CT Blue

Last month I mentioned an article I read about “credit default swaps”, another off the books sort of financial chicanery that might be lurking in the background ready to cause financial havoc. These are, as best as a I understand, freely tradable credit “insurance policies”, which, for the holders, amount to bets that insured loans will default.

There are three excellent articles in today’s Times on the financial crisis, one on the front page (here) , and two in the business section (here and here). The first article has been justly criticized for noting that George Bush and his treasury secretary are philosophically opposed to regulations that hamper economic activity, as if there are people who are philosophically in favor of such regulations. Nonetheless, it does a pretty good job of laying out the issues we will be facing as we look to regulate investment banks and the various financial instruments in which they trade. If, as seems more and more likely, we are to endure another four years of a Republican chief executive, we are likely to get next to nothing by way of real regulation of these entities. If the people opposing these regulations had the interests of these institutions at heart they would accept a fair degree of regulation, because their long term existence is at risk if they must compete with other unregulated institutions in dealing with ever riskier and more complex instruments that they don’t understand. But if you stand to gain a hundred or two hundred million dollars in income in a year or two, income you get to keep when the institution you are “serving” tanks, you have a powerful disincentive to fight something that might be to everyone’s long term good. It is beyond belief that these greedheads are allowed to make unregulated decisions that, eventually, are bound to have catastrophic effects on the economy. But they are, and there are always true believers who will tell you that unregulated markets are the cure for all that ails you, notwithstanding history and common sense to the contrary.

Both articles in the business section put those credit default swaps at the heart of the financial mess and/or the recent bailouts, and Gretchen Morgenstern, in the first of the linked articles from the business page, pretty much claims that the recent Bear Stearns bailout was at least in part an attempt to deflate this unregulated market:

But a closer look at the terms of this shotgun marriage, and its implications for a wide array of market participants, presents another intriguing dimension to the deal. The JPMorgan-Bear arrangement, and the Bank of America-Countrywide match before it, may offer templates that allow the Federal Reserve to achieve something beyond basic search-and-rescue efforts: taking some air out of the enormous bubble in the credit insurance market and zapping some of the speculators who have caused it to inflate so wildly.

Of course, it could be simple coincidence that the rescues caused billions of dollars (or more) in credit insurance on the debt of Countrywide and Bear Stearns to become worthless. Regulators haven’t pointed at concerns about credit default swaps, as these insurance contracts are called, as reasons for the two takeovers. (And Bank of America’s chief executive, Kenneth D. Lewis, has flatly denied that his deal with Countrywide was at the behest of regulators.)

Yet an effect of both deals, should they go through, is the elimination of all outstanding credit default swaps on both Bear Stearns and Countrywide bonds. Entities who wrote the insurance — and would have been required to pay out if the companies defaulted — are the big winners. They can breathe a sigh of relief, pocket the premiums they earned on the insurance and live to play another day.

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On the other hand, the big losers here are those who bought the insurance to speculate against the fortunes of two troubled companies. That’s because the value of their insurance, which increased as the Bear and Countrywide bonds fell, has now collapsed as those bonds have risen to reflect their takeover by stronger banks.

Naturally, of course, the losers will not really be the speculators who have caused the problem, because they are the hedge fund managers. The losers will be the people who invested in these hedge funds. There is probably no need to shed tears for these folks, but it would be nice to see the managers take it on the chin. But will they? According to Morgenstern:

It’s pretty clear that some major losses are floating around out there on busted credit default swap positions. Investors in hedge funds whose managers have boasted recently about their astute swap bets would be wise to ask whether those gains are on paper or in hand. Hedge fund managers are paid on paper gains, after all, so the question is more than just rhetorical.

If I understand that right it means that the hedge fund managers can give themselves a payday by declaring paper gains when they buy these instruments, and then hand the losses over to the investors (and the hedge funds) when those paper gains become real losses. Like the heads of all those mortgage companies, they’ll walk away with real millions while leaving failed companies in their wakes. Presumably this will cause more financial havoc, and as with the investment banks, we will somehow end up picking up the pieces.