Back to the Future PII: a silver lining?
only earlier today i posted a brief on Mary Schapiro, and my disappointement in her appointment … and this evening i found a silver lining.
Before i discuss it, i need to make sure everyone understands ‘credit default swaps’ and the market that trades them.
a person can buy a bond from a company- basically an IOU from the company that pays with interest. however, if you buy a bond from a company that goes out of business before the bond matures, your bond is worthless. a credit default swap is a financial instrument originally designed to allow people to buy ‘insurance’ on their corporate bonds, paying a small percentage of the total value of the bond in exchange for the safety and peace of mind.
the problem is that the credit default swaps market is completely unregulated- its a giant backroom betting game where companies and individuals who don’t own bonds at all buy credit default swaps on those companies that they see as having the possibility of going bankrupt. experts estimate that the CDS market is 10 times larger than the bond market it’s supposed to operate as a safety net for.
the CDS market is the massive tentacled beast which connects all business with financial components– its how come lehman brothers defaulting bankrupted AIG, and reduced the ‘off the book value’ of GE– the CDS market is a web of contracts connecting all businesses, and guaranteeing a wave of defaults and writedowns following any large bankruptcy.
this is a quote from Mary Schapiro to the board of her for-profit regulatory agency in october of this year- [i know its a long quote, but its pretty excellent]
“My final principle of regulation is the following: We must bring large systematically important yet unregulated participants in the financial markets under the regulatory umbrella and we must develop centralized clearing houses and exchange trading facilities for products that can affect the capital of our large institutions. Of course, I am principally speaking of the credit default swap market. I have been advocating a centralized clearing house to eliminate counterparty risk for nearly 15 years. Credit default swaps and other over-the-counter derivatives are being traded in volumes that could not have been foreseen even a few years ago. A turn in the CDS market can threaten the capital adequacy of a large firm. At the same time, a firm with a large CDS position, with many counterparties around the world, may be a firm that the federal government feels compelled to support with taxpayer money. At a minimum, this market needs a centralized clearing house so that the participants are known, adequate margin or collateral supports positions and the risks from counterparty failure are minimized.”
so, thats my silver lining, she at least pays lip service to the importance of regulation and transparency of the CDS market, though as with anything else complex and dangerous, the devil is in the details, and we’ll have to wait for innaugeration day and shortly after to see what kinds of new rules get added, and what kinds of teeth those rules get.
Wow, that actually could be a silver lining. I remember talking to you about the credit default swap market in the car that day. If she really is going to try to reform/regulate it, good news. We’ll see, I guess.
Corrie sent me the link last night and I’ve only had an opportunity to read the most recent three posts (so far). Absolutely fascinating! Thanks particularly for describing credit default swaps so clearly. If you keep it up I might actually start understanding economics.