Forum Post: Credit Default Swaps and Regulation
Posted 12 years ago on Oct. 5, 2011, 8:34 a.m. EST by Researcher
(11)
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One issue that has not been adequately dealt with, in my opinion, is the issue of Credit Default Swaps (CDS). CDS are often referred to as derivatives but they don't derive their value from some underlying asset. CDS, rather, are more like an insurance policy.
If I own a bond, the last thing I want is for there to be a default. It might mean I might miss a payment or two. It also results in a decline in the value of my bond. To protect myself against this risk, I can purchase CDS that will pay out in the event of a default (depending on the terms of the CDS).
The problem is that there is this other risk that is referred to as "counter-party risk". The organization that offered this insurance needs to have sufficient capital to actually make the pay-out. What if they don't?
This is the situation that happened with AIG. AIG wrote a bunch of insurance policies on some crappy mortgage bonds. When they collapsed, AIG was on the hook for billions and billions of dollars. They, of course, did not have sufficient capital for these payouts.
(For more details on AIG's involvement in the crisis, see Roddy Boyd's "Fatal Risk" - http://www.amazon.com/Fatal-Risk-Cautionary-Corporate-Suicide/dp/0470889802/)
One option we could consider is simply banning CDS. I'm less sympathetic to this if just for the fact that the finance sector will find some alternative to it.
Another option is to put CDS on an exchange with oversight and appropriate regulations. This can mitigate the counter-party risk and require insurers to have appropriate capital for payouts if they arise.
Regardless of what we do, what we are currently allowing - which is unregulated CDS markets - is not wise. Why our government has failed us here I'm not sure but this is an issue that, in my opinion, needs to be addressed.
I believe we need better regulation and accountability.
"Why our government has failed us here I'm not sure but this is an issue that, in my opinion, needs to be addressed."
Our government has failed us here because it's less a "democracy" and more of a "corporatocracy." Corporations, including AIG and all the Wall Street firms, have a vested interest in a completely unregulated market. And ironically, it worked perfectly for them. They trashed the economy, and instead of being thrown in prison or being fired, they were rewarded with a bailout. Of course, the Tea Party wants completely unfettered markets--NO REGULATION AT ALL. Of any business. Ever. Why? Because they think corporations are Gods. They are not Gods. They are, as the documentary "The Corporation" put it so eloquently, sociopaths, interested only in advancing an agenda of profit and greed. That's what they're based on, and government regulation is anathema to that core goal--hence the corporate-funded Tea Party...
"The Corporation" is one of the few online documentaries that I actually like.
But the corporations didn't benefit per se. Ask any of Lehman's shareholders or Bear Stearn's shareholders and you get a different picture.
Management of these firms are the real winners in my opinion. They are able to take home large salaries and have bonus incentives that depend upon short-term profits at the expense of the long-term well-being of the corporation. They can lever up and take huge bets which, if they pay off, will greatly enhance executive pocket books. If they fail, then the corporation fails, people are put out of jobs, shareholders take losses, bondholders take losses (unless the govt. bails them out.)
No doubt the "corporatocracy", as you put it, has allowed them to live on longer. But there is a principal/agent dynamic in there as well. The agents (management) reap rewards at everyone else's expense.
As for the corporate entity, I have mixed feelings to be honest. On the one hand I don't like their "personhood" status and I don't like their influence. On the other, it is a nice way for small players (the 99%) to take ownership in a business.
But I definitely agree about the regulation aspect. In fact, the "no regulation" aspect is what Yves Smith contends is a big underlying cause the crisis. See her book Econned for her argument. (http://www.amazon.com/ECONned-Unenlightened-Undermined-Democracy-Capitalism/dp/0230114563/)
As another side note, I came across this movement when it was featured in Yves Smith's blog http://www.nakedcapitalism.com/
Thoughtful response--I like http://www.nakedcapitalism.com a lot. You raise good points, but small players--based on the current system--will always remain small players. As for corporations not benefiting, well, Wall Street bonuses continue to be in the many billions of dollars (according to Feb 24 2011 Economist) and apparently the CBO data recently revealed that TARP wont' cost as much as originally thought. But still, in the tens of billions...
Good question as, although they did not cause the crash, they certainly helped it spread.
There are a number of companies that have been trying to create a centralized market for swaps, including CDS, TRS and Interest Rate Swaps - IRS making up the largest share of volume, and get these trades out of OTC. IDCG comes to mind. Unfortunately, this has not yet universally caught on. Of course, there are also a number of securities, such as FX forwards, that have never been traded on a standardized exchange and have never caused counter-party issues.
As a sidestep, there are numerous new reporting requirements created by the Fed to keep track of all Value at Risk for all big players within the financial industry. Theoretically, this will help ascertain counterparty risk exposure.