Time to Stop Feeding the Monster

26 November 2008


Note: A number of the reference links have become stale and no longer reference existing pages.

In a democratic society the economy should work to support people rather than people working to support it. Let’s not forget we invented the economy—every bit of it, from the creation of money and credit, to the way we keep score with double entry bookkeeping, to the notion of GNP and theories of monetary and fiscal policy. When things go terribly wrong, as they have in recent months, we should be able to reinvent a functioning system not have it turn on us like some Frankenstein monster.

Our market system is exceptional. It needs to be rescued. But to function it requires good information and a clear connection between cause and effect. We have lost that connection. Nowhere is this more evident than the myth the sub-prime market was responsible for the current financial crisis. The facts show that the market was neither large enough nor struggling enough to cause this chaos.

At the end of 2006, when large US mortgage lenders started to fall like dominoes, the entire mortgage market in the US was worth $10 trillion. The sub-prime portion, and its close cousin the slightly better-heeled Alt A, represented 15% and 5%, respectively. At its peak, when financial executives started to call in their insurance policies, the pool of high risks mortgages was about $2 trillion.

Let’s think about that. The tab for the financial crisis in the US is $7.8 trillion. For a quarter of the cost all homes underlying sub-prime mortgages could have been purchased outright. The US could have had a housing program for its low and middle income families envied around the world, rather than what its ending up with; a corporate welfare scheme shoring up the bad decisions of a few hundred financial executives.

When the sub-prime mortgage market allegedly triggered this crisis, delinquency and default rates were lower than they had been in 2001-2002. The problems could have, and should have, been contained and redressed well within traditional mortgage lending practices if the old rules of the game had been in play. But they weren’t.

What’s changed? Enter the monster. In less than five years the rules of the game fundamentally changed due to the rise in power of derivatives markets and the underlying agreements embedded in the clauses of credit default swaps.

A credit default swap is a contract between two parties where the buyer makes regular payments to a seller in return for protection. Although credit default swaps are often referred to as insurance, unlike insurance which requires the insured party own the protected assets, the holder of the swap does not need to. In fact, the buyer of protection does not have to suffer a loss to collect—all that has to happen is for a predetermined default event to occur and the buyer collects a payment. The existence of these contracts on a wide scale, often providing multiple contracts for the same class of assets, has transformed the historical market incentive to accurately assess and underwrite risk into an incentive to disregard it.

Consider the impact credit default swap protection had on mortgage loans. Historically the prudent course of action, even within the sub-prime sector, was to keep known risks within a certain range: some would-be home owners were refused. Not so when you have unlimited protection. No income, no job, no assets, no problem. Prudent business practices got in the way of gobbling up market share. The appetite of the derivatives market for new mortgages was insatiable, as it was for credit card receivables, car loans, or any other activity that could be leveraged into an ante-up for the default swap market. The market was fattened up and then? Well, the monster sunk its teeth in.

The majority of credit default swaps last 1-5 years with a sizable increase in volume starting in 2004. It’s like these bets against the success of the economy were sitting on the shelf chanting “don’t forget our best-before date”. Remember, these are like insurance contracts without the insurance checks and balances of responsibility. Knowing your pool is insured if defaults begin to climb reduces significantly the desire to mitigate them, particularly if the negotiation process takes you past an expiry date. This built-in disincentive to take prudent action in the face of adverse circumstances is known in insurance circles as “moral hazard”. The greater the degree of coverage, the easier the claims process, the more likely the insured party will act in a hazardous fashion—will act irresponsibly.

An absence of consequence ruins prudent lending practice and destroys the incentive to workout a solution when borrowers face difficulty. Renegotiating loans, behind closed doors and in good faith, has become old school. In the past we could rely on renegotiation to contain a downturn. Not any more. It’s not so much that credit is unavailable, its that its going to feed the monster leaving the rest of the market to starve.

The unwillingness of lenders to renegotiate loans is now seeping into the consumer retailing sector causing large companies to head straight for bankruptcy rather than seek the useful protection of Chapter 11. The closed door to renegotiation in the private sector is what causes companies to ask for government bailouts.

The recent $326 billion rescue package for Citigroup was in response to the company’s exposure to collateral debt obligations (CDOs). Guess what, behind every synthetic CDO lurks a credit default swap, but its impossible to ascertain how Citigroup’s problems are in direct consequence of these obligations. These contracts are generally held in entities not reflected on the balance sheet and the definition of credit events differ from contract to contract. How, if and when they net out is important to know. Based on their losses to date they’ve found themselves on the wrong side of protection way too often. What we do know–a $25 billion problem grew thirteen times in a matter of weeks.

The powerful role credit default swaps play can not be overlooked in the recent requests for public aid from the top three auto makers. Both US and Canadian governments are being pressured to come up with bailout packages. What assurance is there that the money will not just go to the holders of swaps to pay off their positions? These contracts have a tail and depending on their terms, financial institutions may be able to benefit many times over on the same pool of assets. The nature of these agreements is that they thrive on instability and volatility. When the tangled web of agreements are unwound its quite possible auto manufacturers will fail anyway because the rescue aid was not directed to its intended purpose.

Protection of industrial activity and jobs is critical, but if we continue to rescue entities who are lined up for slaughter to feed the economically unreasonable demands of derivatives contracts, we will not find the solutions we seek. Until we reign in the derivatives mess we’re looking at taxpayers bailing out just about everything—except ourselves. It’s time to stop feeding the monster.

1. In December 2004 the notional value of credit default swaps in the over-the-counter (OTC) derivatives market was $6.4 trillion (2.5% of the total notional value of all OTC derivatives contracts). By December 2007 it was $57.9 trillion (9.7% of the notional value of all OTC derivatives) while credit default swaps to OTC derivatives contracts in terms of gross market values, went from 1.4% of the total in December 2004 to 14% in December 2007. See Table 19, statistical appendix September 2008 and September 2007 Bank for International Settlements Quarterly Reviews.