess what happened with the swaps. A very specific set of economic behaviors emerged: Companies that wrote insurance typically set aside reserves for expected risk of loss and payout. When it came to swaps, the companies that underwrote them had no such obligation.
This had enormous repercussions. The biggest underwriter of default swaps was AIG, the world’s largest insurer. Without that reserve-requirement limitation, it was free to underwrite as many swaps as it could print. And that was just what it did: AIG’s Financial Products unit underwrote more than $3 trillion worth of derivatives, with precisely zero dollars reserved for paying any potential claim.
Keep reading: Credit default swaps are insurance products. It’s time we regulated them as such. – The Washington Post.
