Sly Capital

This is a well thought out article by Rolfe Winkler in his new job at Reuters.

The only obvious flaw is confusing volume with liquidity. If you have capital of $100 and borrow $1,000 it is easy to make the mistake that you are providing liquidity of $1,100. As has been proved ad nauseum in the history of finance the only real part of this transaction is the $100. There is always a mechanism whereby the $1,000 gets called on by the lender and this always happens.

Goldman Sachs demand for collateral from AIG is a recent example. AIG could not meet the call as the money did not exist – it was a fiction agreed to between GS and AIG.

Credit default swaps nearly brought down the world financial system last fall when it was discovered that AIG Financial Products had written hundreds of billions of dollars worth of credit protection without setting aside sufficient reserves. Yet since then, pathetically little has been done to get this corner of the derivatives market under control. There’s a simple way to fix the problem. Regulate CDS as insurance. That could happen if some state insurance legislators get their way.

Treating these financial weapons of mass destruction as insurance instead of as merely swaps would subject them to sensible regulation. But Wall Street is fighting the idea because it would hammer profits and, more importantly, force them to reduce leverage.

Are credit default swaps insurance? As with insurance contracts, the seller of credit protection promises to reimburse the buyer’s losses in case his creditor defaults. If that sounds like an insurance policy, that’s because it is.

I recently attended a conference on derivatives regulation where a trader argued that CDS aren’t insurance. Asked to describe their precise function, he struggled mightily for the correct infinitive, finally settling on “to insure.”

Why the obfuscation? For one thing, to pump up the real estate bubble Wall Street needed a cheap way to hide risk, for securities they marketed to investors and for their own balance sheet. Toxic CDOs “wrapped” by an AIG insurance policy were suddenly marketable as AAA-rated investments. Risky assets retained on Wall Street’s collective balance sheet could be “hedged” with CDS in lieu of holding actual capital.

In properly regulated insurance markets, when insurers ramp up risk, their regulators force them to increase reserves. As risks rise, so does the cost of insurance. Had credit protection been properly regulated, it would have been too expensive to enable the fiction that subprime risk, wherever held, was somehow free. Consequently, it’s likely that risk wouldn’t have been manufactured in the first place.

Another reason to confuse the issue is that Wall Street makes markets trading CDS, a far more profitable business than selling insurance policies.

Selling insurance is pretty boring thanks to regulations that date back to 18th-century England. In a recently published paper in the Connecticut Insurance Law Journal, Arthur Kimball-Stanley argues that, in its earliest days, insurance policies were often used to gamble. Policies could be purchased for items that weren’t yours, and for amounts greater than the insured property was worth. The moral hazard is obvious: Unregulated insurance gave speculators incentives to destroy property.

Are CDS speculators actively destroying property? Take Delphi Corp. When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds. If CDS were subject to insurance laws, investors would be required to show an interest in the insured bonds. This would drastically reduce trading volumes, hammering Wall Street’s profits. It would also reduce systemic risk.

The bank lobby counters that regulating CDS as insurance would restrict liquidity. It would, but that’s a red herring. Wall Street is more concerned with the profitability of their trading desks and their ability to continue hiding risk. And in any case, markets functioned fine before CDS.

With no solutions coming out of Washington, state authorities are taking the first steps to restore order. This week the National Conference of Insurance Legislators, or NCOIL, will discuss model legislation for credit default insurance.

New York State Assemblyman Joseph Morelle, the chairman of the state’s Committee on Insurance, is leading NCOIL’s task force that drafted the legislation.

“Credit default insurance can provide a very valuable function in the market by protecting legitimate credit investors,” he argues. “But sacrificing fundamental business practices at the altar of liquidity is dangerous.”

And very expensive. The $183 billion needed so far to rescue AIG is but a fraction of the bill. To it must be added much of the cost of recapitalizing the entire financial sector, which grew ridiculously overleveraged thanks to unregulated CDS.

All of this could have been avoided by applying the same laws to CDS that we apply to other insurance markets. If we miss this opportunity to do so, expect banks to create new risks that will plunge the world back into the financial abyss.