Barry Ritholz wigs out - understandably - about Credit Default Swaps, and how they should
not be treated as Yet Another Tradeable Asset, but should instead be regulated as insurance products.
Whats the difference?
A
Tradeable Asset, usually, doesnt require you to reserve any money against future claims - I sold you the apple, you bought the apple and that is that.
Insurance products, by definition,
do require you to reserve money - you're basically betting against an event happening, but you need to reserve
some money in the off-chance that it does occur and you need to shell out cash.
But, thanks to Phil Gramm (responsible for almost as much financial chaos as Greenspan), CDS are now treated as Tradeable assets. Take it away Barry...
Our story thus far: The Commodity Futures Modernization Act of 2000, sponsored by Texas Senator Phil Gramm as a favor to his wife Wendy (who sat on the Board of Directors of Enron, which wanted to trade energy derivatives without oversight) was rushed through Congress in 2000. Unread by Congress or their staffers, it was signed into law by President Bill Clinton on the advice of his Treasury Secretary Lawrence Summers.
The CFMA radically deregulated derivatives. The law changed the Commodity Exchange Act of 1936 (CEA) to exempt derivatives transactions from regulations as either “futures” (under the CEA) or “securities” under federal securities laws. Further, the CFMA specifically exempted Credit Defaults Swaps and other derivative products from regulation by any State Insurance Board or Regulators.
This rule change exempting CDS from insurance oversight led to a very specific economic behavioral change: Companies that wrote insurance had to explicitly reserve for expected losses and eventual payout in a conservative manner. Companies that wrote Credit Defaults Swaps did not.
Hence, AIG was able to underwrite over THREE TRILLION DOLLARS worth of derivatives, reserving precisely zero dollars agianst potential claims. This was enormously lucrative, except for that whole crashing & burning into insolvency thingie.
The radical deregulation the CFMA generated led directly to the collapse of AIG, Bear Stearns and Lehman Brothers; indirectly to the collapse of Citigroup, Bank of America, and Fannie/Freddie. It was a significant factor in the near death experiences of Goldman, Morgan Stanley and others.
Despite this horrific impact this legislation had, it was never actually overturned, only modified. Obama made the personnel error of bringing back Larry Summers (he apparently had not wrought enough damage to the nation yet). Rather than admit the error of CFMA, and overturn it, Summers instead downplayed its role. CFMA was not overturned, but rather modified. Swaps now must be be cleared through exchanges or clearinghouses — but they are still exempt from Insurance regulations. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement. Counter-parties may or may not demand one, but the dollar amount is negotiable.
Phil Gramm - because every story needs a villain, and some people are just
begging for the role.
Theres more - go read it...
Comments