Eleven of the world’s largest investment banks have announced the creation of a clearing house, to open in September, for the $62.3 trillion credit derivatives market. Since it has been patently obvious for several years that such an innovation was essential for the stability of the market, the news is welcome, if a little belated. However $62.3 trillion is real money, so the question arises: how did something so dangerous grow so big before efforts were made to control its risks?
Credit default swaps and other credit derivatives were invented in the late 1980s, shortly after the interest rate and currency swap markets became substantial. Under a CDS, one bank promises to pay another bank money if a particular debt obligation of a third party borrower defaults. The precise definition of “default”, the mechanism for calculating the amount of money payable and the extent to which the deal relates to general debts of the third party or to one particular obligation all vary between CDS, as do the maturity and amount. There is thus no easy mechanism whereby a liquid securities market could be created in CDS, since the differing terms of each transaction tend to make them un-substitutable.
The $62.3 trillion figure for the total principal amount of credit derivatives outstanding is to some extent a “scare” number. Nevertheless, the soothing explanations from market participants that suggest they are simply a mechanism to transfer credit risk to more capable hands come up against an awkward fact: the volume of credit derivatives outstanding is now a substantial multiple of the total volume of loans and bonds to which they relate, and that multiple shows every sign of increasing rather than diminishing. In this as in other derivatives markets, it is obvious that something more than mere “hedging” and risk transfer is occurring.
Comparisons with other markets are telling. The total volume of home mortgages outstanding in 2007 was about $12 trillion, while the total of life insurance in force was $20 trillion. Thus the entire insured population of the United States could be wiped out, and its entire housing stock fall down (a not unlikely contingency for the McMansion portion thereof) and still the losses to mortgage lenders and the insurance industry would be only about half the overall losses from a credit derivatives meltdown.
Proponents of credit derivatives will indignantly point out that the aggregate exposure in the credit derivatives market adds to zero, so that for every contract there is a winner and a loser. Either the debt pays when due, in which case the seller of credit protection gains, or it defaults, in which case the buyer gains. However that is also true of life insurance; either the assured party lives through the term of the insurance, in which case the insurance company wins, or he dies, in which case the assured party wins, or rather his heirs do.
In the insurance case, mass slaughter would wipe out the insurance industry, because the gainers would be individuals not insurance companies. However that is also true for credit derivatives; the gains and losses are not confined to the “banking system” however that amorphous entity is defined, but are spread among insurance companies, hedge funds, investment institutions and well connected riff-raff. Even financial institutions may fail, as did Bear Stearns, for whom the network of credit derivatives obligations was so threatening that the Fed was compelled to step in and arrange a bailout. If the financial institutions don’t initially fail, their counterparties may fail in large numbers, plunging the system into disaster.
At first sight, the contingent nature of credit derivative exposure appears to offer protection, but in practice it offers little. Although losses on credit derivatives only occur when an underlying loan defaults, and the modest hiccups of normal years can thus easily be absorbed, in a credit crunch such losses will be bunched. In such a situation the credit system is already under strain. If several underlying companies fail, financial institutions will be placed in a precarious position at a time when funding is hard to come by. Then a cascade effect would take place, with each default making other defaults more likely.
Thus in a severe credit crisis, the potential losses on credit derivatives may indeed approach the same fraction of total exposure that the $1-1.5 trillion of potential home mortgage losses bears to the $12 billion of home mortgages outstanding. The ultimate loss would then be not 10% of $12 trillion, but 10% of $62.3 trillion or $6.23 trillion, several times the capital base of the entire US banking system, more than the current total of Federal government debt outstanding and about 40% of a year’s US Gross Domestic Product. That would make a credit derivatives crash far larger in monetary terms and somewhat larger in terms of the economy than the Japanese banking problems of the 1990s, which caused 13 years of recession in that country.
The new clearing house will help this situation, but only if most currently outstanding credit derivatives are transferred to it. The credit derivatives market is not something that might become a problem going forward; it is already a gigantic problem that needs to be addressed in terms of the business already done. In any case, the clearing house is not a panacea; in a truly deep credit disruption it would go under along with most market participants. If a company with $10 billion of debts fails, there may well be credit derivatives outstanding relating to its debt of $100 billion. Thus while a clearing house will solve the problem of the bankruptcy of an individual participant such as a hedge fund, it is only too likely to be overwhelmed by a systemic problem.
In the Bear Stearns case, the existence of a credit derivatives clearing house would have allowed Bear Stearns to be pushed into bankruptcy, and its counterparties would have been able to continue dealing with the clearing house instead of being subject to severe uncertainty. If credit conditions among Bear Stearns’ clientele remained satisfactory, that would have been the end of the matter; the clearing house would have borne any modest losses involved, less what it could recover from the corpse of Bear Stearns. However if after a clearing house-assisted Bear Stearns bankruptcy a substantial portion of credits underlying Bear Stearns’ credit derivatives fell into default, the clearing house would very probably follow Bear Stearns into collapse, precipitating an implosion of the entire $62.3 trillion market.
It is clear what has led to the tottering and bloated nature of the credit derivatives market: the perverse incentives of Wall Street. Senior traders are rewarded with “drop dead money” – amounts that enable them to leave the business at any time, financially secure for life, with only the distant threat of long-term imprisonment to deter them. Since the financial services industry also works excessive hours, allowing little time for reflection and intellectual stimulation, a high proportion of its inmates become possessed with a monomaniacal urge to accumulate the cherished “drop dead money.”
The obvious way to do this is to find some product area in which profits can be accumulated with great rapidity in the short term albeit with the risk of enormous losses in the long term. Complex and poorly understood products, for which the accounting can be rigged to maximize current profits and push losses into the future, are particularly attractive. Credit derivatives, for which the appropriate accrual of reserves against loss is little if at all understood, have provided an ideally attractive field of endeavor for such machinations.
Once the credit derivatives problem is defined in this way, there is an obvious historical analogy: the life insurance market. Like credit derivatives, life insurance provides cash flow in the form of premiums in its early years, while losses in the form of deaths occur only later, often decades later. Like credit derivatives, the proper reserving for such losses was initially poorly understood, so life insurance companies with aggressive salesmen and low premiums could record excellent profits, and raise additional capital on the basis of those profits. The tsunami of new business and apparent surge in profitability enabled rewards to be paid to such companies’ proprietors, who were thus acting economically rationally in the same way as today’s credit derivatives traders.
The first large insurance bubble occurred over the generation leading up to the South Sea crash of 1720, after which almost all existing insurance companies went under. Similar bubbles occurred in New York and other US jurisdictions throughout the nineteenth century. Gradually it became obvious that life insurance companies should not be allowed to scam investors and policyholders in this way, and regulations were introduced – the first by the Life Assurance Act of 1774 — to ensure the actuarial soundness of insurance companies, and prevent their looting by proprietors.
The analogy between the credit derivatives market and pre-1720 life insurance is a close one, even if it is difficult to imagine credit derivatives traders taking to periwigs and snuff and decamping to Antwerp rather than Brazil when things go wrong. It also suggests a solution to the problem: the Fed can make itself useful by regulating the market tightly, in particular by requiring the establishment of large reserves against each credit derivatives transaction, to be held in escrow and not paid out until the credit concerned has been repaid. Naturally, this will cramp the future growth of the credit derivatives market, but on balance that can only be a blessing.
Preventing future such casinos from growing to a size that endangers the entire financial system is more difficult. Part of the solution will come from much tighter money, reducing the immense pools of leveraged speculative capital that have disfigured the global economy in the last decade. Part of it could probably be achieved by tighter regulation of Wall Street’s compensation schemes. While government regulation of earnings is in principle unattractive, it would certainly make sense for both overall caps and limitations on short term profit-related payouts to be introduced for institutions that were deemed “too big to fail” and thus ultimately risks on the taxpayer.
Such restrictions would have the salutary effect of driving the best talent away from very large institutions and towards medium sized ones, whether hedge funds or “merchant banks.” That in turn would ensue that new innovations remained of moderate size while their long term viability remained untested, since counterparties would not risk gigantic potential liabilities against houses of only moderate size. If the new houses could be constructed as partnerships, so managers had primarily their own money at risk, so much the better.
Even in the financial services industry, innovation is welcome. Nevertheless, the perverse incentives of today’s Wall Street and the implicit state guarantee of the largest houses have together combine to produce in the credit derivatives market a nexus of liabilities that serves little comprehensible economic purpose and would wreck the global economy if it collapsed. Free markets are economically optimal, but partially free markets, with endless creation of fiat money and implicit government guarantees of the big boys, can produce perverse and dangerous results.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)