WHITE-COLLAR CRIME & CREDIT DEFAULT SWAPS

You may recall that an analyst at Standard & Poor's realized that mortgage-backed securities were junk:

Meanwhile, an analytical manager in the collateralized debt obligations group at S&P told a senior analytical manager in a separate email that "rating agencies continue to create" an "even bigger monster -- the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters.;O)"

If someone did have doubts, the people peddling parts of the Big Shitpile could also sell credit default swaps (CDS) on those parts. What are they? CBS's 60 Minutes had a good description¹:

KROFT: (Voiceover) But before your eyes glaze over, Michael Greenberger, a law professor at the University of Maryland and a former director of trading and markets for the Commodities Futures Trading Commission, says they're much simpler than they sound.

What is a credit default swap?

Mr. MICHAEL GREENBERGER: A credit default swap is a contract between two people, one of whom is giving insurance to the other that he will be paid in the event that a financial institution or a financial instrument fails.

KROFT: So it's an insurance contract.

Mr. GREENBERGER: It is an insurance contract, but they've been very careful not to call it that because if it were insurance, it would be regulated. So they use a magic substitute word called a swap, which by virtue of federal law is deregulated.

KROFT: So anybody who was nervous about buying these mortgage-backed securities, these CDOs, they would be sold a credit default swap as sort of an insurance policy.

Mr. GREENBERGER: A credit default swap was available to them, marketed to them as a risk-saving device for buying a risky financial instrument.

Calculated Risk has a video clip of some of this 60 Minutes segment and Harold Meyerson of the WaPo let's us know who was behind the deregulation of the CDS: "Whiner" Phill Gramm, one of McCain's senior economic advisers (h/t Atrios):

Chief among those to whom responsibility attaches for the financial crisis that is plunging the nation into recession is former Texas senator Phil Gramm, McCain's own economic guru.

Gramm was always Wall Street's man in the Senate. As chairman of the Senate Banking Committee during the Clinton administration, he consistently underfunded the Securities and Exchange Commission and kept it from stopping accounting firms from auditing corporations with which they had conflicts of interest. Gramm's piece de resistance came on Dec. 15, 2000, when he slipped into an omnibus spending bill a provision called the Commodity Futures Modernization Act (CFMA), which prohibited any governmental regulation of credit default swaps, those insurance policies covering losses on securities in the event they went belly up. As the housing bubble ballooned, the face value of those swaps rose to a tidy $62 trillion. And as the housing bubble burst, those swaps became a massive pile of worthless paper, because no government agency had required the banks to set aside money to back them up.

The CDS weren't regulated, so the firms that sold them had no legal obligation to have enough money in reserve to cover them in case of defaults:

KROFT: But there was a problem?

Mr. GREENBERGER: Oh, there was a big problem.

KROFT: What was the problem?

Mr. GREENBERGER: Well, the problem was that if it were insurance or called what it really is, the person who sold the policy would have to have capital reserves to be able to pay in the case the insurance was called upon or triggered. But because it was a swap and not insurance, there was no requirement that adequate capital reserves be put to the side.

KROFT: Now, who was selling these credit default swaps?

Mr. GREENBERGER: Bear Stearns was selling them, Lehman Brothers was selling them, AIG was selling them. You know, the names we hear that are in trouble, Citigroup was selling them.

KROFT: These investment banks were not only selling the securities that turned out to be terrible investments, they were selling insurance on them?

Mr. GREENBERGER: Well, it made the--it made it easier to sell the terrible investments if you could convince the buyer that not only were they going to get the investment, but insurance.

KROFT: (Voiceover) But when homeowners began defaulting on their mortgages and Wall Street high-risk mortgage-backed securities also began to fail, the big investment houses and insurance companies who sold the credit default swaps hadn't set aside the money they needed to pay off all the insurance contracts they'd written. Bear Stearns was the first to go under, selling itself to JPMorgan for pennies on the dollar. Then Lehman Brothers declared bankruptcy. And when AIG, the nation's largest insurer, couldn't cover its bad debts, the government stepped in with a $85 billion rescue.

¹CBS News Transcripts
October 5, 2008 Sunday
SHOW: 60 Minutes 7:30 PM EST CBS
Wall Street's Shadow Market; Credit default swaps
ANCHORS: STEVE KROFT
LENGTH: 2210 words