THE BEAR'S LAIR Exploding innovations
By Martin Hutchinson
Eleven of the world's largest investment banks have announced the creation of a
clearing house, to open in September, for the US$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 (CDS) 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.
Little protection
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 trillion to
$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.
Bubbles galore
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.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-07 David W Tice & Associates.)
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