Rolling a Hard Six with the Economy
by Devilstower
Sat Apr 12, 2008 at 10:11:00 AM PDT
I usually leave the technical economic stories to more fiscally knowledgeable editors (and considering the state of my checking account, that would be everyone). But here's a story on which I feel I can write with equal authority to those who account for every last penny, because in this story no one knows what's going on. Not me. Not economists. Not Ben Bernanke. Not even the investment bankers involved in the story. Certainly not the government, because -- as part of the worship of free markets -- this is an area that's completely unregulated.
It's called credit default swaps. Just defining a credit default swap can be difficult, but here's my best shot. When you buy one of these things, you're buying a level of protection for an investment. For example, say someone has some double-yuck rated bonds, and is concerned that these things may soon be worth as much as a Zimbabwean dollar. With the right credit default swap, you can pay out a small amount over time to ensure that the the bonds still pay out close to face value in case of a default. So, in a sense, a credit default swap is insurance you buy for a risky investment.
Originally, these things were used mostly by banks and large bondholders, where they served the purpose of spreading around the threat posed by risky corporate or municipal bonds. That function is what made Alan Greenspan and meny economists great fans of swaps.
So far credit derivatives have proved a triumph of the financial sector's ingenuity. By dividing the bond market into digestible chunks, they have increased investors' appetite for corporate debt. That may well have lowered the cost of capital—good for the economy, since it should allow companies to invest more over the long run.
But there's a downside to a system that allows more investment on the risky side of town. Not surprisingly, it promotes more risks. As the "risky investment" part of most financial institution's portfolios went from molehill to mountain, credit default swaps came along for the ride. Better still, around the start of this decade, people began to swap the swaps themselves as a new kind of investment. And to bundle them. And to sell secondary instruments based on them. Something like a meta-investment. Keep in mind that this is a completely unregulated market, so investment banks have been free to get creative in this area. These are very creative folks.
So, okay. People started out making pseudo insurance policies for bonds and other investments, then turned those things into another kind of investment. How big can something this new and this obscure be? Here's American Public Media's Marketplace to put it in context.
BOB MOON: OK, I'm about to unload some numbers on you here, so I'll speak slowly so you can follow this.
The value of the entire U.S. Treasuries market: $4.5 trillion.
The value of the entire mortgage market: $7 trillion.
The size of the U.S. stock market: $22 trillion.
OK, you ready?
The size of the credit default swap market last year: $45 trillion.
KAI RYSSDAL: That's a lot of money, Bob.
Yes, Bob, more than all the stocks, mortgages, and federal bonds put together seems kind of high. And here's the scary thing. Now that we have have so much of our economy's wealth in this odd little instrument that the dollar value would be enough to lay a trail of bills to Saturn and back (Really. I did the math.), how much are these swaps actually worth? Answer: nobody knows.
The original valuations were complex enough.
MOON: Well, this is where it gets tough, Kai, because a lot of people on Wall Street, even some of the leading economists in the academic world, don't really understand exactly how these things work. A lot of them are whipped up with some computer wizardry, some advanced math -- think of those fancy Greek letters turned on their sides. And there's a lot of guesswork to this, too, about how much they're really worth.
And with all the flux in the rest of the investment world, no one can now tell what's lurking behind all those Deltas and Thetas. What we have are banks holding paper that they can't value, and system that could come apart like the zipper on a Wal-mart windbreaker.
The weirdest thing about all this is that credit default swaps in their original form helped to spur the housing bubble by tossing a supposed safety net over bundles of the miserable mortgages banks were handing out, and in their investment form, they don't do anything. They don't provide money that companies can use to up production or employment. They don't shore up the banks. They don't reflect any activity at all. They just slide back and forth sucking dollars into a froth of pure uncertainty.
[Risk expert] CHRISTOPHER WHALEN: They are the most hideous kind of speculation. To have a federally insured bank like JPMorgan as the largest dealer in this market, to me says we don't know what we're doing anymore, and we don't understand the difference between real work -- real economic activity -- and something that's essentially wasting.
In article after article, credit default swaps are referred to as "gambling." I take that as an insult. I'm strictly an amateur gambler, but before I sit down to a blackjack table, I can tell you the odds the house has over me to the tenth of a percent. A halfway decent poker player knows the odds at almost any given moment.
What the banks are doing isn't gambling. It's worse. The Economist was upbeat on credit default swaps and their "benign" affect on the economy only a year ago. Still, they had their reservations.
But it is in the nature of capitalism to test new ideas to destruction and to use new instruments as the basis of speculative excess. As Mr Roche puts it: "Credit derivatives are like good things to the Catholic Church. If you have too much of them, they're a sin." Nobody will be sure how robust credit derivatives are until they have been tested in a severe economic or financial downturn. And that is not something anyone should wish for.
Bear Sterns was the first pop quiz. No one is sure when the real exam will start.
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