Fixing Those Swaps

Posted Jan. 29, 2009, at 5:38 p.m.

Few of us understand credit-default swaps and most of us never even heard of them until recently. But their nominal market value is $58 trillion, according to BusinessWeek, far more than the collapsed subprime mortgage market. They lurk at the center of the deepening financial mess.

Gretchen Morgenson, The New York Times’ financial reporter, calls them the elephant in the room and writes that people haven’t wanted to talk about them. But reining them in is now high on the to-do list of the new Obama administration’s economic team.

These swaps are a sort of insurance contract. Wall Street devised them in the 1990s to allow bondholders to protect themselves against defaults by debt issuers. Banks issue them and investors receive them. Unlike normal insurance, a bank can issue a CDS on a bond that it doesn’t own. Another difference is that, unlike other insurance and most other markets, the trade in swaps is unreported and unregulated.

That is where the trouble started. The value of a CDS stems from the flow of premiums if the insured company flourishes and the payout if it fails. That value quickly attracted speculators, who began trading in swaps as bets on the health of companies.

The gigantic market in credit-default swaps locked up when defaults mushroomed and the swaps guarantors couldn’t make good on the insured losses. The CDS crisis figured in the need for the multi-billion dollar taxpayer payments to rescue American International Group and Bank of America. Your own bank and your own money market account may well include some of these swaps.

Two specialists cited by Ms. Morgenson agree that the financial system is frozen largely because of credit-default swaps. As Christopher Whalen, managing partner at Institutional Risk Analytics, puts it, the failures of Lehman Bros. and Bear Stearns don’t explain the deepening turmoil: “No, the reason for the continued heebie-jeebies in bank equity and debt stems from unfinished business in the market for credit-default swaps.” He says that Fed Chairman Ben Bernanke and the U.S. Treasury must confront Goldman Sachs, JPMorganChase and other CDS dealers and force them to drive speculators out of the swaps market by putting it onto the regular securities exchanges, raising margin requirements and requiring physical presentation of bonds to collect insurance payments.

Sylvain R. Rayes, a mathematics professor at Baruch College, proposes an eight-step resolution starting with suspension of further Treasury loans to Wall Street until the various financial assets are revalued and put under FDIC regulation. He predicts that money would start moving within one or two months and the crisis would be effectively over.

Such solutions should be considered before the situation gets worse.

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