Bankruptcy

The Bailout -- another perspective (part 2)

By Stephen Lubben

In my prior post I talked about why the bailout was probably the best, if still unattractive, solution to the current mess, while noting that the Fed and administration have done a pretty lousy job of explaining what is at stake.  In this post I take up the regulatory issues that naturally flow from the present crisis, particularly the issue of credit default swaps, which I've been following for a while.

During the hearings earlier today, Senator Dodd called the current crisis ?entirely foreseeable and preventable, not an act of God."  He is right.

The crisis is complex, but there seems to be general agreement that the root problem was a deadly co-dependence between irresponsible borrows and irresponsible lenders.  While I leave the problem of the borrowers to my colleagues that study them, I will state at the outset that if this bailout is our national moment for "moving on," it seems reasonable that that this should apply to the borrows and lenders equally.  In short, I don't buy Secretary Paulson's suggestion that this is "unlreated."

Turning to the lenders, the part of the problem that is within my jurisdiction, I agree with Christopher Cox, the chairman of the Securities and Exchange Commission,who today called for more regulation of the credit derivatives markets.  While I was willing to give this new market some space while it developed, it is clear that the atomistic nature of the market is at odds with the larger economic good.

Stated bluntly, the industry had its chance and blew it.  Time to consider something new.  More after the jump.

As many Credit Slips readers may already know, credit default swaps (CDS) are basically insurance contracts -- the "protection seller" promises to pay the "protection buyer" a lump sum of money if some other company (GM, Enron, whomever) defaults on its debts.  The idea is to replace the credit risk of a shaky company (GM) with the credit risk of a company with a high credit rating (Lehman Brothers, oh wait . . . ).  The one key difference between CDS and insurance is the possibility to buy CDS protection on a debt you are not exposed to (kind of like buying insurance on a car you don't own).

How do these things relate to the present crisis?  Well, according to its last 10-Q AIG sold more than $440 billion worth of credit protection -- a good bit of which went to European banks who used the protection to hedge the risk of not getting paid on various loans.  If AIG fails, the banks of the world suddenly have to "fess up" to a lot more risk.

In addition, another big chunk of CDS went to hedge CDOs on mortgage obligations (essentially CDOs are what we used to call securitization pools).  Default rates on mortgages are generally low, so what could go wrong . . . (especially if the banks writing the mortgages know they don't have hold them to maturity .  . . ).

I will note that while Chairman Cox identified the potential use of CDS for "naked shorting" as the justification for regulation, I'm a bit skeptical -- unless the shorts planned well in advance, buying protection on many financial firms last week would have been a very expensive proposition.

But there is a real problem here that comes from the lack of transparency in the market:  failure to diversify.  Normally this would not be an issue, because a company that fails to diversify in the CDS market will fail.  But if we don't have a good bankruptcy system for financial firms -- see my prior post for more on that -- and thus some firms know that they will not be allowed to fail, the companies won't have any reason to be risk adverse.  And because there is no obvious limit to the amount of CDS that can be written -- in many recent chapter 11 cases the amount of outstanding CDS was many times the amount of debt issued by the bankrupt company -- the risk that the failure of a single firm will have oversized effects looms large.

All of which cries out for transparency, which the CDS market and ISDA (a trade group for the derivatives industry) have strongly resisted.  Indeed, opacity is said to be a virtue here, because a bank can hedge its customer's loan without offending the customer.  Sorry, but we're several trillion dollars past that point.  Given where we are today it is clear that this opacity foists an external cost on the rest of society -- bail out the markets or suffer the consequences -- such that it cannot be allowed to persist.

Now one would normally expect that AIG's exposure to $440 billion of credit risk would have influenced its credit rating a lot sooner than it did -- but we've been down this road before with the credit rating agencies.  Clearly, the market needs adequate information to make an independent judgment.  As part of the "new era" we need to know what exposure large financial firms have to defaults by particular companies or counterparties.  We also need to know if their exposure is concentrated in particular industries or instruments.  We need to know if a GM default will take out Lehman, but we also need to know that several other large banks will cease to write new loans if Lehman fails.  The State of New York is getting there -- the SEC appears to be stuck on the red herring of short sales.

And while we're at it, do we want to reconsider those pesky new provisions regarding derivatives in the Bankruptcy Code?  Perhaps that's the stuff of another post . . .

Full post as published by Credit Slips on September 23, 2008 (boomark / email).