Thought of the Day
“Greece – It’s Like Déjà Vu all Over Again”February 26, 2010
Reading the lead article in yesterday’s New York Times on how the situation in Greece was aggravated by the same notorious misuse of credit-default swaps as helped bring down AIG eighteen months ago, one was reminded of the famous Yogi Berra quip: “It’s like déjà vu all over again!” And like magic, amidst the dust of financial chaos appears the ubiquitous Goldman Sachs – first as creator of the mess and then, mop in hand, as saviour.
As I and others have written in the past, the CDS market is an example of financial innovation, not only out of control, but deliberately misused for the benefit of broker and speculator alike. The concept behind credit defaults, as a form of insurance, is perfectly legitimate. They operate on the same principal as house or auto insurance, but with some distinct differences: they are tradable; their value can greatly exceed the nominal value of the asset being insured; they are not subject to insurance regulation. In the New York Times’ article, Nelson Schwartz and Eric Dash quote the head of credit strategy at UniCredit in Munich: “It’s like buying fire insurance on your neighbor’s house – you create an incentive to burn down the house.” In their present form, CDS’s should be ruled illegal.
A buyer or owner of Greek bonds may well decide to purchase insurance (using the credit-default swap market), as long as the coupon minus the cost of the insurance provides a return commensurate with the perception of risk. A glaring problem is that, in this unregulated market, the total amount of insurance written often exceeds the nominal value of the security (securities) insured, thereby allowing speculators to bet aggressively in favor of default. A major difference, however, between Greece and AIG is that, astonishingly, AIG was a writer of the insurance against its own default. Greece does not bear that risk. (Though the EU or the IMF, inadvertently, may.)
In yesterday’s Financial Times, Gary Gensler, Chairman of the Commodity Futures Trading Commission, had a (somewhat self-serving) op-ed piece in which he called for three essential components for reform of the over-the-counter derivative market, rules that already exist in the regulated securities and futures market. But he doesn’t go far enough, as it applies to CDS’s or to non standard derivatives.
Mr. Gensler writes, first, that all financial groups that deal in OTC derivatives should have sufficient capital, post collateral and be subject to regulation. Second, standard OTC derivatives should be required to be traded on an exchange in a transparent manner and, third, the trading of standard OTC derivatives should be required to be brought to a clearing house. But, even tougher standards are needed. Non standard derivatives should be required to be fully disclosed in filings with the SEC, in a transparent manner and not be carried off balance sheet.
Credit-default swaps are insurance. As such, presuming they are permitted to continue, CDS’s should be required to be registered with state or federal insurance regulators; the dollar amount insured should never exceed the value of the underlying asset and pricing should be subject to actuarial rules and subject to review by the appropriate regulator.
If we fail to learn from earlier mistakes, if we continue to permit darkness to shroud derivative transactions, if we permit products that generate enormous profits, but add very little economic value, to risk our financial system, if we allow speculators to drive companies (and perhaps countries) into bankruptcy then we deserve our fate. I hope we have learned, but eighteen months have gone by since those frightening days of September-October 2008, and the White House, focused on cap-and-trade, health care and climate change, has been generally silent on this far more relevant and important issue.