It is all about the Credit Default Swaps Folks

So just in case you haven’t gotten my message on CDS’s here is an Editorial that I should have posted last week.

The Editorial Board at the NYT’’s writes a very good editorial on Credit Default Swaps and AIG. I believe it is a must read. So, here it is:

March 15, 2009

Editorial

Following the A.I.G. Money

The bailouts of American International Group are also rescues of its trading partners — banks and other financial firms — that would have lost out if the insurer had been allowed to fail. But even after four bailouts between last September and this March, no one knows with certainty who those partners are or how much of the bailout money, now totaling $160 billion, has gone to make them whole.

A.I.G. has not said who they are, and neither have government officials in charge of the A.I.G. bailouts — mainly Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke — despite repeated inquiries from Congress. (The Wall Street Journal, citing confidential documents, reported recently that about $50 billion in 2008 bailout money from A.I.G. went to at least two dozen firms, including Goldman Sachs, Merrill Lynch, Bank of America and European banks.) Late last week there was talk that more official information was forthcoming, but no one has seen it yet.

The secrecy is unacceptable. Taxpayers have a right to know how their tax dollars are being spent. Equally important, understanding how the financial crisis happened is crucial to ensuring that it does not happen again. To that end, Congress and the public alike need to know which firms are on the receiving end of the bailouts, how they came to require a government lifeline, and what responsibility they bear for the financial mess.

From what is known, it certainly does not appear that A.I.G’s trading partners were entirely innocent victims of extraordinary circumstances. A.I.G. was a key player in a type of unregulated derivative called a credit default swap. Such swaps are often defined as a form of insurance because the seller guarantees payment to investors in case their investments go bust. They are not safe insurance in any familiar sense, however, because A.I.G. was not required to set aside reserves in the event of a claim. That is why, when the bubble burst and defaults rose, A.I.G. was unable to make good, provoking the bailouts.

Still, the trading partners knew, or should have known, how dangerous the swaps were. And that is not necessarily the whole story. In the manic years of this decade, credit default swaps took off as a way to bet on the likelihood of default by a firm or an investment portfolio, without having to own any financial interest in the firm or portfolio. That is definitely not insurance, it is gambling. The reason it is not illegal gambling is that, in 2000, Congress specifically exempted credit default swaps from state gaming laws.

The result? Eric Dinallo, the insurance superintendent for New York State, has said that some 80 percent of the estimated $62 trillion in credit default swaps outstanding in 2008 were speculative.

It is unknown how much of the credit default swaps between A.I.G. and its partners were for speculation. That is a question that demands an answer. Also unknown is how much had been wagered on the demise of A.I.G. By intervening to prevent the insurer’s failure, the government prevented those bets from having to be paid. Who was let off the hook?

It is not enough to simply know more about A.I.G., its trading partners and their activities. What is needed is transparency going forward. Banks resist the idea of requiring that all trading in credit default swaps be conducted on exchanges, in the open and subject to full regulatory scrutiny. It is an idea, however, that is long overdue.

This is just one idea that is long overdue. The bonuses are interesting but I think a diversion from the billions, not millions (pretty soon you are talking real money,) that are flowing to the counterparties for 100 cents on the dollar. For what, that is the question?