The Bailout -- another perspective (part 2)

In my prior post I talked about why the bailout was probably the best, if still unattractive, solution to the current mess, while noting that the Fed and administration have done a pretty lousy job of explaining what is at stake.  In this post I take up the regulatory issues that naturally flow from the present crisis, particularly the issue of credit default swaps, which I've been following for a while.

During the hearings earlier today, Senator Dodd called the current crisis “entirely foreseeable and preventable, not an act of God."  He is right.

The crisis is complex, but there seems to be general agreement that the root problem was a deadly co-dependence between irresponsible borrows and irresponsible lenders.  While I leave the problem of the borrowers to my colleagues that study them, I will state at the outset that if this bailout is our national moment for "moving on," it seems reasonable that that this should apply to the borrows and lenders equally.  In short, I don't buy Secretary Paulson's suggestion that this is "unlreated."

Turning to the lenders, the part of the problem that is within my jurisdiction, I agree with Christopher Cox, the chairman of the Securities and Exchange Commission,who today called for more regulation of the credit derivatives markets.  While I was willing to give this new market some space while it developed, it is clear that the atomistic nature of the market is at odds with the larger economic good.

Stated bluntly, the industry had its chance and blew it.  Time to consider something new.  More after the jump.

As many Credit Slips readers may already know, credit default swaps (CDS) are basically insurance contracts -- the "protection seller" promises to pay the "protection buyer" a lump sum of money if some other company (GM, Enron, whomever) defaults on its debts.  The idea is to replace the credit risk of a shaky company (GM) with the credit risk of a company with a high credit rating (Lehman Brothers, oh wait . . . ).  The one key difference between CDS and insurance is the possibility to buy CDS protection on a debt you are not exposed to (kind of like buying insurance on a car you don't own).

How do these things relate to the present crisis?  Well, according to its last 10-Q AIG sold more than $440 billion worth of credit protection -- a good bit of which went to European banks who used the protection to hedge the risk of not getting paid on various loans.  If AIG fails, the banks of the world suddenly have to "fess up" to a lot more risk.

In addition, another big chunk of CDS went to hedge CDOs on mortgage obligations (essentially CDOs are what we used to call securitization pools).  Default rates on mortgages are generally low, so what could go wrong . . . (especially if the banks writing the mortgages know they don't have hold them to maturity .  . . ).

I will note that while Chairman Cox identified the potential use of CDS for "naked shorting" as the justification for regulation, I'm a bit skeptical -- unless the shorts planned well in advance, buying protection on many financial firms last week would have been a very expensive proposition.

But there is a real problem here that comes from the lack of transparency in the market:  failure to diversify.  Normally this would not be an issue, because a company that fails to diversify in the CDS market will fail.  But if we don't have a good bankruptcy system for financial firms -- see my prior post for more on that -- and thus some firms know that they will not be allowed to fail, the companies won't have any reason to be risk adverse.  And because there is no obvious limit to the amount of CDS that can be written -- in many recent chapter 11 cases the amount of outstanding CDS was many times the amount of debt issued by the bankrupt company -- the risk that the failure of a single firm will have oversized effects looms large.

All of which cries out for transparency, which the CDS market and ISDA (a trade group for the derivatives industry) have strongly resisted.  Indeed, opacity is said to be a virtue here, because a bank can hedge its customer's loan without offending the customer.  Sorry, but we're several trillion dollars past that point.  Given where we are today it is clear that this opacity foists an external cost on the rest of society -- bail out the markets or suffer the consequences -- such that it cannot be allowed to persist.

Now one would normally expect that AIG's exposure to $440 billion of credit risk would have influenced its credit rating a lot sooner than it did -- but we've been down this road before with the credit rating agencies.  Clearly, the market needs adequate information to make an independent judgment.  As part of the "new era" we need to know what exposure large financial firms have to defaults by particular companies or counterparties.  We also need to know if their exposure is concentrated in particular industries or instruments.  We need to know if a GM default will take out Lehman, but we also need to know that several other large banks will cease to write new loans if Lehman fails.  The State of New York is getting there -- the SEC appears to be stuck on the red herring of short sales.

And while we're at it, do we want to reconsider those pesky new provisions regarding derivatives in the Bankruptcy Code?  Perhaps that's the stuff of another post . . .

Comments

[Patches]

I have read several publications about CDOs and CDSs but your explanation of what they are and their play on the market was the best I have read. A layman such as I can really wrap my brain around your explanation. I have the bankruptcy vocabulary but chapter 11 is still somewhat foreign to me but it seems to me that it would be a difficult task to assign value to credit default swaps and collateralized debt obligations. I mean, no one has ever done a really good job at it so far. Moodys was a part of that wasn’t it? I can’t take Hanks explanation that it’s just like a painting or work of art; you never really know the value until after the auction. Transparency…..

[Mike Dillon]

"I will note that while Chairman Cox identified the potential use of CDS for "naked shorting" as the justification for regulation, I'm a bit skeptical -- unless the shorts planned well in advance, buying protection on many financial firms last week would have been a very expensive proposition."

Professor, I recently came across apparent evidence that mortgage notes - at least one in particular - was sold several times. Nothing wrong so far. The note was apparently sold twice between January and April 2002. The problem lies in that the mortgage associated with the note was discharged in a Chapter 7 in 1999.

If it happened once, I can't imagine that it happened ONLY once in the industry. That being the case, I'd like to briefly address one small aspect of the naked short selling issue as best as I can from a layman's POV.

Servicers, for the most part, are aware of specific loans or CDOs are going to tank - mainly because they can control which ones tank through Mortgage Servicing Fraud. This essentially boils down to the equivalent of "insider trading" and/or some form of market manipulation, however it should be properly worded.

Based on this oversimplified explanation, and knowing how pervasive Mortgage Servicing Fraud really is, would this not help bolster Chairman Cox's position to at least some extent?

[caleb Mardini]

Considering the place for derivatives in bankruptcy code is interesting, thanks for bringing it up.

From what I understand (and tell me if I'm wrong) the buyers and sellers of derivatives had no expectation they would be able to be paid, or in the very least knew the liabilities were so large that they could not be covered.

The participation in the market amounted more to fraud on the part of both parties.

[Jeff Finsley]

If you listen closely to Paulson's testimony he talks about buying MBS and related securities which now includes corporates I believe. The key takeaway is that CDS's will be bought. If the Government buys a cds that promised to pay, the financial firms will keep the bonds and sell the cds's and demand payment. Thievery at every level. AIG's bet on $440 B of CDS's is now backed by the US treasury. Great, the Gov lent them $85B for operations, and the Gov now has the obligation to pay on any of the $440B defaults. Let the mbs's default, collect full value on the MBS and let the Gov have the leftover bones. If Paulson was truly trying to help the citizen, CDS's would not be included.

[Mark]

Last I checked, CDS has not caused one default. If there were a tsunami, earthquake and hurricane all on the same day, AIG would default. Did insurance cause the default or the actual events. AIG defaulted (or needed rescue) because it took risks that turned out bad. Note they were probably good trades at the time, just sometimes things turn out bad. That can and does happen. How did CDS contribute to that?

Couple of additional points.
AIG understood the risks it was taking. Trust me, they are not dumb people.
State regulators knew the risks AIG took.
Federal regulators knew the risks AIG took.
AIG institutional customers (EU banks) who bought protection from AIG, knew the risks they were taking with possible AIG.

[Mark]

One follow up to the above question. If AIG Ins Co. defaults what recourse do I have? Do I have a claim against an insolvent company in court? Or against a pool of seized assets that the government manages? This is meant as a serious question. I have an AIG life policy (US Life sub I think). If that insurance company subsidiary defaults, do I continue making premium payments? Do I, or my kids more likely, have a claim should the unforntuate happen? Does a regulator have to pay that claim, or judge the weight of that claim versus other policy holders?

What is different in a CDS contract? I have potentially bk remote collateral (assuming I was smart enough to ask for it upfront and you believe it is bk remote) and a claim against a pool of assets to be disbursed by a judge instead of a state regulator?

[jeff finsley]

Comments to additional points...
-yes AIG understood the risks and were smart enough to turn profits into increased stock price, they were not concerned with the long term
- I dont trust you. I agree AIG people are not dumb and use their intellingence for their own benefit
-State regulators dont regulate CDS
-Federal regulators dont regulate CDS
-EU banks bought the protection to dress up the assets for the next round of musical chairs, but the music stopped.
-There are no regulations for CDS, hence the problem
You dont hear about the value of CDS causing default because there now does not exist a market for them. ie. people dont buy worthless assets. However Mr. Paulson is going to start a market for them with the bailout bill. This is a one sided trade, and the Gov will be on the hook for the failing assets.

The real insurance business in AIG is OK. Life policies etc, because they are subject to regulations and backed by agencies. Hence this is the valuable part of AIG.

[Mark]

Jeff - Not worth a response but I will throw a few points back.

CDS aren't regulated. I agree. I did not say they were. I said, regulators knew and implied they did nothing. They claim today to be the great saviours yet a cruise ship went by already and they didn't seem to care. Trust me, if NYS insurance commissioner said, "Hey, talk to me about your CDS business", AIG would have shared it. In fact, I would be willing to bet that EVERY insurance company started selling protection AFTER consultation with regulators. No regulators do not have the authority to regulate CDS, but they definitely had and have the influence to be effective.

EU banks bought protection because of favorable accounting treatment and arbitraging their balance sheet. Fairly simple. Theirs, and others, mistake was entering into these trades on AIG's terms, namely no collateral from AIG. Had they received collateral, they would have been far more protected. Banks which provide collateral against the protection they sell are far better and more transparent providers of risk protection. Insurance companies are opaque by comparison. They and some mystery regulator know what is going on, but not their customers.

AIG needed a bailout because their creditors/customers needed it. Lehman's creditors had been demanding and were receiving protection already via collateral. No bailout needed for Lehman. Who ultimately served their customers better, sadly AIG. Thank you Mr Paulson for providing skewed rewards.

AIG's life business is fine because a massive [insert catastrophe/disease here] has not hit [insert major city here] population. Massive- 100k deaths in 10 days. If it does, good luck with your agency paper (which is also crap without the government).