Credit default swaps (CDS's) total $58 trillion in notional value (face value) worldwide and is regulated by…no one; this according to September 23, 2008, testimony given before congress by Christopher Cox, US Securities and Exchange Commission chairman. Cox stated that "swaps" are not defined as securities and are thus not under SEC enforcement. Brenda Wells, Ph.D., CPCU, AAI adds, "CDS's were carefully labeled 'swaps' rather than 'insurance' to avoid regulatory oversight by insurance commissioners." Wells is an associate professor of risk management and insurance at the University of North Texas.
Compounding the problems created by the apparent lack of a responsible regulatory authority is the explosive growth of CDS's. Credit default swap values have grown exponentially, more than quadrupling since 2005. The Bank of International Settlements estimates that at year-end 2005 the worldwide CDS notional value totaled $13.9 trillion; as of September 2008, estimated notional value tops out over $58 trillion; a 414 percent increase in less than three years, making CDS's the world's most widely traded credit derivative product.
To put this in perspective, the United States' gross domestic product (GDP) was $13.8 trillion for 2007. The face value of US-based credit default swaps totaled $15.5 trillion mid-year 2008, nearly $2 trillion more than the prior year's GDP. That's a $2 with 12 zeros behind it ($2,000,000,000,000) difference between the country's 2007 GDP and the face value of US credit default swaps. An estimated 33 percent of these CDS's are based on "sub-prime assets" (not all "sub-prime assets" are from securitized sub-prime mortgages).
Berkshire Hathaway's Warren Buffet labeled credit default swaps as, "financial weapons of mass destruction." However, CDS's have become an important measure of the state of the international economic position.
Mervyn King, Governor of the Bank of England, highlighted the international importance of CDS's in a speech to the CBI, Institute of Directors, Leeds Chamber of Commerce and Yorkshire Forward at the Royal Armouries on October 21, 2008, "Perhaps the single most important diagnostic statistic is the credit default swap premium - an indicator of market concerns about solvency of banks."
Increases in a CDS's premium/fee indicate a deteriorating perception of the credit quality of the asset covered by the CDS; conversely, any decrease in premiums/fees points to a favorable perception of the assets credit quality and rating.
King went on to state that the premiums/fees for credit default swaps guaranteeing the performance of financial institutions in England had been cut in half in the two weeks beginning October 7 and ending October 21, 2008. This dramatic drop in price was seen as an indication that the recapitalization plans instituted by the world economic powers was producing the desired result.
Credit default swaps are also used as a financial benchmark and warning signals in US financial markets. Federal Reserve Chairman Ben Bernanke testified before Congress' Joint Economic Committee on September 24, 2008, that, "The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized - as evidenced, for example, by the high cost of insuring Lehman's debt in the market for credit default swaps - that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures."
The worlds largest (and likely the fastest growing) financial derivative product, used by investment firms, regulators and banks to judge the strength of the national and world economy, is not regulated, to any degree, at the state, national or international levels. As intertwined as are CDS's in the world's economy, at least a nominal level of over site, contract consistency and reserving may be warranted to avoid or lessen the possibility of Buffet's warning becoming reality.
What are Credit Default Swaps?
Credit default swaps have established a stronghold as a major part of the world's economy since their blueprint was laid in the early 1990's; nearly doubling in size every year since 1996. Their use as an economic indicator is evidenced above; but what is a credit default swap?
Wells states, "Essentially it [a CDS] is an insurance policy on debt instruments. When investing in bonds, there are two major risks. The first is that the bond issuer goes bankrupt and doesn't pay you back, which is default risk. The second is that interest rates rise and the bond falls in value, which is interest rate risk.
With a CDS, you are buying insurance against the default risk. The seller of a CDS will pay off bonds you hold if the bond issuer goes bankrupt. So, a CDS is insurance against a speculative risk, which is typically not something insurance was designed to cover."
Credit default swaps are financial hedging devices developed to allow banks and other financial/investment firms to spread the risk of default and continue to safely speculate. Put in insurance terms, it is financial reinsurance with one financial institution guaranteeing another financial institution, protecting it from the financial consequences of a default. One CDS can be sold in multiple transactions to many different financial institutions in successive contracts, each institution promising to protect the previous (retrocessionaires, in a sense) against the default of the original bond selling company (some estimates put the number of these "retrocessions" as high as 10 or 12 different institutions).
This multi-layered scheme sounds convoluted, and it really is. If the underlying bond issuer defaults, Bank "B" (the guarantor counterparty) owes the face amount of the bond to Bank "A" (the buyer of the original bond and the default protection) as per the agreed upon contract (there are two payout methods). However, in this "reinsurance" and "retrocession"-type process, Bank "B" may have sold all are part of the default risk to Bank "C," Bank "C" to Bank "D" and so on. Bank "B" has potentially taken on the greatest exposure because it has to pay the default amount then try to collect from "C" who has to collect from "D." If any bank in the chain fails to pay, the system breaks down.
"And of course, there is no guaranty fund protection or regulatory body to step in and help," states Wells. "This can then set off a chain reaction of defaults that could impact the entire global economy."
Following
Are credit default swaps the next major product to be regulated by state departments of insurance? The next article will first compare credit default swaps against the customary standards of classical insurance; ending with a discussion on how regulation of these derivative products may be difficult at the state level.
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smartest crook was or is. Sounds like a pyramid scheme of biblical proportions.
I am amazed at all the new words we have created to describe phantom balance sheets.
I am curious if anyone knows who was responsible for the precise wording so this instrument was defined in such a way as to be unregulated? Also, what was the motivation for wanting to shun any oversight?
As far back as 1921 when F. Heinemann Wright published his authoritative book "Risk Uncertainty and Profit" it was clear that transfer of this kind of business uncertainty is a lethal step: and as a structural market necessity, it cannot be allowed.
For proof, if any were needed, every time that underwriters have been foolish enough to play around with it they have brought about disaster.
I cannot understand why it has not yet been mentioned in this current crisis, but surely readers must remember the mess made of the UK Insurance Market when it got itself involved with "Mortgage Guarantee" in the late '80's and early '90's. A fatal decision, not recognised as such, regarding an apparently small and harmless line of business led to a meltdown of the whole system; but luckily only the insurance system on that occasion: banking is a whole different ball-game of course.
The forensics are still with us in the shrunken contemporary UK market. Royal and Sun Alliance had to merge to survive it, so did Commercial Union, Norwich Union and General Accident. Many others were seriously harmed by that self-inflicted and up to then uncharacteristically idiotic shot in their own foot. That it wrecked what had been a proud and distinctive industry should have been a salutary and unforgettable warning. But not a bit of it: unbelievably, rather than having remembered, much less learned from this disaster, AIG and Swiss Re amongst many others; and the banks, have carried the flag for it, and carried it on to a far greater disaster: in fact playing their part in the potential downfall of the world financial system.
This unforgivable ignorance of basic insurance principle suggests that all these businesses have been bonkers for some time. They have dismissed fundamental underwriting principle, regardless of the known dangers.How is that possible for a sane banker, let alone a sane insurer? It can only be because too much knowledge would have frustrated some hallucination to which they had become addicted, and apparently we can no longer allow reality to do that: so we have to go through the nightmare afterwards instead as those of unsound mind often have to. That is the extent of their madness as far as I can see, and by the continuing failure of both leaders and regulators to have diagnosed the malady, it is still there firmly in place for post rescue, if there is a post.
"I am curious if anyone knows who was responsible for the precise wording so this instrument was defined in such a way as to be unregulated? Also, what was the motivation for wanting to shun any oversight?"
I need to do more research, but understand that CDS's were deemed exempt from regulation by the Commodity Futures Modernization Act of 2000, signed into law by President Bill Clinton on December 11, 2000. Prior to passage of this legislation, there was concern that credit (and equity) swaps might be ruled invalid because of the Commodity Exchange Act (CEA)which required that all "futures" contracts must be traded on a regulated exchange unless there was some statutory or regulatory exemption. If credit default swaps were found to be subject to the CEA then they could have been unenforceable. What I still don't understand is why they are not regulated by the SEC.