The Meltdown That Wasn’t

A primer on credit default swaps, the latest Beltway scapegoat.

On Friday, the Federal Reserve, SEC and CFTC announced an agreement to begin anointing “central counterparties” for the credit default swap market. Before the pols create still more institutions that are too big to fail, and further endanger taxpayers, they might want to spend time defining the problem they intend to solve.

The same goes for House Oversight Chairman Henry Waxman. On Thursday he held his latest hearing designed to blame everything other than failed housing policy for the credit debacle. Eager to avoid being scapegoated, hedge-fund managers at the hearing agreed that the credit default swap market is a problem in need of a regulatory solution. But no matter how many financiers can be made to swear under the hot lights that credit default swaps are the problem, reality is not cooperating with this politically convenient theory. This derivatives market continues to perform better than the market from which it is derived.

Mr. Waxman’s committee exists to stage show trials; he doesn’t have jurisdiction to legislate about credit markets or anything else. But his media events are helpful to his comrade in exculpation, Barney Frank. The House Financial Services Chairman is among the most desperate to blame something other than housing, where he famously vowed to “roll the dice” with Fannie Mae. He too has fingered credit default swaps and now promises “sensible” regulation. If he does to this market what he did to housing, he will again be rolling the dice with other people’s money.

Credit default swaps are contracts that insure against a borrower defaulting on its bonds. The buyer of a CDS contract essentially pays annual premiums and the seller agrees to pay back the principal if the issuer of the bonds doesn’t. It’s different from insurance in that an investor doesn’t actually have to own the underlying bonds — he can simply buy a CDS as a way to make a bearish bet on a company or to offset other risks.

Shattering Beltway illusions, the unregulated CDS market is holding up better than the regulated bond market. Here we are more than a year into the credit meltdown and the CDS market is offering more liquidity than the actual cash market. Eraj Shirvani at Credit Suisse notes that “over the last 18 months, the CDS market — not the bond market — has been the only functioning market that has consistently allowed market participants to hedge or express a credit view.”

Large investors have often struggled mightily this autumn to find buyers for their bonds, but they could still trade CDS. The U.K. government seems to agree this is a good thing. Her Majesty’s Treasury has recognized the CDS market as an efficient mechanism for setting prices by using it as the benchmark to set the rates in its Credit Guarantee Scheme for banks.

In the U.S., meanwhile, the market has spoken, and CDS contracts are the way that investors now price credit. This means Congress should tread very carefully unless it wants to prolong the downturn. In an environment in which fewer companies are able to issue bonds and trading is light, a liquid CDS market that can put a price on credit will hasten the day when more companies are able to borrow money to build their businesses. A Congressional overreaction or too heavy a hand from the New York Fed could delay needed capital from reaching Main Street.

But the Beltway crowd has a vague sense that while they may not understand this market, financial Armageddon will result when a major participant fails. Lehman Brothers was supposed to be exhibit A. The firm was on one end of roughly $5 trillion in CDS contracts, according to Moody’s, and Lehman was itself the subject of $72 billion in CDS, in which other investors were betting on Lehman’s success or failure. Here was the doomsday scenario, with a major player in CDS going bankrupt.

It turned out to be the meltdown that never melted. Amazing as it is to Washington ears, those greedy, crazy people running large financial institutions did a decent job of managing their exposures to Lehman. When large banks and insurance companies were vulnerable to Lehman, many had offsetting trades that paid off when Lehman went bust. The net amount of $6 billion owed by sellers of credit protection on Lehman was far smaller than expected and was arrived at through the same orderly settlement auction process that has smoothly managed about a dozen such failures — and all without government regulation.

This is not to say that Lehman’s failure didn’t damage credit markets. But the problem was not a failure of the CDS market, nor was Lehman’s failure caused by CDS. Toxic mortgages killed Lehman. Once Lehman went bust, CDS contracts added relatively little stress to other banks. The stress came from the failure of a big investment bank, which made people unwilling to lend to other banks.

Identifying major systemic risks in the CDS market has proven much harder than the pols expected. The big dealers that trade CDS often demand collateral from customers who owe them money on a trade. But these big dealers usually don’t post collateral when the roles are reversed and they owe the customer. While this is not necessarily a sweet deal for small hedge funds doing business with a Goldman or a J.P. Morgan, it minimizes counterparty risks for the major firms. Also, the large dealers generally make their money facilitating trades for customers, not betting one way or another on corporate defaults. So if they sell a lot of credit protection to one customer, they will seek to buy it from somebody else.

AIG, by contrast, was almost entirely a seller of CDS. By selling credit protection on mortgage-backed securities, the firm used CDS to make a big bet on housing, which again is the cause of this crisis. Meanwhile, the search continues for the major counterparty that would have been destroyed by AIG’s collapse.

As for Mr. Waxman, he should spend more time investigating the cause, not the effects, of market turmoil. Mr. Frank would seem to be the perfect witness.

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