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This story comes to us from the experiences of our American neighbours, but it must be remembered that many products sold in Canada as triple A rated "asset backed commercial paper" were nothing but thinly disguised Credit default swaps where someone like DeutcheBank was using Canadian taxpayer monies as a loss prevention strategy for any losses it experienced on it's sub prime mortgage portfolio. Here, for posterity is as simple an explanation as I have found to show the manner in which adult men will act irresponsibly if it makes them millions........
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Credit default swaps are insurance products. It’s time we regulated them as such.
Posted: 17 Mar 2012 06:00 AM PDT
Barry Ritholtz
Washington Post
March 10 2012
http://www.ritholtz.com/blog/2012/03/cr ... roducts-it’s-time-we-regulated-them-as-such/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29
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Last week, Greece officially defaulted on its debt. (Unofficially, it defaulted long ago.) This formal default on about $100 billion triggered payment of $3 billion in credit-default swaps. These are the non-insurance insurance products that pay off in the event of a default.Let’s take a closer look at the tortured history of the swaps and see why they should be regulated as commercial insurance policies.
Our story thus far: CDS obtained their favored status as unregulated insurance policies courtesy of the Commodity Futures Modernization Act of 2000. It was sponsored by then-Sen. Phil Gramm (R-Tex.) — and benefited Enron, where his wife, Wendy, was a director on the board. The energy company had discovered the fast profit of trading energy derivatives, which was much easier to achieve without those pesky regulations. Late in the year, the CFMA was rushed through Congress. Passed unanimously in the Senate and overwhelmingly in the House, it was mostly unread by Congress or its staffers. On the advice of then-Treasury secretary Lawrence H. Summers, the bill was signed into law by Bill Clinton.
No one associated with this awful legislation has yet to be rebuked for it. Anyone who actually read this debacle and recommended it should be banned for life from having anything to do with public policy or economics.
Why? The act was a radical deregulation of derivatives. It was an example of the now widely discredited belief that banks and markets could self-regulate without problems. Management would never do anything that put the franchise at risk, and if it did, it would be suitably punished by the shareholders.
It didn’t quite work out that way. Across Wall Street, nearly all senior management involved escaped with their bonuses and stock options intact. Lehman chief executive Dick Fuld lost hundreds of millions of dollars and now must scrape by on the mere $500 million or so he squirreled away.
The act did more than change the way derivatives were regulated. It annihilated all relevant regulations. First, it modified the Commodity Exchange Act of 1936 (CEA) by exempting derivative transactions from all regulations as either “futures” (under the CEA) or “securities” (under federal securities laws). Further, the CFMA specifically exempted credit-defaults swaps and other derivatives from regulation by any state insurance board or regulator.
Hence, the law created a unique class of financial instruments that was neither fish nor fowl: It trades like a financial product but is not a security; it is designed to hedge future prices but is not a futures contract; it pays off in the event of a specific loss-causing event but is not an insurance policy.
Given these enormous exemptions from the usual rules that govern financial products, you can guess what happened with the swaps. A very specific set of economic behaviors emerged: Companies that wrote insurance typically set aside reserves for expected risk of loss and payout. When it came to swaps, the companies that underwrote them had no such obligation.
This had enormous repercussions. The biggest underwriter of default swaps was AIG, the world’s largest insurer. Without that reserve-requirement limitation, it was free to underwrite as many swaps as it could print. And that was just what it did: AIG’s Financial Products unit underwrote more than $3 trillion worth of derivatives, with precisely zero dollars reserved for paying any potential claim.
Though this may sound utterly absurd today, circa 2005 it was considered brilliant financial engineering. Consider this quote from Tom Savage, the president of AIG FP: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”
Ahhh, free money — how could that dream ever go wrong?
As it turns out, quite easily. Underwriting swaps was enormously lucrative — so long as you don’t count that unpleasant crashing and burning into insolvency at the end.
Oh, and that massive $185 billion AIG government bailout. Aside from those tiny hiccups, there was some good money to be made.
It was more than just AIG. While the radical deregulation wrought by the CFMA led to AIG’s self-directed collapse, it also helped steer two of the largest securitizers of mortgages — Bear Stearns and Lehman Brothers — into insolvency. Perhaps they were lulled into complacency, believing (wrongly) that they were hedged against losses. The CFMA led to their demise, and it was indirectly responsible for the collapse of Citigroup, Bank of America and Fannie and Freddie. It also was a significant factor in the near-death experiences of Goldman Sachs, Morgan Stanley and quite a few others.
Despite the CFMA’s horrific fatality toll, it has never been overturned. Parts of it were modified by Dodd-Frank regulations, but not the insurance exemptions. Today, these swaps are cleared through exchanges or clearinghouses — but they are still exempt from all insurance regulatory oversight. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement.
Which brings us more or less up to date — and onto more topical issues, such as Greece. Two weeks ago, the International Swaps and Derivatives Association said that “based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”
That is an odd statement about a tradable asset — based on evidence? Typically, an option or futures contract expires, and it either is in or out of the money. Any tradable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year. No interpretation is required. Why on earth would anyone need a committee ruling for a trade?
On Friday, the ISDA committee ruled that Greece formally defaulted. Thank goodness that was cleared up. Had they failed to do so, it would have fatally damaged the swaps market and made sovereign debt financing much more expensive.
What makes this issue so fascinating is not whether Greece has or has not technically defaulted. Rather, it is that there is a committee of conflicted interested parties rendering a verdict on that issue.
Funny, no sort of group declaration is required when a futures contract or an option must settle. No committee decision is required. Which (again) is why credit-default swaps look, sound and act a lot more like insurance than they do other tradable assets.
Why does it matter if swaps are not insurance? In a word, reserves. That is the key difference between insurance and swaps. State insurance regulators actually require reserves from insurers — a lot of reserves — to ensure payments can be made in the event any payable event occurs. The swaps industry does not require reserves. Not even one penny against billions in potential losses.
I think you can see why this matters so much. Swaps are a lot less profitable as an insurance product than they are as a trading vehicle. That is the primary issue that we all should be concerned about. It is exactly how AIG blew itself up. There is nothing that prevents the marketplace from doing it again. We could very well see a repeat unless this gets resolved. Indeed, the odds heavily favor such an event occurring, unless we collectively do something to stop it.
Credit-default swaps are insurance products. It is well past time we regulated them as such.
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http://www.ritholtz.com/blog/2012/03/cr ... roducts-it’s-time-we-regulated-them-as-such/?utm_source=feedburner&utm_medium=email&utm_campaign=Feed%3A+TheBigPicture+%28The+Big+Picture%29
Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture at Ritholtz.com. Twitter @Ritholtz
