Shuffle - Peter J. Wallison
After the failure of Bear Stearns, Lehman Brothers, and A.I.G. had signaled the global financial meltdown, Securities and Exchange Commission chairman Christopher Cox was quoted in the Washington Post as telling an S.E.C. roundtable:
The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis . . . and requires immediate legislative action. . . . The over-the-counter credit-default swaps market has drawn the world's major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. (O'Harrow and Dennis 2008)
The chairman's statement is puzzling for reasons both abstract and concrete.
First, it is in the nature of credit markets to be interconnected: That is the way money moves from where it is less useful to where it is more useful, and it is why financial institutions are called "intermediaries."
Second, a credit-default swap (CDS) is, loosely speaking, a form of insurance: The seller of a CDS protects against loss the loans the buyer of a CDS holds. Far from being destabilizing, a CDS simply transfers risk.
Third, there is very little evidence that the failed financial institutions were the victims of their participation in credit-default swaps, or that their failure jeopardized their swap counterparties and, thus, the global financial system.
Credit-Default Swaps in the Panic of 2008
Had the Treasury Department and the Federal Reserve really believed that Bear Stearns had to be rescued because the market was interconnected through credit-default swaps, they would never have allowed the failure of Lehman, which was a much bigger player in credit-default swaps than Bear. Moreover, while Lehman was a major dealer in credit default swaps--and a borrower on which many credit-default swaps had been written--when it failed, there was no discernible effect on its swap counterparties.
Within a month after its bankruptcy, the swaps in which Lehman was an intermediary dealer had been settled bilaterally, and the swaps written on Lehman itself ($72 billion, notionally) were settled by the Depository Trust and Clearing Corporation (D.T.C.C.). The settlement was completed without incident, with a total cash exchange among all counterparties of $5.2 billion. There is no indication that the Lehman failure caused any systemic risk arising out of its CDS obligations--either as one of the major CDS dealers, or as a failed company on which $72 billion in notional credit-default swaps had been written.
The fact that A.I.G. was rescued almost immediately after Lehman's failure led once again to speculation that A.I.G. had written a lot of CDS protection on Lehman, and had to be bailed out for that reason. When the D.T.C.C.'s Lehman settlement was completed, however, A.I.G. had to pay only $6.2 million on its Lehman exposure--a rounding error for this huge company. A.I.G.'s failure was not due not to its exposure to Lehman through credit-default swaps, but to its use of a credit model that did not account for all the risks it was taking (O'Harrow and Dennis 2008).
The collapse of A.I.G., then, had nothing to do with credit-default swaps per se. The cause was the same as with the collapse of the financial system as a whole: the faulty evaluation of the risks of residential mortgage-backed securities (RMBSs) that contained subprime loans. Apparently, A.I.G.'s credit-risk model failed adequately to account for the risks of subprime RMBSs; for a sharp decline in the mortgage market; and for a downgrade in A.I.G.'s credit rating, as a result of the first two failures. Initially, the counterparties in A.I.G.'s credit-default swaps generally agreed that A.I.G. did not have to post collateral, because its debt was rated AAA. When it was downgraded by the rating agencies, it was immediately required by its CDS agreements to post collateral. In addition, since A.I.G. had written a great deal of protection on RMBS portfolios, as these declined in value, A.I.G. was again required by its counterparties to post collateral to cover its increased exposure. When A.I.G. could not do so, it was threatened with bankruptcy, and that is when the Fed stepped in with a rescue.
This narrative highlights a fact that gets too little attention in the discussion of credit-default swaps: that the best analogy for a CDS is an ordinary commercial loan. The seller of a CDS is taking on virtually the same risk exposure as a lender. It is no more mysterious than that.
Successful lending requires expertise in assessing credit--the same skill required for writing CDS protection. A.I.G., like many banks, misjudged the riskiness of portfolios of securitized subprime mortgages, and therefore sold insurance on them through credit-default swaps. These swaps were no riskier than the loans contained in the portfolios; if A.I.G., instead of selling protection on the portfolios, had bought the portfolios themselves, commentators would have merely clucked about the company's poor credit judgment. For some reason, the fact that it did substantially the same thing by selling protection on these securities through credit-default swaps has caused hysteria about the swaps that insured the securities. Regardless of how it was insured, however, the real risk was created when banks borrowed the funds necessary to assemble a portfolio of subprime mortgage-backed securities. The fact that A.I.G. was the final counterparty and suffered the loss means that someone else did not. Ultimately, there is only one real risk, represented by the original loan or purchase transaction (in the case of an asset like an RMBS portfolio). Credit-default swaps merely transfer that risk, for a price, to someone else.
Credit was extended unwisely (at least in retrospect)--there is no doubt about that. The question is, Why? The answer is unlikely to relate to the vehicles in which the credit was packaged after it was issued--or the CDSs that were purchased as insurance. Credit-default swaps were that insurance. There is no analytical difference between issuing a residential mortgage (or buying a portfolio of RMBS) and writing protection on any of these assets through a CDS. Faulty credit evaluation will, in either case, result in losses. If we wanted to prevent losses that come from faulty credit analysis, we would have to prohibit lending.
If credit-default swaps did not trigger the rescue of Bear Stearns and A.I.G., what did? The most plausible explanation is that in March 2008, when Bear was about to fail, the international financial markets were very fragile. There was substantial doubt among investors and counterparties about the liquidity and even the solvency of many of the world's major financial institutions. It is likely that Treasury and Fed officials believed that if a major player like Bear Stearns were allowed to fail, there would be runs on other institutions. As Fed chairman Ben Bernanke said at the time, "Under more robust conditions, we might have come to a different decision about Bear Stearns."
When the markets are in panic mode, every investor and counterparty is on a hair-trigger alert, because the first one out the door is likely to be repaid in full, while the latecomers will suffer losses. The failure of a large bank like Bear in that frenzied environment can be responsible for a rush to the exits; in a normal market, there would have been a much more muted reaction. For example, when Drexel Burnham Lambert failed in 1990, there was nothing like the worldwide shock that ensued after Lehman Brothers' collapse, although Drexel was as large a factor in the market at that time as Lehman was before its failure.
The Lehman bankruptcy demonstrates what Bernanke feared would happen if he did not rescue Bear Stearns. When Lehman was allowed to fail, the markets froze, overnight interbank-lending spreads went straight north, and banks stopped lending to one another. In these circumstances, the rescue of A.I.G. was inevitable. If the reaction to the Lehman failure had not been so severe, it is likely that A.I.G. would have been allowed to fail. In the Fed's words, "in current circumstances, a disorderly failure of A.I.G. could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance" (quoted in O'Harrow and Dennis 2008).
How Credit-Default Swaps Work
Figure 1 shows a series of simple CDS transactions. Bank B has bought a $10 million bond from company A, which in CDS parlance is known as the "reference entity." B now has exposure to A. If B does not want to keep this risk--perhaps B believes that A's prospects are declining, or perhaps it wants to diversify its assets--it has two choices: sell the bond or transfer the credit risk. For a variety of tax and other reasons, B may not want to sell the bond. But it is able to eliminate most or all of the credit risk of keeping the bond by entering a CDS.
A CDS is nothing more than a contract in which one party (the protection seller) agrees to reimburse another party (the protection buyer) against default on a financial obligation by a third party (the reference entity). In Figure 1, the reference entity is A, the protection buyer is B, and the protection seller is C.
The CDS market is a dealer market, so transactions take place over the counter rather than on an exchange. Accordingly, in purchasing protection against A's default, B's swap is with C, a dealer--one of many, including the world's leading banks, that operate in this market.
Although Figure 1 shows B purchasing protection against its entire $10 million loan to A, it is important to note that B also could have purchased protection for only a portion of the principal amount of the $10 million bond. The amount of protection that B purchases is called the "notional amount."
Thus, C, the dealer, agrees to pay $10 million (or whatever notional amount the parties negotiate) if A defaults, and B agrees to make an ongoing premium payment (usually paid quarterly) to C. The size of this premium will reflect the risk that C believes it is assuming in protecting B against A's default. If A is a good credit risk, the premium will be small.
Under the typical CDS contract, B is entitled to request collateral from C in order to assure C's performance. As a dealer, C generally aims to keep a matched book. For every risk it takes on, C typically acquires an offsetting hedge. So C enters a CDS with D, and D posts collateral.
Sixty-three percent of all credit-default swaps--and 65 percent of the dollar exposure--are collateralized, precisely because the parties that are paying for protection want to make sure it is there when they need it (Gibson 2007).
The transfer of B's risk to C and then to D (and occasionally from D to E and so on) is often described by CDS critics as a "daisy chain" of obligations, but this description is misleading. Each transaction between counterparties in Figure 1 is separate. B can look only to C if A defaults, and C must look to D. B will not usually deal directly with E. However, there are now services, such as those of a firm called Trioptima, that are engaged in "compressing" this string of transactions so that the intermediate obligations are "torn up." This reduces existing interparty obligations and counterparty risk.
Does this hypothetical string of transactions create any significant new risks--beyond the risk created when B made its loan to A?
In the transaction outlined in Figure 1, each of the parties in the chain has two distinct risks in case of a default: Namely, that its counterparty will be unable to perform its obligation either before or after the default.
If C becomes bankrupt before A defaults, B will have to find a new protection seller. If C defaults after
A defaults, B will lose the protection that it sought from the swap. The same is true for C and D if their respective counterparties default.
In the CDS market, premiums are negotiated based on current views of the risk of A's default. Accordingly, the premium for new CDS coverage against A's default could be more costly for B, C, and D than the premium that was initially negotiated. Although this might mean a potential loss to any of these parties, it is likely--if the risk of a default by A has been increasing--that the seller of protection will have posted collateral, so that each buyer will be able to reimburse itself for the additional premium cost for a new CDS.
It is important at this point to understand how the collateral process works. Either the buyer or the seller in a CDS transaction may be "in the money" at any point. That is, the CDS premium--also known as the spread--may be rising or falling, depending on the market's judgment of the reference entity's credit worthiness. At the moment the CDS transaction was entered into, the buyer and seller were even. But if the credit of the reference entity begins to decline, the CDS spread will rise, and at that point the buyer is in the money: It is paying a lower premium than the risk would now seem to warrant. Depending on the terms of the original agreement, the seller then may have to post collateral--or more collateral than originally agreed upon. But if the reference entity's credit improves, then the CDS spread will fall and now the seller is in the money. In this case, the buyer may have to put up collateral to ensure that it will continue to make the premium payments.
What happens if A defaults? Assuming that there are no other defaults among the parties in Figure 1, there is a settlement among them in which E is the ultimate obligor. Conceptually, C has paid B, D has paid C, and E has paid D. But if E defaults, D becomes the ultimate payer, and if D defaults, C ends up holding the bag. Of course, D then would have a claim against E, or E's bankrupt estate; and the same holds for C if D defaults.
Do Credit-Default Swaps Pose Systemic Risks?
Critics of credit-default swaps argue that the interconnections they create might lead to systemic risk as each member of the string of transactions defaults because of the new liability it must assume. But this analysis is superficial. If credit-default swaps did not exist, B would suffer the loss associated with A's default, and there is no reason to believe that the loss would stop with B. B is undoubtedly indebted to others, and its loss on the loan to A might cause B to default on these obligations, just as E's default might have caused D to default on its obligations to C.
In other words, the credit markets are already interconnected. That is their very purpose. With or without credit-default swaps, the failure of a large enough participant can--at least theoretically--send a cascade of losses through a highly interconnected structure. Credit-default swaps simply move the risk of that result from B to C, D, or E. They do not, however, materially increase the risk created when B made its loan to A. No matter how many defaults occur in the series of transactions presented in Figure 1, there is still only one $10 million loss. The only question is who ultimately pays it.
If anything, credit-default swaps reduce systemic risk.
Financial regulators have few tools that will materially reduce risk taking. They can insist on more capital, which provides a cushion against losses. They can clamp down on innovation, which can always be a source of uncertainty and therefore risk. But beyond that, they are limited to ensuring that banks, securities firms, and insurance companies--to the extent that they are regulated for safety and soundness--carefully review the risks they are taking and document the process of review.
We have no reason to think that regulators' second-guessing of these risks will be any more insightful into actual creditworthiness than the judgments of those who are making the loans. The current crisis is testimony to that fact. Despite the most comprehensive regulatory oversight of any industry, the banking sector was riddled with bad investments and the resulting losses.
In fact, by creating moral hazard, it is likely that the regulation of banks has reduced the private-sector scrutiny that banks would have received as part of a fully operating system of market discipline. In light of the consistent failure of traditional regulation, the risk-management innovations that have been fostered by the private sector may have a greater potential to control risk than does government oversight.
An outstanding example is the interest-rate swap, which--like the CDS--was developed by financial intermediaries looking for ways to manage risk.
Say that a bank has deposits on which it must pay a market or "floating" rate of interest, but it also holds mortgages on which it receives only a fixed monthly interest payment. This is a typical position for a bank--but a risky one. If interest rates rise, it may be forced to pay more interest to its depositors than it is receiving from the mortgages it holds, and thus would suffer losses.
Ideally, this bank would want to trade the fixed rate it receives on its mortgage portfolio for a floating rate that will more closely match what it pays its depositors. That way, it is protected against increases in interest rates. An interest swap, in which the bank pays a fixed rate to a counterparty and receives a floating rate in return, is the answer; it matches the bank's interest rate receipts to its payment obligations.
Who else might want to engage in such a swap?
Consider an insurance company that is obliged to pay out a certain sum monthly on the fixed-rate annuities it has written. Insurance companies try to match this obligation with bonds and notes that are the ultimate source of the funds for meeting their fixed obligations, but these do not necessarily yield a fixed return for periods long enough to fully fund their annuity commitments. They mature well before the annuity obligations expire, and may--if interest rates decline--yield less than is needed for paying annuitants.
The insurance company, then, would be able to avoid risk with a swap that is the mirror image of what the bank needs.
Into this picture steps a swap dealer, who arranges a fixed-for-floating interest-rate swap between the bank and insurance company. The notional amount can be set at any number; its purpose in an interest-rate swap is simply to provide the principal amount on which the interest will be paid. Suppose the parties agree on $100 million. The bank agrees to pay the insurance company a fixed amount--say, 5 percent--on $100 million, and the insurance company agrees to pay the bank a floating rate of interest on the same notional amount. If interest rates rise to 6 percent, the bank is in the money and the insurance company pays the bank the 1 percent difference; if rates fall to 4 percent, the bank pays the insurance company 1 percent.
The important thing to notice is that both the bank and the insurance company have reduced their risks. The bank now gets a floating payment that assures it of the funds necessary to pay its depositors, no matter how high interest rates rise. The insurance company is better off because it gets a fixed payment from the bank that allows it to pay its annuitants no matter how far interest rates fall. Overall risk has declined. This is the only feasible way to reduce systemic risk.
The Notion of Notional Amounts
Shortly after Bear Stearns was rescued, George Soros (2008) wrote:
There is an esoteric financial instrument called credit-default swaps. The notional amount of CDS contracts outstanding is roughly $45 [trillion]. . . . To put it into perspective, this is about equal to half the total U.S. household wealth.
This is not putting credit-default swaps "into perspective." "The notional amount of credit-default swaps outstanding"--although suitable for scaring people, because it is so large--is not in any sense relevant to the size of the risks associated with credit-default swaps.
Returning again to the hypothetical transaction in Figure 1, we can calculate the notional amount that comes out of the reporting of the transaction by the various participants. B reports that it is paying a premium for protection on a notional amount of $10 million (the loan to A), C reports that it has sold protection for this amount, as have D, and E, and the dealer intermediary between D and E. Thus, the total notional amount arising from this series of transactions is $50 million, or five times the actual potential loss in the event that A defaults. The same risk has been counted five times because, under different scenarios, B, C, D, E, or the intermediary between D and E will cover A's default.
The Depository Trust and Clearing Corporation recently began publishing data on credit-default swaps from its Trade Information Warehouse, which gathers information about 90 percent of all CDS transactions (Rogoff and Anderson 2008). The D.T.C.C.'s data eliminate the multiple counting in each swap transaction and report that as of the week ending December 12, 2008, the "gross notional amount" of credit default swaps outstanding was $25.6 trillion--about half of Soros's figure, $45 trillion.
Even $25.6 trillion, however, vastly overstates the real potential loss on all credit-default swaps outstanding, because the protection sold must be reduced by the protection bought. When this fact is taken into account, the result, the "net notional amount," has been estimated at 10 percent of the gross notional amount (Rogoff and Anderson 2008). Accordingly, the net notional amount is actually about 5 percent of the figure Soros used.
That is still a lot of money, of course, but it does not threaten to overwhelm the economy, as Soros would have it.
The most troubling aspect of credit-default swaps is not their financial effects, which are to move and, at best, to reduce risk. It is their political effects. They are sufficiently complex that, like "speculation" in general, they can become political piñatas, and divert scrutiny from the actual causes of problems such as the financial calamity that began in 2008.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.
1. The term "insurance" is used here in its broadest sense, as protection against loss. Credit-default swaps are not insurance in the strict sense--the service provided by insurers of life and property. Insurance of that kind is an actuarial, not a credit activity, and depends on an understanding of the likelihood that losses will occur to similar pooled risks, not to a specific insured party.
2. Editorial, "Bear's Market," Wall Street Journal, 4 April 2008.
3. An excellent discussion of the role of credit-default swaps appears in Mengle 2007.
4. Depository Trust and Clearing Corporation, "Trade Information Warehouse Data," week ending 12 December 2008. www.dtcc.com/products/derivserv/data_table_i.php
Gibson, Michael S. 2007. "Credit Derivatives and Risk Management." Finance and Economics Discussion Series 2007-47, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board of Governors, 22 May. www.federalreserve.gov/pubs/feds/2007/200747/200747pap.pdf
Mengle, David. 2007. "Credit Derivatives: An Overview." Paper presented at Financial Markets Conference, Federal Reserve Bank of Atlanta, 15 May. www.frbatlanta.org/news/conferen/07fmc/07FMC_mengle.pdf
O'Harrow, Jr., Robert, and Brady Dennis. 2008. "Downgrades and Downfall." Washington Post, 31 December.
Rogoff, Bradley, and Michael Anderson. 2008. "DTCC Data Show Corporate CDS Fears Overblown." Barclays Capital Credit Strategy, 6 November.
Soros, George. 2008. "The False Belief at the Heart of the Financial Turmoil." Financial Times, 3 April.