The term “Credit Default Swap (CDS)” is not a household term. Politicians almost never mention it. I have never heard it explained on Good Morning America, or even on the Jim Lehrer News Hour. Unrecognized by the public, the unregulated CDS market has grown huge, and threatens the stability of the entire capitalist system. The AIG CDS inventory is one of the core reasons that the U.S. government felt obliged to take over AIG and extend $85B in Federal Reserve loan guarantees. AIG had a CDS inventory with a notional value of over $400 Billion. That was too large an amount for the U.S government to let unravel in a chaotic bankruptcy. Yet that amount is small compared to the total CDS market.
To be more specific, under the Bush Administration laissez faire policy toward the financial industry, the notional value of the Credit Default Swap market has grown from approximately $900 Billion at the end of the year 2000 to a total of $62.2 trillion at the end of 2007 (according to the International Swaps and Derivatives Association). That is more than four times the U.S. Gross Domestic Product and larger than the entire world stock market.[i]
Credit Default Swaps are derivative instruments intended to insure losses to banks and bondholders when companies fail to pay their debts. A CDS is a private contract between two parties, in which the buyer of protection agrees to pay the seller premiums over a set period of time; the seller pays only if a particular credit crisis occurs, like a default or a government takeover. A CDS can be sold, on either end of the contract, by the insurer or the insured.
There is no standard form for these contracts, they are not regulated, and the market is so large that even sophisticated computer accounting systems have trouble keeping track of who the counterparties are. During the credit market upheaval in August 2007, 14 percent of trades in these contracts were unconfirmed, meaning one of the parties to the resale transaction was unidentified in trade documents and remained unknown 30 days later. In December, that number stood at 13 percent. Because these trades are unregulated, there is no requirement that all parties to a contract be told when it is sold. In general, there is a risk that if a one counterparty tries to collect on a CDS obligation, it may be difficult to determine who owes the payment due (i.e., who the other counterparty is). Furthermore, because there is no public market for these derivatives, it is difficult to determine what their value is at any point in time (e.g., at the end of the accounting quarter). That is why the market size is described using the term “notional value”.
There was a precursor to this week’s problems that led to the AIG bailout. In the first week of February 2008, AIG said that it had incorrectly valued some of the swaps it had written and that sharp declines in some CDS’s had resulted in $3.6 billion more in losses than the company had previously estimated.[ii] This week, the U.S. Treasury and the Federal Reserve clearly worried that a disorderly AIG bankruptcy could result in a chain reaction of losses at financial institutions, creating a liquidity crisis that would plunge the country into a severe recession.
There are no legal reporting requirements, although the Federal Reserve Bank of New York has urged financial institutions to inform other counterparties of a change of ownership. There is a risk that some entity E could purchased a CDS from insuring counterparty A (e.g. J.P Morgan Chase) insuring against a default on a bond bought from party B (e.g., Washington Mutual) and may not be informed that the insuring counterparty sold the CDS liability to counterparty C (e.g. AIG). If counterparty C (e.g., AIG) goes bankrupt, followed some time later by party B’s default, the insured counterparty E would have difficulty collecting what it was owed on the CDS, and might not have known that it should have been on the list of creditors involved in counterparty C’s bankruptcy proceedings.
This example is not trivial. Barclays analysts estimated in February that if a financial institution that had $2 trillion in credit-default swap trades outstanding were to fail, it might trigger between $36 billion and $47 billion in losses for those that traded with the firm. That doesn’t include the market-value losses investors face as the cost to protect companies against a default widens.[iii] So, assuming linearity, the bankruptcy of AIG could have resulted in between $7 billion and $10 billion in losses for its counterparties. Since investment banks are often leveraged at 20 to 1 or higher, the asset sales necessary to maintain a leverage of 20 to 1 could have been of the order of $140 billion to $200 billion.
Large commercial banks (e.g. JP Morgan Chase and Bank of America) use CDS as part of their risk management. However, many speculators, including hedge funds, use these instruments to bet on a company failure easily. Before the insurance was developed, such a bet would require selling short a corporation’s bond and going into the market to borrow it to supply to the buyer. In times of market turbulence, such as we have seen recently, undercapitalized participants could have trouble paying their obligations. This perceived threat adds to the instability and lack of liquidity in the financial markets.
There are many cases of more CDS contracts being written than there are bonds to insure. If the bond issuer defaults, there will be a scramble of insured parties to find bonds to deliver to the insurer counterparty, in order to collect. There have been bankruptcy cases in which the holder of naked CDS contracts received a fraction of the bond value. If the naked CDS was valued on the insured counterparty’s books at the face value of the bond, there could be a large problem if the insured counterparty is highly leveraged and needs to raise capital as a result of an accounting loss. This problem was well described by Gretchen Morgenson in the New York Times on February 17, 2008 .
The policy implications are clear. The U.S. government needs to regulate derivative markets such as the CDS market. There needs to be a centralized CDS clearinghouse, privately managed by the financial industry, but regulated. The CDS clearinghouse would provide a standardized CDS contract with rules for reporting counterparties to a transaction, price, and settlement terms. All CDS transactions would be required to be made through the CDS clearinghouse, so that counterparties would be known, minimum capital requirements could be established and enforced, and CDS value could be determined for mark-to-market accounting rules.
What is the appropriate regulatory agency? Not the toothless Commodity Futures Trading Commission (CFTC)! Not the Federal Reserve, which is already overloaded in dealing with monetary policy formulation and implementation, as well as ongoing financial crisis management. Legislation is needed to establish a streamlined framework for regulating the equity, debt, commodity and derivatives markets. The functions of the SEC and CFTC, as well as functions undertaken by the Fed and the Treasury on an ad hoc basis, should be transferred to this new regulatory agency.
The regulatory principles needed to underpin this new regulatory authority, as well as the details of the legislation to establish it, are yet to be decided. The International Swaps and Derivatives Association will probably oppose this recommendation. However, the collapse of Lehman and the nationalization of AIG have provided impetus to the establishment of a clearinghouse for credit derivatives.[iv] Let the debate begin.