Credit Default Swaps Are Not The Bad Guys

by Sean Purcell

Real Estate Renaissance Man

Author website

David Shafer is a frequent commenter here on BHB and his insights often make me think.  We do not always agree, but I always listen to what he has to say.  He recently posted an interesting and (typically) well written article entitled Credit Default Swaps; The real financial WMD.  You can imagine from the title his take on these instruments.  Part of the article quotes from a recent 60 Minutes segment on credit default swaps  called The Bet That Blew Up Wall Street which is a hatchet job… I mean fair and balanced investigation for which this particular news show has gained such renown.

I commented on this article to the point that it was obvious I was writing a post, which brings us up to date.  I do not agree with the popular sentiment regarding CDS’s and I definitely do not agree with the simplistic view put out by sources such as 60 Minutes that imply derivatives are nothing more than gambling.  The problem is not with the tool but rather the hand that wields the tool (and no doubt, some of the hands at the helm of the credit default swaps market belonged to real tools, if you know what I mean).

Read this very carefully: Credit Default Swaps serve a very legitimate and important purpose.  Derivatives are a must in the market place and here’s why: they provide a hedge on risk.  The ability to hedge risk is an extremely important aspect of our markets.  Without it equities would be lower, rates would be higher and capital would move more slowly.  Derivatives are NOT some bastardized form of gambling.  The suggestion by 60 Minutes and others that they should be outlawed only reflects their rudimentary understanding of how markets work.

I’ll give you an example using a derivative called options, which were my area of specialty as a floor trader.

ABC company insures the debt of XYZ company, allowing XYZ company to borrow desperately needed funds for expansion, research and other job creating endeavors from a large pension fund that would not otherwise have bought XYZ’s bonds (lent them the money).  In turn, ABC company short sells XYZ’s stock, thus hedging their risk.  That way, if XYZ does default on their debt obligations and ABC has to pay the pension fund themselves, they recoup much of their losses in the profits made from shorting XYZ’s stock (which has obviously tanked after defaulting on their debts).

This, by the way, is what made the recent ban on short sales so laughable.  Congress, in all its market ignorance, tries to help companies find liquidity by removing one of the mechanisms that allows them to get liquid.  But I digress…

Let’s go back to our example and let’s say that ABC company does not want to short the stock.  There may be many reasons for this: the cost of carry is too high, shorting the stock may send the wrong sell signals to the market at a time when XYZ is trying to grow and ABC is insuring that growth and so on.   So how does ABC hedge their risk?  They buy puts in the options market (a derivatives market) which allows them to make money should the stock go down.  Again, this “derivative” that is so maligned has been instrumental in helping a company grow and adding jobs to the economy.

With that understanding of the possible good to come from a derivative, let’s take a look at credit default swaps.  These were basically insurance policies written by one company to “insure” or raise the credit rating of another company so that the latter company could borrow money.  Very reminiscent of our previous example, isn’t it?  The difference being that instead of shorting stock or buying puts to hedge risk, they simply carried the risk.  “Ahhh,” you say, “but that is a big difference.”  Plus, there is a big problem arising from that difference: with no regulation there is no minimum reserves required of the insuring company like there would be with a formal insurance company.  There was no way to know if the insuring company – the one trading on their AAA credit rating – could in fact handle a claim (never mind multiple claims).

So how in the world did all these financial giants expect to participate in this unregulated market?  What was supposed to be the regulating aspect?   Once again we get to point our tired fingers at the Credit Rating Agencies.  THEY FAILED AGAIN.  If they had been doing their job (instead of just collecting a fee), they would have looked at a company that was over-extended (didn’t have the reserves to justify the default swaps they were doing) and lowered that company’s rating (hey now, there’s a novel idea).  That would have ended the transaction on the spot.  But none of this happened.  The press has not investigated and – other than appearing before a Congressional hearing a couple of days ago – there have been no repercussions for those ratings agencies that were asleep at the wheel while the whole train barreled down the tracks.

One last thought: an easier way to fix this problem than counting on the ratings agencies who have shown themselves to be completely untrustworthy.  Utilize an open exchange for these products.  Again, regulation does not solve the problem nearly so cleanly or simply as just putting these transactions out in the open.  The Chicago Board Options Exchange (there’s my bias again) is made up of multiple open outcry options pits.  Every trade is called out for anyone to do and every transaction is posted and recorded transparently.  No specialist system (like the NYSE) to create legalized theft and no back room shenanigans such as existed with the credit default swaps thus far.  In an open exchange a company over-extending themselves would be clear for all to see and the market – just as the ratings agencies would have done had they valued their responsibilities rather than the warm embrace of bribery – would have ended that particular company’s growth in credit default swaps.