When Even Good News Worsens a Panic

Despite hysteria, credit default swaps won’t wreck the economy.

So it should have been reassuring that one of the most nerve-racking of the unknowns turned out to be benign.

We now know that we should not have feared huge losses in the multitrillion-dollar, unregulated market for esoteric instruments called credit default swaps. Transactions in this market have been orderly, and the losses have been modest.

Instead of cheering this happy news and reassuring investors, Washington last week pilloried these swaps and set out to regulate or even ban them. Bankers know this puts at risk one of the few remaining smoothly functioning parts of the credit market. Markets reacted to this new unknown unknown: How much damage will be caused by regulators creating new problems and distracting attention from the real ones?

To be fair, credit default swaps are complex and poorly understood. These swaps let investors buy insurance against a company or a country defaulting on its debt payments. If a bank decides it has too much exposure to, say, the oil industry, it can insure against the risk of companies in this industry defaulting.

Last week, banking expert Peter Wallison of the American Enterprise Institute walked the sophisticated audience of the Exchequer Club through how these swaps work. He offered the example of bank A making a $10 million loan to company B. Bank A can eliminate most of the risk of B from its books by going to C, a dealer in these swaps, who agrees to pay the $10 million to A if B defaults, in exchange for A paying an annual premium to C for the protection. A will want collateral from C to be sure it’s good for the debt. As a dealer, C will hedge its exposure, entering into a swap with D, which also hedges through E.

The three swaps in this example total $30 million, but the actual credit risk is the same $10 million. “The notional amount of all the CDSs is a meaningless figure for the purpose of assessing the risk in the system,” Mr. Wallison concluded. More than that, “one of the keys to effective risk management is diversification, and CDSs make diversification easy.”

Contrast that with comments by Sen. Tom Harkin, who has proposed banning these swaps and last week introduced a bill to regulate them. “With the value of swaps at a high of some $531 trillion for the middle of this year — eight ?189 times the world GDP of $62 trillion — it is long past time for accountability in the markets,” he said. The notional amount of the credit default swaps got as high as $62 trillion, with the rest of Sen. Harkin’s estimate coming from other financial transactions. “Shouldn’t we just outlaw all of these fancy little things?” he asked.

No. Credit default swaps reduce risk for those who buy protection. They stabilize markets. Indeed, these swaps are now the best way to price credit. Making the level of corporate credit risk clear is key to getting lending back into the system.

Mr. Wallison focused on these swaps to make an important point about Washington. “If the searchlight is turned on credit default swaps,” he said, “it won’t be focused on the government policies that encouraged the production and distribution of the junk loans that are at the root of an unprecedented world-wide financial crisis.” Congress has still not focused on how its policy of making mortgages too available led to unsustainable mortgage loans through Fannie Mae, Freddie Mac and the Community Reinvestment Act that were the proximate cause of the credit collapse.

The swaps market should be more transparent. This will show that it is faring better than the mortgage-related debt on which it’s based. Some propose a central clearinghouse, but this runs the risk of another too-big-to-fail institution. Or we could have decentralized electronic execution of swaps, with greater disclosure of trades. The market can work out the best approach.

The credit crisis reflects many failures, but a central theme is people not knowing what they were doing and the panic that results in an Information Age when we lose confidence that we have the information we need. Financial professionals didn’t understand that models based on prior experience would fail when confronted with a housing bubble, or that bundling bad mortgages together only made the rocks sink faster.

For regulators, too, some humility is now in order. In the case of credit default swaps, there’s no reason to fix what’s not broken.

Election Fraud in Nicaragua

Two strongmen team up to undermine democracy.

Every crisis presents opportunity. That seems to be the thinking of Nicaraguan President Daniel Ortega, who is trying to steal an election while much of the world is focused on the financial upheaval threatening the global economy.

[The Americas] AP

Nicaraguan President Daniel Ortega (left) embraces Venezuelan President Hugo Chávez in Caracas, Venezuela, Jan. 25, 2008.

On Nov. 9, Nicaragua held municipal elections in 146 cities and towns. For such a tiny country these races are big, because mayors have a great deal of autonomy and can act as a check on central government power. But this round of balloting was even more important than usual. Consolidating Marxist power in Nicaragua is a prime goal of Venezuelan President Hugo Chávez and Mr. Ortega is supposed to carry out the plan. If he fails it will be another setback for the hard-left’s 30-year dream of establishing a communist foothold in Central America.

Mr. Ortega ruled the country from 1979-1990 as a Sandinista dictator. Since winning the presidency in 2006 with 37% of the vote, he has demonstrated that, like his friend Mr. Chávez, he finds institutional checks and balances on his power rather inconvenient. Mr. Ortega’s popularity rating is down to about 20%, suggesting that although he is the executive in charge, a lot of Nicaraguans now wish it weren’t so.

It is within this reality that Mr. Ortega seems to have decided that Sandinista victories in the Nov. 9 municipal elections were a must. The government has proclaimed Sandinista victories in 94 municipalities, but the opposition is claiming fraud. A bitter struggle is under way.

Sandinista shenanigans began long before the polls opened. Not surprisingly, given Mr. Ortega’s history as a “revolutionary,” violence was a key campaign tactic. But don’t take my word for it. No less than the nongovernmental organization known as the Washington Office on Latin America — renowned for its left-leaning politics — warned of state-sponsored repression ahead of the vote.

The Americas in the News

Get the latest information in Spanish from The Wall Street Journal’s Americas page.

In a Nov. 6 communication, the organization wrote: “We are alarmed by the growing climate of intolerance for those who are perceived as critics of the federal government. The physical attack on a march of opposition party activists, and the apparent unwillingness of the police to restore order, the criminal investigations of several civil society organizations and their leaders, as well as the investigation of international NGOs that have funded some of these organizations, is extremely troubling.” The Washington Office on Latin America also referenced “violent acts by government supporters against human rights defenders.”

Terror was not the only tool at Mr. Ortega’s disposal. As this column discussed several weeks ago, his campaign efforts were underwritten by Mr. Chávez, who sends millions of dollars of oil to Mr. Ortega but asks to be paid for only 50% of it. The balance is a long-term loan. This oil is then sold at market prices and the profit is used to fund a social investment operation called Albanisa and a Sandinista political slush fund called Albacaruna. The director of the Nicaraguan oil company and of Albanisa is also the treasurer of the Sandinista party. The Sandinistas also have control over the judiciary and the Supreme Electoral Council, which disqualified two political parties from even competing on the ballot.

But Mr. Ortega still had lingering doubts about his odds. And perhaps because he has so long been the darling of the international left, he seems to have decided he could improve those odds without scrutiny.

Step one was to block the Organization of American States, the European Union and the Carter Center from receiving credentials to observe the balloting. He even barred Nicaragua’s highly respected independent watchdog, Ethics and Transparency — which had recognized Mr. Ortega’s 2006 victory — from the polling stations.

Despite getting shut out, Ethics and Transparency managed to post observers to watch from outside polling stations. It estimated that one-third of the stations experienced irregularities. There were also reports that in some places opposition-party observers were kicked out of polling stations, and some polling stations closed ahead of schedule.

The post of Managua mayor is one of the most hotly contested races. Constitutionalist Liberal Party (PLC) candidate Eduardo Montealegre is challenging the “victory” of Sandinista Alexis Arguello. Mr. Montealegre, who graciously accepted his defeat to Mr. Ortega in the 2006 presidential election, says that his party made its own vote tallies and that he won. The Catholic Church and the country’s two largest business groups are backing his call for a recount. The Supreme Electoral Council has agreed to a recount, but behind closed doors with no observers.

Mr. Montealegre’s efforts to lead rallies in favor of a transparent recount have been broken up by Sandinistas wielding bats and lobbing rocks. But he insists that holding firm is about more than the office of mayor. “It’s more fundamental,” he says. “It’s about dictatorship versus democracy.”

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