RandomGuy
10-07-2008, 04:53 PM
Unregulated swaps hastened Wall Street collapse
AP
Unregulated swaps hastened Wall Street collapse
Tuesday October 7, 4:57 pm ET
By John Dunbar, Associated Press Writer
Trillions of dollars in bets on 'credit default swaps' hastened Wall Street's downfall
WASHINGTON (AP) -- It can be a fine line between investing and gambling. But in Las Vegas, you know the odds. On Wall Street, that's not always the case.
Especially when it comes to the $62 trillion market in arcane financial contracts known as "credit default swaps."
ADVERTISEMENT
"Moreover," adds Michael Greenberger, former director of trading and markets for the Commodity Futures Trading Commission, "Las Vegas is regulated."
These swaps are increasingly being blamed for the near-collapse of insurance giant American International Group Inc., the bankruptcy of investment bank Lehman Brothers, and the downfall of other investment houses and financial institutions.
Members of the House Oversight and Government Reform Committee on Tuesday accused the world's largest insurance company, American International Group Inc., of opening "a casino in London" when it began dealing in these complex derivative contracts. The Federal Reserve came to AIG's rescue three weeks ago with an $85 billion line of credit; so far the company has tapped it for $61 billion.
So what are credit default swaps and how have they caused all this trouble?
The swaps are a form of insurance, but they aren't regulated that way.
Say a big investor buys a bond from a company. But the investor is worried about the company's ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit default swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it.
The issuer of the credit default swap doesn't write this insurance for free. It gets a fee, usually a percentage of the value of the bond.
The transactions are made "over the counter," meaning they are not regulated by any public exchange.
And since these contracts are not considered "insurance," Greenberger says, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.
The swaps have given those invested in all manner of debt, including mortgage-backed securities, a false sense of security.
"Everyone walked around saying 'we're insured,'" said Greenberger, who is a law professor at the University of Maryland.
As housing prices rose and more people could get mortgages despite questionable credit records, mortgage-backed securities were an attractive place for pension funds and other investors to park their money.
"Were it not for that insurance, it certainly wouldn't have reached this manic state of growth," Greenberger said of the questionable investments.
Mortgage-backed securities have turned sour with plummeting home prices and increasing default rates. The securities have clogged the credit market, prompting the Bush administration and Congress to put taxpayers on the hook buying them up.
As the government buys mortgage-backed securities from teetering financial institutions at less than face value prices, issuers of the credit default swaps could be liable for the difference.
That's troublesome enough, but it actually gets worse.
Buyers of credit default swap insurance are not required to own the underlying securities they are insuring.
In other words, the investor can buy insurance on a mortgage-backed security without having to buy the security itself. When that security turns sour, whoever is holding the credit default contract -- whether they actually own the security or not -- can demand payment for the face value of the security.
This has created a market in which speculators actually are betting that mortgage-backed securities will lose their value.
Because the market is unregulated, the size of the credit default market is difficult to estimate.
The International Swaps and Derivatives Association, a trade group, estimates its "notional value" for year-end 2007 at $62.2 trillion -- roughly five times the entire U.S. production of goods and services last year. The total represents how much sellers of the protection would have to pay if every one of the securities were to default, an unlikely scenario to be sure.
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But even this is a rough estimate. Participation on the survey was voluntary. What is helping drive the panic in these contracts is that little is known about who owes what to whom.
"Nobody knows where all the credit default swaps lie," Greenberger said. "And that's really proven to be a big problem."
NO SHIT, SHERLOCK.
AP
Unregulated swaps hastened Wall Street collapse
Tuesday October 7, 4:57 pm ET
By John Dunbar, Associated Press Writer
Trillions of dollars in bets on 'credit default swaps' hastened Wall Street's downfall
WASHINGTON (AP) -- It can be a fine line between investing and gambling. But in Las Vegas, you know the odds. On Wall Street, that's not always the case.
Especially when it comes to the $62 trillion market in arcane financial contracts known as "credit default swaps."
ADVERTISEMENT
"Moreover," adds Michael Greenberger, former director of trading and markets for the Commodity Futures Trading Commission, "Las Vegas is regulated."
These swaps are increasingly being blamed for the near-collapse of insurance giant American International Group Inc., the bankruptcy of investment bank Lehman Brothers, and the downfall of other investment houses and financial institutions.
Members of the House Oversight and Government Reform Committee on Tuesday accused the world's largest insurance company, American International Group Inc., of opening "a casino in London" when it began dealing in these complex derivative contracts. The Federal Reserve came to AIG's rescue three weeks ago with an $85 billion line of credit; so far the company has tapped it for $61 billion.
So what are credit default swaps and how have they caused all this trouble?
The swaps are a form of insurance, but they aren't regulated that way.
Say a big investor buys a bond from a company. But the investor is worried about the company's ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit default swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it.
The issuer of the credit default swap doesn't write this insurance for free. It gets a fee, usually a percentage of the value of the bond.
The transactions are made "over the counter," meaning they are not regulated by any public exchange.
And since these contracts are not considered "insurance," Greenberger says, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.
The swaps have given those invested in all manner of debt, including mortgage-backed securities, a false sense of security.
"Everyone walked around saying 'we're insured,'" said Greenberger, who is a law professor at the University of Maryland.
As housing prices rose and more people could get mortgages despite questionable credit records, mortgage-backed securities were an attractive place for pension funds and other investors to park their money.
"Were it not for that insurance, it certainly wouldn't have reached this manic state of growth," Greenberger said of the questionable investments.
Mortgage-backed securities have turned sour with plummeting home prices and increasing default rates. The securities have clogged the credit market, prompting the Bush administration and Congress to put taxpayers on the hook buying them up.
As the government buys mortgage-backed securities from teetering financial institutions at less than face value prices, issuers of the credit default swaps could be liable for the difference.
That's troublesome enough, but it actually gets worse.
Buyers of credit default swap insurance are not required to own the underlying securities they are insuring.
In other words, the investor can buy insurance on a mortgage-backed security without having to buy the security itself. When that security turns sour, whoever is holding the credit default contract -- whether they actually own the security or not -- can demand payment for the face value of the security.
This has created a market in which speculators actually are betting that mortgage-backed securities will lose their value.
Because the market is unregulated, the size of the credit default market is difficult to estimate.
The International Swaps and Derivatives Association, a trade group, estimates its "notional value" for year-end 2007 at $62.2 trillion -- roughly five times the entire U.S. production of goods and services last year. The total represents how much sellers of the protection would have to pay if every one of the securities were to default, an unlikely scenario to be sure.
:wow:wow:wow:wow:wow:wow:wow
But even this is a rough estimate. Participation on the survey was voluntary. What is helping drive the panic in these contracts is that little is known about who owes what to whom.
"Nobody knows where all the credit default swaps lie," Greenberger said. "And that's really proven to be a big problem."
NO SHIT, SHERLOCK.