This article first appeared in the St. Louis Beacon: October 12, 2008 - A ubiquitous term in the news about financial crisis is "credit default swap." The subtle mysteries of the mechanism seem to confound commentators and the general public alike. Apparently, they remain a mystery even to some of the practitioners, particularly senior decision-makers at several affected companies. To delve into their meaning and effect, it is helpful to understand them as a substitute for a variety of the age-old institution of insurance.
Insurance, an industry formed in the distant past, is regulated by states. The cornerstone of the regulation is to assure that the issuer of insurance has sufficient capital (reserves) available to satisfy policy-holders claims, even in a case of widespread disaster. Often insurance companies contract for reinsurance to supplement their capital. As well, they ration their exposure to certain markets that might lead to common disasters that would otherwise overwhelm their ability to sustain losses.
Credit default swaps are a form of insurance, and - here is the key - they are unregulated and unsupervised except by the participants. They involve contracts between the issuer and a party to a contract (party A) to provide payment in cases when the party with whom A has made the contract is unable to pay or suffers a credit rating downgrade below a level specified in the agreement with the person seeking assurance of creditworthiness. For instance, a company that invests in a company holding mortgages, gets insurance to guarantee that the investment will be covered if the value of the assets falls below the money it has on the line.
No one other than the parties place requirements limiting the exposure of either the seller or purchaser of the credit default swap to a particular category of risk, or indeed of the necessary capital or reserves as well as reinsurance contracts required to sustain losses occasioned by market changes or financial events.
This very lack of information is demonstrated by the fact that after a $61 billion infusion to the insurance company AIG, the Treasury and Federal Reserve had to ask for more public money for their financial salvage operation to account for anticipated losses not countenanced either by the capital resources originally available to AIG or by supplemented amounts available after the initial infusion.
Given the role of these instruments in global markets, many have long called for regulation and oversight. These have always been opposed by financial gurus and public figures such as Alan Greenspan. His affinity and those of his fellow political conservatives for unregulated markets have arrived face to face with the current disastrous circumstances.
This is not to minimize the naïve willingness of countless financial institutions including Fannie Mae and Freddie Mac in purchasing obligations guaranteed by these instruments without prudent investigation into their soundness. The financial losses and public suffering that will be visited on many Americans as well as citizens of a variety of our international trading partners and financial customers are still difficult to quantify.
We have here the consequence of cowboy capitalism allowed to run wild by "public servants" sustained by political contributions and the blandishments of financial highbinders.
In Missouri, the Kool-Aid has been consumed as well. Under the administration of Gov. Matt Blunt, the same attitude of lax or non-regulation has invaded the Insurance Division, as market supervision has relaxed and been deeded to the very companies that have so often proved incapable of regulating themselves. We are at the point of revisiting the circumstances that led to the New Deal regulatory reform of the 1930s, albeit with Credit Default Swaps instead of the long forgotten manipulations that characterized the stock market prior to its crash in 1929. The lesson is that the techniques may vary but the motivation to game good sense persists.
What is the solution?
Comprehensive regulation and oversight wherever the possibility of wide-spread public hurt stemming from the unregulated private marketplace exists. It may at times be inconvenient and it will always be disparaged as a characteristic of a nanny-state. However, its absence has now been felt in spades by the proverbial little people who have joined a few of the privileged facing the loss of their financial sustenance.
John Roach is a lawyer who has long been involved in transportation and other civic issues.