Regulating Credit Default Swaps

Imagine taking out a life-insurance policy, not on yourself, but on a sick man who lives down the street. That way, if he dies, you’ll be sure to turn a profit. This is but one of many bizarre features in the world of credit default swaps—a financial instrument that crippled our global economy. While many different events and policies contributed to the financial crisis, it is safe to point a finger at credit default swaps. The U.S. government should decisively regulate these complex financial instruments.

When a group of J.P. Morgan bankers conceived credit default swaps 19 years ago at the Boca Raton Resort & Club in Florida, they could not have imagined what a monster they had unleashed. In 2007, the credit default swaps market value was $62 trillion, more than quadruple the entire U.S. gross domestic product.

A credit default swap is an insurance policy on an investment. Wall Street took out insurance on risky investments, like taking insurance out on your car. The party that issues the CDS agrees to insure an investment in the event of a loss, and, in return, the CDS buyer agrees to pay a monthly premium. However, a CDS is not your average insurance policy. Insurance is highly regulated, and CDSs are unregulated, creating many dangers.

In a typical insurance policy, the insurer must set aside some money, called collateral, that proves that it can make some payoff when needed. There was often little or no collateral required for CDSs. The obvious problem is that in an unforeseen catastrophe, the insurer may not be able to honor its commitment. Therefore, the CDS buyer must totally trust that the issuer is good for the money.

This trust requires considerable faith in rating agencies, such as Standard & Poor’s and Moody’s. To make a low-risk purchase of a CDS, a firm needs to buy from an insurer with an excellent credit rating. If any of these ratings are inaccurate or get downgraded, this will dramatically affect the CDS and cause panic. Therefore, the government must institute a reasonable collateral requirement for the sale of CDSs. Further, rating agencies must closely monitor investing schemes that use insurance from highly rated firms like AIG to make risky investments in poorly rated firms.

A firm can purchase a CDS on a company with which it has no direct relationship. Consequently, if a firm looks like it will fail, one can purchase a CDS on it so that when it collapses one receives the insurance payout. This incentivizes firms to work against each other and was one reason why Lehman Brothers collapsed. As the Financial Times asserts, “a house insured for more than its value is always considered a fire risk.” Healthy competition among banks is essential to a vibrant economy, but incentivizing the failure of banks is not. Furthermore, the government should regulate who is eligible to buy a CDS. If a firm attempts to purchase a CDS without the intent to insure their own investment, strict scrutiny should be applied.

Although CDSs work like insurance for investments, buying and selling them is similar to trading stocks. This generates a hazardous web of firms that hedged bets by both buying and selling CDSs. If one firm defaults, it cannot pay out the next firm’s insurance that can cause another firm to default, and so on. To further complicate matters, since CDSs are unregulated, there is no authority to which these transactions are reported. Thus, no single firm knows how many CDS deals have been made, and firms do not know to whom most CDSs have been sold. Additionally, after the original transaction, a firm may sell its end of the CDS bargain to another firm without notifying the original counterparty. This exposes the financial system not only to a significant chain reaction, but also an inaccuracy in gauging it, even as it occurs.

The ensuing panic results in a lack of confidence, since one cannot be sure if a company is doing as well as it claims to be. Therefore, the government must make CDS transactions a matter of public record.

Finally, many CDSs insured products ill-suited for insurance. Insurance works best when a disaster is random, infrequent, and independent from other disasters. This is not the case for mortgage-backed securities. In the housing market, prices are dependent on the surrounding area. A firm can attempt to mitigate this problem by slicing up mortgages and repackaging them in complex financial instruments like collaterized debt obligations, but the risk persists. If enough houses drop in value, others will follow, and this domino effect is the current housing crisis.

For CDSs that back investments in mortgage-backed securities, this is especially potent. There is no way to insure a disaster that in turn causes other disasters. It would be like providing health insurance when one heart attack induces a chain of other heart attacks in the population. Therefore, the government must regulate CDSs to guarantee that insurance firms have the capital to remain solvent.

These are only a few of the issues to be fixed with credit default swaps. Although they are not innately bad instruments and can provide much-needed liquidity, when left unregulated they can be used in ways that cause tremendous detriment to our financial system. It is not surprising that investor Warren Buffet refers to credit derivatives as “financial weapons of mass destruction.”


George J. J. Hayward ’11, a Crimson editorial editor, is a government concentrator in Currier House. He is the political action chair of the Black Students Association and a member of the Undergraduate Council.