Swapped Out of Our Underwear by Credit Defaults

In Light of Crisis, Common Trading Practice Looks Risky

By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Friday, October 3, 2008; D01
Regulators and Wall Street’s scarred survivors increasingly are zeroing in on a massive risk to the stability of the financial system posed by rampant, unregulated trading in credit-default swaps.
A key linchpin in global securities trading, swaps are basically insurance policies bought by investors to protect against an investment such as a corporate bond losing all value if the company falls apart. Over time, the broader market has come to view the price of that insurance, which fluctuates, as a leading indicator of a company’s health.
. . . Similar price spikes in the swap market sent the shares of some of the nation’s leading insurance companies plummeting yesterday, including Hartford Financial Services, Prudential Financial and MetLife.
The movements have raised alarm over whether investors are manipulating the swap market to falsely suggest that companies are in trouble.

Companies that have been punished by the swap market say that a recent ban on the short-selling of financial stocks, intended to protect companies from this kind of speculation, has pushed predatory investors into credit-default swaps.

. . . Credit-default swap is a complicated name for a simple concept.
It is a legal contract in which an investor who buys, say, $10 million worth of bonds could pay from tens of thousands of dollars to more than a million dollars for the insurance, depending on how credit analysts view the safety of the mortgages underlying the security. The insurance contracts enabled banks and other investors to buy securities and hold them as if they were top-grade assets, because even if the security defaulted, the credit-default swap would kick in and make the investor or bank whole.
One big problem: Anybody could write a credit-default swap. . . There is no federal regulation of the credit-default swap market, but the Securities and Exchange Commission has asked Congress for that authority in what would be a sweeping extension of its responsibilities.
It’s a bit late to zero-in on massive risk to the system. We’re (how long has Ronnie Reagan been out of office?) years too late to fill all the leaky holes in the financial boat that deregulation built for us. Any fix will wait for a January Congress, while the bones of the body-economic will have been picked clean by then.
$700 billion is a fart in a whirlwind, folks. There is far more gastric discomfort yet to come.
Totally unregulated trading in credit-default-swaps, which are basically bets on the survival of insurance companies, investment banks (those that are left) and hedge-funds that are heavily exposed to their own toxic derivatives, are the order of the day. Credit default policies are supposed to pay off in case the underlying equity that supports an investment is worthless.
The fact that anyone can conjure them up out of thin air and flim-flam is (apparently) beyond Henry Paulson’s, Ben Bernanke’s and even Sir Alan Greenspan’s understanding. They are financial wind-pudding, the stuff of Fantasia and Peter Pan.
Money (that stuff that is still very much out there looking for a safe place to land) is subject to the endless (and fraudulent) machinations of those who would pick clean the bones rather than feed the bird. Regulation is meant to stop (or at least control) that. But regulation is dead–legs-up in the middle of the road. What will be the first morsel to be picked clean in this Wild West of deregulated markets?
Why Henry Paulson’s $700 billion, of course.
Ensuring that the new president (moose-hunter or Senate veteran in tow) will have virtually nothing with which to work in the toxic fields of chaos. All those weeds and nary a hoe in sight.
Never has a good idea been born of pre-election posturing. Never has the idiotic rhetoric of campaign promises spilled over into a frantic Congress passing bills with nine zeros attached.
We are being yet again swapped out of our underwear by emergency surgery and no second opinion. Everyone is on the sky-is-falling bandwagon.
Everyone but the 200 professionally disinterested economists whose voices are lost in the babble of terrified interested parties.

Hedge fund managers, derivative packagers, fraudulent bankers, congressmen and Senators up for re-election, bond-rating firms fearing indictment and investors heavily leveraged in sub-prime crap instruments, all want their garbage hauled.

They want someone else–anyone else–to haul it and you and I will do just fine. Two truths are evident, despite all the posturing and wild claims:

  • The patient will not die on the table while we take the time to look at the Xrays and run some blood samples.
  • If the patient should go into toxic-shock between now and (pick a logical time) May of next year, when cooler heads will have heard the diagnosis–he would have most certainly expired in frantic and ill-advised emergency surgery.

From Daniel Ackerberg at UCLA to Eric Zitzewitz at Dartmouth College, with 198 additional economic luminaries salted in between, the considered opinion, the unbiased opinion, the unleveraged and thoughtful opinion is unanimous–don’t throw this $700 billion to the Wolves of Wall Street.

By the time you read this, it will undoubtedly have been done.

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