The following Edward Lotterman "Real World Economics" column was published on page 1C of the Thursday May 15, 2008 issue of the St. Paul Pioneer Press.
It is dangerous when anyone plunges into business deals they don't fully understand. Over the past 25 years, the securities industry has developed myriad new financial instruments intended to better manage risk. But it's becoming clear that not everyone dealing in these securities really knows the risks relative to the rewards.
Most people have never heard of a "credit default swap," but they're making news as the risks posed by such once-obscure financial instruments gain visibility.
A credit default swap is insurance against loss from default on another financial instrument. Suppose you own a corporate bond. It is highly likely the corporation will make all promised principal and interest payments. But you want to be sure, so you make periodic payments to a third party who agrees to make good your loss in the unlikely event that the bond goes bad.
This is little different from insurance on houses. I don't expect my house to burn down or blow away, but I am willing to pay several hundred dollars a year for the right to be reimbursed if that does happen.
At this basic level, a credit default swap is straight-forward and useful. One party wants to reduce their risk and is willing to pay a premium to do so. Someone else is willing to assume risk for a fee. Both can be better off in the long run.
But such swaps do differ from insurance in important ways. Insurance companies won't write policies unless the buyer has an "insurable interest." I can buy a policy on my own house, but I cannot go out and buy a policy on Joe Blow's house three blocks down the street. I can insure my own life, but I cannot buy policies that will pay me if Tom Hanks or Tiger Woods dies.
One can, however, either buy or sell protection against a bond defaulting even when neither you nor your counter-party actually owns the bond.
Moreover, default swaps fail a classic test for separating "investors" or "hedgers" from "speculators." Is a given party always on the same side of the transaction or not? Homeowners always are insurance buyers. Insurance companies always are sellers. Grain elevators contract to sell wheat in the future. Flour millers usually contract to buy.
But a financial institution may sell default protection on a bond one week and buy it for the same bond a week later, depending on its assessment of which side is more profitable.
The number of houses in a country limits the volume of mortgage lending. The borrowing needs of governments and corporations limits the number of bonds issued. The number and size of corporations limits the total value of shares of stock. A country's total stock of buildings puts an upper limit on how much property insurance can be sold.
But there is no limit to the volume of credit default swaps that can exist at any time. And their growth has been enormous.
In 1994, there were some $45 billion in such swaps. By 1998, that had quadrupled to $180 billion. Over the next six years the volume increased 44 times to $8 trillion. It is now estimated at $45 trillion, three times the U.S. Gross Domestic Product.
So what, you may ask. Why should the fact that large financial institutions have made large bets on unlikely events affect the average family?
There need not be any effect if all of the players in the credit default swaps market have correctly estimated the underlying risks, and if the prices paid for swaps fully reflect that risk. As long as everyone involved holds up their end of the bargain, come what may, these swaps need not affect the real economy.
However, the ongoing collateralized mortgage debacle demonstrates that financial institutions can be way off base in pricing new, poorly understood securities. Moreover, it is clear that many of the institutions that have jumped on the credit swap bandwagon, including obscure banks in Africa and Asia, don't have the financial wherewithal to pay up if some insured default actually occurs.
When financial institutions lose trust that other parties in deals are willing and able to carry through on commitments, fear comes to dominate markets and they seize up.
That is what happened to commercial paper last August and September. Fear that Bear Sterns no longer was a reliable counterparty is what brought that firm from apparent strength to near bankruptcy in days in March.
As with many other financial sector innovations, the horse is long out the door. There isn't much government can do right now to reduce the threat default swaps pose for the broader economy. We can hope that participants can unwind their positions smoothly in coming months, allowing firms' exposure to drop, without anyone going broke in the process. But don't count on it.