The Anatomy of Poor Regulation

What are Credit Default Swaps? Are they stocks? No. Are they bonds? No. Are they insurance? Yes, but they’re not considered such for the purposes of regulation. Are they bets? Yes, but not even regulated the way betting is regulated in Los Vegas! This is what took down our economy, not Fannie Mae, not low-income borrowers who were screwed over on their loans.

Say a big investor buys a bond from a company. But the investor is worried about the company’s ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit default swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it. The issuer of the credit default swap doesn’t write this insurance for free. It gets a fee, usually a percentage of the value of the bond.

This is the bad part:

And since these contracts are not considered “insurance,” Greenberger said, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.

There are over fifty-two trillion dollars worth of this stuff out there. If they had had the money to pay all these things up (I’m not sure, but I think there isn’t enough money in the world to pay these things off.)

Now don’t get me wrong, since these things are essentially insurance against default, and most people won’t, most of these are probably good. But how do you know?

The problem is that owners of the mortgage bonds don’t know what the bonds they are holding or trading are worth. If you knew they were crap, you could take the lost, if you knew they were gold, you could realize a profit. But you don’t know.

With insurance, it helps to know whether you need to cash it in. Unfortunately for many, the regulations on Mortgage bonds allowed both a laundered credit rating on these bonds and a great deal of mystery as to whether they hold, as collateral, bad mortgages.

The potential and real liabilities that this has created has both yanked a boatload of money out from under big financial institutions, and made them very uncertain as to whether they can loan out more money, even for things like short-term commercial paper. That’s your devastating losses on Wall Street, and your credit crunch, right there.

Some blame the mortgage holders who accepted loans they couldn’t pay. But isn’t it the responsibility of the mortgage lenders to make sure these people were capable of paying these things back? Who holds the power here? The lenders. They can refuse people, when the evidence shows they can’t pay. Folks bring up the CRA, but most of the banks involved in the mess weren’t covered by the law to begin with. Those that were covered by CRA, on average, were foreclosed at a lesser rate, originated at a lesser rate, and not backed so much by mortgage bonds and derivatives.

Why did this happen? In no small part because folks wanted to make money without having to put that money out. They wanted to take big risks, but not see those risks on the balance sheets. But in its own way, this system was itself a fraud against investors and against consumers. The lenders were free with these mortgages because they had sold off so much in bonds, and ensured those bonds. Now that’s not bad in itself, but the lenders and the insurers created an unregulated mess where the quality of the mortgage no longer mattered in the short term. If the credit default swaps had required full or substantial collateral on their issuance, fewer might have been issued. If the mortgage bonds had been written more transparently, with the composition of its collateral better known, there would be no credit crisis, no black hole sucking in certainty and freezing up bank that lend out money. Nobody trusts anybody anymore.

We have gotten to the point where our central banks can’t trust that the other banks have the money to cover their debts, where the money that banks lend each other doesn’t seem to be any good.

And then you have absurdities like this, out of the first article:

Buyers of credit default swap insurance are not required to own the underlying securities they are insuring.

In other words, the investor can buy insurance on a mortgage-backed security without having to buy the security itself. When that security turns sour, whoever is holding the credit default contract — whether they actually own the security or not — can demand payment for the face value of the security.

This has created a market in which speculators actually are betting that mortgage-backed securities will lose their value.

Because the market is unregulated, the size of the credit default market is difficult to estimate.

So in essence, we have people actually betting on, standing to benefit from our nation’s financial problems. The more pain and suffering our economy goes through, the better for them. These are the perverse incentives that develop in a poorly regulated economy.

What we want in an economy are incentives for healthy financial behavior and penalties for irresponsibility and excess. We pay executives extra millions for their failures, send them to spas, let them enjoy ill-gotten gains as their companies go down in flames, and somehow, with these people in charge, coddled and irresponsible, expect the market to solve all problems.

To be blunt, the market, as we have configured it now, IS the problem. We need regulation, not because people are idiots, but because they’re not, and not everybody who is smart and capable is also wise or moral. We have people out there who, when given the responsibility, will betray it for their own benefit.

These people aren’t stupid. If they know they’ll get caught, if they know they’ll get in trouble, the frequency of such actions will decline, if only because the people involved have to be more careful, more sophisticated in their attempts. But any reduction is good, and if we lay down the law sufficiently, we will force them ultimately towards more productive behavior. Additionally, the market forces would then stop being a moral hazard, stop encouraging irresponsible behavior from those who know better, but are obligated to follow the truly unscrupulous when their methods prove most profitable. Our laws have consistently required companies to make money, to return on investments to those putting their money in. It is self-destructive for our nation not to apply laws and regulations to steer these people away from socially and financially behavior that is self-destructive to society and the economy.