Credit Derivatives for Dummies

[snot]

Heard a discussion of credit derivatives on PBS last night by their business "expert," and was disappointed that he totally ignored the WORST thing about derivatives.

So here it is, for the benefit of media experts as well as the rest us. Feel free to share this if you think helpful; comments and corrections also welcome.

As Solman explained, credit derivatives are like insurance. If you hold debt of a company, e.g., the company issued bonds that you bought, and you're nervous about the company's ability to pay, you can buy a credit derivative to insure that if the company goes bankrupt, you'll still collect the amount of the debt.

So, first, regarding other, regular kinds of insurance, you can buy insurance for your own house or other property in case of fire, flood, etc. But you can NOT buy insurance on a house in which you have no ownership interest, because you're deemed not to have a sufficient interest in its NOT burning down. In fact, your owning insurance on a house in which you have no ownership interest gives you a positive incentive to commit arson. It's a big conflict of interest.

Owning the house, or whatever you're buying insurance for, is therefor called "having an insurable interest." You actually have a vested interest in the property, or the life, or whatever it is that's insured -- you have a vested interest in its NOT being destroyed, so you're unlikely to abuse the insurance system to, say, merely gamble speculatively on its destruction, let alone commit arson or whatever.

Because credit derivatives are unregulated, not only do we have no clear idea of what's out there (although the commonly agreed estimate is $62 TRILLION, which is several TIMES the US's gross national product). But much WORSE is that we have no idea whether most of the parties who bought and are still buying credit derivatives are doing so in order to protect the value of an asset they actually own, or if they're just making speculative bets.

In other words, while some credit derivatives may have been bought by owners of bonds, mortgage-backed securities or other securities to hedge the risks of owning those securities, large amounts of derivatives may well have been bought by people who were NOT purchasing insurance to protect any insurable interest, but who merely felt like betting that certain companies would fail.

In fact, they could have been purchased by people who not only felt like betting that certain companies would fail, but who had enough inside info, if not power, to know that such failure was likely to happen, or even to help CAUSE it to happen.

SO. The BIGGEST outrage about the bailout is that the gigantic wads of taxpayer money given to Wall St. may well be being used to pay off these bets, at least some of which were probably made by speculators with no insurable interest -- i.e., no real NEED for the money -- and who may even have helped bring about the failure of the companies they bet against.

(The AIG bonuses are of course trivial by comparison.)

Before we give any money to derivatives issuers like AIG, we should find out what their obligations are, including which of them are to counterparties with "insurable interests" and which are to speculators. Then we'd be in a position to make informed choices about how best to allocate taxpayer money.

And there's no good reason we can't find that out. We don't even need AIG's cooperation. All the government has to do is announce to the world, if you bought a derivative from AIG and you think AIG owes or could in the future owe you money on it, tell us who you are, the amount of the payment to be made, and some other info like what if any "insurable interest" it's intended to cover. And if you don't file your claim, your claim will be wiped out.

This is what happens if you or I become insolvent. It's called bankruptcy. Another thing about regular bankruptcy is, if the total of all the claims filed against you are bigger than all you've got to pay them with, then generally, the court just divides whatever you've got left among your creditors, and the remainder of your obligations is wiped out. The creditors take cents on the dollar, and eat the remainder as a loss. And they don't get reimbursed by taxpayers. This is fair because the creditors had the opportunity to investigate what kind of credit risk you were before deciding to extend any credit to you; the taxpayers didn't.

Because the banks and AIG are so big, we're told, we can't afford to make their counterparty/creditors eat the loss. That may be true in some cases. In others, not so much.

You and me are sacrificing our retirements, kids' educations, etc., to make good on bets we never agreed to, placed by parties who not only stood to lose little if the catastrophes they bought insurance against weren't paid, but who may actually have had the power to bring about the catastrophes they were buying insurance against.

Yes, it's complicated; so is rocket science, but we don't throw up our hands and say it's too hard.

Nouriel Roubini, the NYU professor who predicted the current crisis, mentioned in a recent talk that throughout recorded history, there's been a more or less regular cycle of economic bubble-and-bust every ten years, with only one exception during which we managed to prevent such crises from arising for a solid fifty years: the fifty years while Glass-Steagall and other post-depression securities regulation remained in effect. Then we allowed Republicans and "New" Dems, financed by Free Marketeers, to dismantle it; and now we've got the biggest meltdown in history.

We need effective government to regulate markets and protect those of us who don't have the time or expertise to figure it all out. We've had effective regulation in the past, and we can have it again. It's not, really, a matter of brain-power; it's a matter of spine.