Commercial Mortgage Lender Explains Credit Default Swaps – What They Are and Why They Matter

Imagine a world where public institutions could not lend money to consumers, businesses or each other. Imagine Treasury bonds downgraded from AAA to B-. Imagine the dollar losing another 20% of its relative value, and imagine the unemployment rate tripling in 3 months. Before the US Government stepped in with a $700B plan to stabilize our faltering financial system and injected hundreds of billions more in liquidity into the world’s central banks, we were, indeed, staring into the abyss; the end of the financial world as we know it was near-at-hand.

Conventional wisdom places blame for the credit crisis on the effect of falling housing prices on sub-prime, residential mortgages. It is said that banks and brokers made bad loans and when the market for single-family homes dipped, too many of those loans went into default leaving said banks and brokers holding the bag. Said bag was then promptly passed to Uncle Sam. And, although it’s true that sub-prime loans in a weakening real estate market are the genesis of the problem, they are not the problem, per-say. Stupid loans originated by lenders, greedy for profit, and taken out by borrowers, greedy for nicer homes and massive equity appreciation and encouraged by politicians, greedy for the votes of constituents with low FICO scores, were only the spark that started the world on fire.

There are fifty one million residential mortgages in force in the US today. A percentage of them are “sub-prime”, (less than 20%) and a percentage of those sub-prime mortgages (less than 30%) are in default. So the question becomes; how did such a relatively small segment of such a huge (multi-trillion dollar) market cause such disproportionate and devastating financial carnage? One would think that the damage would be confined to lenders that failed to diversify their mortgage portfolios, and homeowner who couldn’t pay their mortgages. Instead we are experiencing global economic chaos on an unprecedented scale. How did it come to this? The culprit is not the lowly sub-prime mortgage that we all love to hate so much, it is a formally obscure category of securities that that depend on the mortgage to impart to them their intrinsic value. They are called “credit derivatives”. Not loans themselves, derivatives are securities “derived” from loans, backed by loans and utterly worthless apart from those loans. Over the last decade credit derivatives played a secondary role in the functioning of the credit markets, today they represent a primary danger to the economic system of the capitalist world. And the most notorious of all derivatives is the shadowy, unregulated “Credit Default Swap”.

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A credit default swap (CDS) is simply a contract that acts as an insurance policy against the eventuality of default of a debt. A debt holder, like a commercial bank that owned a pool of mortgages, would buy protection against the possibility of default from a CDS dealer. If the covered bond defaulted, the dealer would be obligated to pay the holder the face amount of that particular bond. AIG was a big CDS dealer, as was Lehman Brothers, Bear Stearns, Goldman Sachs, Morgan Stanley, Deutsche Bank, J.P. Morgan, Chase, and Merrill Lynch just to name a few. All the big financial firms use them and all the big financial firms issued them. A CDS market is not a necessary element of a credit market; bonds can function with or without them, but, none-the-less, they became ubiquitous. Bond holders were eager to transfer their risk to some third party and thereby free up capital for lending, and brokers, banks and insurance companies were happy to take on the risk for a nice fee.

It didn’t take long for speculators to figure out there were no rules when it came to the CDS market. Anyone could buy or sell a CDS against any bond whether they owned the bond or not, any broker could issue a CDS contract even if they were not authorized by the bond’s owner. Dealers started selling CDS contracts against mortgage backed bonds that they had no connection to, and investors bought protection against the default of other people’s debt. By the end of 2007 $62 Trillion in debt was protected by CDS paper, and because the CDS market is a closed, bilateral market (a private transaction with no clearing platform or exchange) no one can really know the true extent of any one firm’s risk exposure. To make matters much, much worse, CDS dealers started buying CDS contracts against the contracts they themselves had issued. So the brokers, who were supposed to be protecting the banks, were buying protection from other brokers, insurance companies and other banks. The result was a complex and intricate interconnected web of undocumented risk that stretched from UBS in Switzerland, to Deutsch Bank in Germany to Goldman Sachs in the US to sovereign wealth funds in the east and mid east. Mutual funds, hedge funds, pension funds, banks, lenders, brokers, insurance companies, financial divisions of international conglomerates (such as GE Capital) and every other firm involved in the credit markets were and are deeply involved.

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Now, armed with a clearer understanding of the extent of the problems, consider what would happen if a major issuer of CDS contracts, or two, went bust. Take AIG for instance, if AIG had been allowed to fail, all their CDS would have become instantly worthless, all their client banks and brokerage firms around the globe would be, once again, on the hook for all the risk they had passed on to AIG. On the day AIG filed for bankruptcy thousands of institutions would become instantly insolvent and would have buy more CDS contracts, come up with a few billion dollars or file for bankruptcy themselves.

Here’s where sub-prime mortgages and falling home prices are a factor. Trillions of dollars of mortgage backed bonds have a sub-prime component. (A component, mind you, not a full blown direct exposure) Because of the crisis in sub-prime, which has been exasperated by the popping of the real estate bubble, the secondary market in mortgage bonds has evaporated. No one wants them; they have become illiquid. Because they are illiquid it is nearly impossible to accurately assess their value or their relative risk. This means that buying a CDS to protect them has become restrictively expensive.

If one or more of the large CDS players fails, it becomes highly unlikely that those contracts issued by them could be replaced quickly. Thousands of debt holders would flood the market and drive up the price of the new CDS contracts and drive down the value of existing CDS contracts. CDS contracts are carried on the books at market value so even banks that did not need to buy new CDS would lose capital as the value of their existing contracts plummeted. The result would be cascading failures of banks, brokers and insurance companies around the world. Nothing short of complete global financial meltdown would ensue.

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In the coming months regulators will authorize and supervise a clearing house for CDS contracts, most likely through Chicago based Clearing Corporation. Once there is a regulated exchange and clearing platform that all CDS contracts will trade through, transparency will increase and volume limits can be placed on dealers. No single dealer will ever be allowed to become dominant and thus “too-big-to fail”.

The risks associated with a massive unregulated credit derivatives market will eventually be mitigated. In-the-mean-time, the system must be stabilized regardless of the perceived cost. The alternative is almost unthinkable, $700B will seam like a mere bag of shells compared to what complete economic collapse would cost us.

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