Climate change bill would ban all credit default swaps

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The Waxman-Markey climate change bill approved by the U.S. House of Representatives on June 26 would ban all credit default swaps if a key section of the legislation were subjected to a literal interpretation.

That's right: All of them.

But while an outright ban is clearly an improvement over President Barack Obama's weak proposal to rein in the products Warren Buffett once described as "financial weapons of mass destruction," it's probably not the best approach to the issue either.

By now, most people who follow the financial markets are familiar with basic CDS history. CDS started out as insurance contracts for debt, but the market eventually grew to serve as a backwater for rampant, unregulated speculation. Today, if a bank is worried that a debtor might default on a loan, it can still go to a CDS issuer like American International Group Inc. and buy insurance on that debt. But completely unrelated firms with no interest in the underlying loan can also go to AIG and bet that the debt will not be repaid. This kind of bet is known as a "naked swap" and, by 2007, the market for naked swaps was completely out of control. The notional value of the CDS market had exploded to over $62 trillion, according to the Depository Trust and Clearing Corporation, well in excess of the entire global economic output for a full year.

"Let's say there's $1 trillion worth of obligations in the economy. You can use CDS to create $5 trillion worth of additional obligations," said Joseph Pastore III, a managing partner with the Fox Rothschild LLP law firm who works with CDS. "When you melt it all down, and there's only $1 trillion worth of cash and $5 trillion worth of obligations, it causes absolute economic devastation."

Here's the key passage from Waxman-Markey, buried on page 1,070 of the 1,428-page bill introduced in the Senate on July 6:

"It shall be unlawful for any person to enter into a credit default swap unless the person:

1)  owns a credit instrument which is insured by the credit default swap;

2)  would experience financial loss if an event that is the subject of the credit default swap occurs with respect to the credit instrument; and

3)  meets . . . minimum capital adequacy standards…"

"Clearly, the intent was to limit the multiplier effect of CDS by requiring only those parties with a risk to be able to insure the risk," Pastore told SNL.

But the restrictions apply to "any person" who would "enter into" a CDS contract, not merely to any company that would purchase one. That means banks are allowed to hedge risks by purchasing CDS, but CDS issuers like AIG are actually forbidden from selling them. When AIG offers insurance protection, AIG is not hedging anything; it's just making a speculative bet that a certain debt will not be repaid. In practice, then, Waxman-Markey would ban any credit default swap whatsoever, hedge or bet.

"A literal reading of it would prevent anyone from entering into a CDS contract, because the party that owns the underlying instrument needs to find somebody else to enter into the swap agreement with," Pastore told SNL.

Given that today's CDS market is an economic wrecking ball, a full-bore ban isn't such a bad idea. But a healthy, heavily regulated CDS market could actually help rein in chaos in the financial system rather than promote it.

There are two fundamental problems with the CDS market. The first is its epic size, which created tremendous distortions throughout the financial markets. AIG used CDS to bet over and over again that subprime mortgages would never default, until the company had literally trillions of dollars riding on the subprime market. Thanks to the accounting rules, AIG booked every CDS it sold as if it were totally risk-free.

"The accounting is so completely screwed up that you really don't have to establish loss reserves," according to William Black, a senior banking regulator during the savings and loan crisis who now teaches law and economics at the University of Missouri at Kansas City.

This destroyed the company last year, but it also helped create irrational, artificial demand for subprime mortgages. Big banks could gorge themselves on subprime mortgage-backed securities and insure themselves against any trouble by going to AIG. Best of all, banks who did this didn't have to put up capital for these mortgages since they supposedly had purchased insurance on them. Ultimately, of course, taxpayers insured these mortgages, not AIG, to the tune of $180 billion. But this did more than prompt a massive bailout. Subprime loans have very high interest rates that bring in very high profits for banks so long as the borrower never defaults. But if the bank can buy insurance against that default, it gets to book the profits no matter what happens to the borrower. So why bother with rigorous underwriting standards?

It's important to note that this wasn't a problem caused by rampant speculation. This is how a "legitimate" hedge actually worked.

By 2007, everybody knew the CDS market was crazy, but nobody really knew just how crazy. Which brings us to the second major problem: transparency. It is extremely difficult to gather information on the CDS market. When AIG went down, Wall Street firms weren't just worried about their own exposure to AIG — they had no idea what any other company's exposure to the insurance giant was either.

Again, the fact that this led to a bailout is only part of the problem. The lack of transparency in the CDS market completely defeated any potential economic benefit posed by the nature of the CDS contract. Whether CDS serve as insurance or pure speculation, they create economically useful information. CDS are essentially a bet on the viability of mortgages, or major Wall Street investment houses, or anything else. That means an accurate and transparent CDS market can paint a clearer portrait of how risky different investments are. If a lot of people think subprime mortgages are going to go belly up, it might be because there is something bad about subprime mortgages, and we might want to have widespread access to that information so we can do something about it before those mortgages create an economic catastrophe.

If we ban CDS outright, we will be blocking this information from public scrutiny. The result would be an improvement over the status quo, but it would also be a missed opportunity. CDS can actually serve a useful economic function and, if we want to take advantage of that, we have to make sure all CDS are traded on an exchange, just like ordinary stocks. People are reluctant to do stupid things when everyone can see them doing it — and this argument for transparency, incidentally, also applies to any other derivatives.

"The main thing is, you want them to be exchange-traded," economist Dean Baker, co-director for the Center for Policy and Economic Research told SNL. "This was a big problem of AIG and even Bear Stearns. They got in way over their heads, and if there had been exchange trading, I think people would have been more aware of the scope of the issuance they had with credit default swaps."

"The problem was not within the CDS contracts themselves," Raj Date told SNL. Date, head of the Cambridge Winter Center for Financial Policy think tank, previously served as an executive with Capital One and a managing director at Deutsche Bank Securities. "It just so happened that several players were woefully inadequately capitalized versus the amount of bets that they were making."

Exchange trading serves two purposes. First, it requires a third party to sign off on each transaction. When two companies make a trade on an exchange, the exchange guarantees each party's ability to pay. If AIG doesn't have the money to back a CDS contract, an exchange isn't going to let it make the bid. Second, it lets the public know what is going on with every single CDS trade. We'd, thus, get a lot more information about who is exposed to what, by how much and how risky different aspects of the economy are.

"You're basically not going to be able to do wild speculative plays on an exchange, where somebody actually has to be there making a market," says Black. "They're going to go, 'No, no, no, this would tube us.' And exchanges will give you dramatically more transparent markets and give the regulators the information they need to spot abuses."

But for this information to be useful, it has to be accurate. And we can't get accurate information if the CDS market is irrationally gigantic. The government should require companies to back up their CDS bets with real money, the same way banks have to back up their loans with real capital. If CDS players were required to recognize an immediate capital cost for CDS transactions, they would not be nearly so eager to dish out reckless bets.

"Part of the way that we make sure that people are able to make good on their various bets is to have margin requirements," Date says.

The Obama plan looks pretty weak in this light. The administration does want to impose capital requirements on CDS issuers, but instead of mandating exchange trades, the Obama team only wants CDS transactions to be cleared by a central counterparty — like an exchange, except the pricing and other critical market information can remain secret. Worst of all, if a CDS trade is "customized" in some way, companies would not even have to report their bets to a clearinghouse. There is no increase in public scrutiny.

"A clearinghouse wouldn't have prevented the current crisis," Black says. "It doesn't provide anywhere near the necessary amount of transparency."

And this is what the Obama proposal looks like before the Wall Street lobby waters it down in Congress. The major investment banks are already fighting capital cushions for CDS tooth and nail. If they prove successful, the administration's proposal becomes essentially meaningless.

So Waxman-Markey has to be viewed as a positive development in the derivatives debate. The House has said it finds the administration's plan to be weak. Instead of working from the Obama recommendations, Congress should be refining the Waxman-Markey approach.