Credit default swaps are financial instruments that serve to protect against a default by a particular bond or security. They were invented by Wall Street in the late 1990s as a form of insurance. Between 2000 and 2008, the market for such swaps ballooned from $900 billion to more than $30 trillion. In sharp contrast to traditional insurance, swaps are totally unregulated. They played a pivotal role in the global financial meltdown in late 2008.
More recently, swaps have emerged as one of the most powerful and mysterious forces in the crisis shaking Greece and other members of the euro zone. And they have become the subject of antitrust investigations in both the United States and the European Union.
The financial regulatory reform bill passed in 2010 called for the creation of new clearinghouses for derivatives, a class of financial transaction that includes credit default swaps. The investigations focus on whether the handful of big banks that dominate the swaps field have harmed rival organizations that could compete in markets for providing information and clearing swaps deals.
The original purpose of swaps was to make it easier for banks to issue complex debt securities by reducing the risk to purchasers. It is similiar to the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture. Here is a more detailed but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:
"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small. As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."
Swaps proved to be very profitable — in the short term. Banks and other companies that issued them earned fees for insuring events they thought would never happen, like the bottom falling out of the market for mortgage-backed securities. As a result, the losses produced by the end of the housing bubble were multiplied manyfold, as the issuers of swaps found themselves faced with huge liabilities they had not prepared for. It was this cycle that brought down the American International Group, the insurance giant, which eventually needed $180 billion in taxpayer support.
Swaps also became something traded in and of themselves, as a form of speculation. That kind of trading also landed investment banks in multiple and seemingly conflicted roles, as when Goldman Sachs helped sell bundles of mortgage-backed securities and then used swaps to bet that they would go belly up.
The role of banks like Goldman also became the focus of criticism as Greece, Spain and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe's common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.
But, just as the true extent of Greece debts began to worry investors, Goldman put on another hat, sending clients a 48-page primer on credit-default swaps entitled "C.D.S. 101." The report said that credit-default swaps enabled investors "to short credit easily" — that is, to bet against certain borrowers. The report made no mention of Greece. But its disclosure in March 2010 fueled the suspicions of European officials who have called for investigations into the role swaps have played in the current crisis.
More recently, swaps have emerged as one of the most powerful and mysterious forces in the crisis shaking Greece and other members of the euro zone. And they have become the subject of antitrust investigations in both the United States and the European Union.
The financial regulatory reform bill passed in 2010 called for the creation of new clearinghouses for derivatives, a class of financial transaction that includes credit default swaps. The investigations focus on whether the handful of big banks that dominate the swaps field have harmed rival organizations that could compete in markets for providing information and clearing swaps deals.
The original purpose of swaps was to make it easier for banks to issue complex debt securities by reducing the risk to purchasers. It is similiar to the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star's next picture. Here is a more detailed but still simplified explanation of how they work, given by Michael Lewitt, a Florida money manager, in a New York Times Op-Ed piece on Sept. 16, 2008:
"Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small. As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized."
Swaps proved to be very profitable — in the short term. Banks and other companies that issued them earned fees for insuring events they thought would never happen, like the bottom falling out of the market for mortgage-backed securities. As a result, the losses produced by the end of the housing bubble were multiplied manyfold, as the issuers of swaps found themselves faced with huge liabilities they had not prepared for. It was this cycle that brought down the American International Group, the insurance giant, which eventually needed $180 billion in taxpayer support.
Swaps also became something traded in and of themselves, as a form of speculation. That kind of trading also landed investment banks in multiple and seemingly conflicted roles, as when Goldman Sachs helped sell bundles of mortgage-backed securities and then used swaps to bet that they would go belly up.
The role of banks like Goldman also became the focus of criticism as Greece, Spain and other southern European countries found themselves facing a debt crisis. Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe's common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.
But, just as the true extent of Greece debts began to worry investors, Goldman put on another hat, sending clients a 48-page primer on credit-default swaps entitled "C.D.S. 101." The report said that credit-default swaps enabled investors "to short credit easily" — that is, to bet against certain borrowers. The report made no mention of Greece. But its disclosure in March 2010 fueled the suspicions of European officials who have called for investigations into the role swaps have played in the current crisis.
No comments:
Post a Comment