Monday, October 13, 2008

A mystery explained

I consider myself a reasonably well-informed person, although like John McCain business and finance aren't my strong points. Still, I thought I had a general handle on the esoteric instruments that seem to be at the heart of the financial crisis. But as I was driving yesterday, I heard an episode of This American Life (apparently first broadcast late in September) that explained one part of it about which, as it turned out, I was wholly ignorant. That is the credit default swap.

Turns out that the credit default swap started as an instrument that was pretty much what you might think from its name: For a fee, someone would insure a security (say one of those mortgage-backed securities that we've hard so much about) against default. Given how over-rated those bonds turned out to be, the issuance of insurance on them would have been bad enough, leaving the insurers open to huge claims. But that doesn't begin to tell the story. Some few years ago, people started writing swaps (that is, insurance contracts) for bonds that the purchasers did not even own. In other words, purchasers would pay good money to cover the chance that the issuer of a security they didn't have in their portfolios would go belly up.

There's a name for that kind of contract: A bet. It's the kind of wager that you'd expect from Sky Masterson, the high-flying gambler in Guys and Dolls, not from supposedly respectable financial institutions. And, apparently, there are 50 or 60 trillion dollars or more of these things out there--ten or twelve times the value of the mortgage-backed securities that are out there.

Now you can get some idea of why the crisis is so bad. Indeed, with trillions and trillions of dollars in actual or potential liabilities out there, the rescue that has received so much publicity looks like a shot in the dark.

And, as you've probably heard, these swaps are not regulated. Indeed, federal law (thanks to John McCain's good friend and financial adviser former Sen. Phil Gramm) forbids regulating them. Even the insurance aspect is not regulated. (State insurance regulators--for reasons I won't go into here, the federal government has never regulated insurance--would normally impose minimum capital requirements on such contracts.)

Remember that a few months ago, credit default swaps were considered to be cutting-edge finance, the most sophisticated aspect of a new kind of capitalism, too advanced for ordinary human beings to understand.

Not for the first time, the smart guys turn out to be incredibly dumb. Unfortunately, when the smart guys control huge amounts of money, their stupidity winds up costing the rest of us.

Thinking about this, I realized that I--like almost everyone--bought into the idea that the end of the Cold War was the triumph of capitalism, that for all its idealism, socialism had proved to be unworkable. I still believe that the market is the best way to allocate resources and set prices, but how supremely ironic that capitalism's great failure has ushered in a new era of socialism!

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