The credit default swaps market - a market that for years was kept out of view and away from any regulation - has suddenly turned into a political hot potato in Washington, where the chairman of the Securities and Exchange Commission said during the week that regulation was needed, while the secretary of the Treasury said efforts were already under way to get things under control, and urged caution.
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A Risky Way to Manage Risk
By Floyd Norris
27 September 2008
NEW YORK: The credit default swaps market - a market that for years was kept out of view and away from any regulation - has suddenly turned into a political hot potato in Washington, where the chairman of the Securities and Exchange Commission said during the week that regulation was needed, while the secretary of the Treasury said efforts were already under way to get things under control, and urged caution.
Such swaps, which enable lenders to a company to purchase what amounts to insurance that will protect them if the company defaults on its debts, have grown exponentially in recent years, with the nominal amount of debt guaranteed rising from $631 billion in mid-2001 to more than $62 trillion at the end of last year.
As the political debate was growing, the International Swaps and Derivatives Association, a trade group, reported that the amount of outstanding credit default swaps declined in the first half of 2008, something that had never happened before.
The 12 percent decline, to $54.6 trillion, still left the market vastly larger than the total amount of debt that can be guaranteed. The total reflects the way the market is structured, and the fact that one does not need to actually be owed money by a company to be able to buy a credit default swap. In that case, the buyer is betting that the company will go broke.
The accompanying charts show the growth of the amount of credit default swaps outstanding, and show how those totals compare to the total amount of outstanding loans from banks and others to corporations and foreign governments. Even with the decline, the swaps volume is more than three times the debt total.
Within that huge market, many contracts offset each other - assuming that all parties honor their commitments. But if one major company goes broke, the effect could snowball as others are unable to meet their commitments.
In regulated futures markets, contracts are centrally cleared. If you buy an oil futures contract Monday and sell it Wednesday, you have made your profit (or taken your loss) and you no longer have any stake in whether oil prices rise or fall. But if you buy a credit default swap Monday from one firm, and sell an identical swap Wednesday to another firm, you still face the potential of risk if the party that sold the swap to you is unable to pay, perhaps years later. That is one reason that the volume of swaps has grown so large.
“One of the major reasons that the government helped out in the Bear Stearns situation,” Treasury Secretary Henry Paulson Jr. testified at a Senate hearing during the week, “was to avoid throwing it into bankruptcy with all the credit default swaps.”
Paulson said the Federal Reserve Bank of New York was working to develop protocols for that market to deal with a failure of a big player, and he indicated he did not see a need for legislation.
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