In all of the post-bubble analysis of what went wrong lots of blame is placed on credit default swaps (CDS), which are fairly new, having not existed before 1994. Inauspiciously enough, CDS stemmed from a disaster.
On March 24, 1989 the Exxon Valdez, an oil tanker headed to Long Beach, CA hit a reef in Prince William Sound, Alaska and spilled somewhere between 260,000 and 750,000 barrels of crude oil. In 1994 a jury awarded the plaintiffs (there were 38,000 litigants) $287 million in compensatory damages and $5 billion in punitive damages. The defendant was Exxon. Exxon appealed the case (this was not settled until 2009) but did not want to tie up $5 billion in capital. Exxon went to JP Morgan and got a $4.8 billion credit line in case it lost the appeal. JP Morgan was (and still is) a bit of an “old school” company. Exxon was a big client and an old client of JP Morgan so they said “yes” to the loan.
Basel bank capital accords call for such a commercial loan to be a 100% risk loan. That means that this loan tied up a minimum of $4.8 billion x 0.08 or $384 million of JP Morgan’s capital. Blythe Masters who was then a member of JP Morgan’s swaps team (see last paragraph on swaps) and is now the head of commodities for JP Morgan Chase had the idea of selling off the risk associated in the event that Exxon defaulted on that $4.8 billion credit line. The deal was made in 1994 and CDS (which did not even have a name at the time) were born. JP Morgan had its capital freed, the insurer got a premium, Exxon had its credit line, the plaintiffs had a guarantee of payment, and Exxon and J. P, Morgan preserved their relationship.
Subsequently CDS became the way that holders of debt purchased insurance in the case that the party owing the money defaulted. They were a form of credit insurance.
CDS started as insurance for corporate debt but what may have happened is that with the economy being healthy and very few corporations defaulting on debt, folks started to think of CDS as a cash cow and aggressively expanded the concept to include other debt including mortgages. With the help of HUD mandated subprime and other subprime non-GSE mortgage debt the prescription for a firestorm was created: 1) bad mortgages 2) expanded money supply and low Fed rates and 3) CDS Since then credit default swaps have grown gigantically.
Total Outstanding Credit Default Swaps
There is a web site with outstanding CDS. By the end of 2007 the outstanding notional amount of CDS was $62.2 trillion. One year later it was $38.6 trillion. The web site above show it currently at $24.2 trillion.
There is nothing inherently wrong with CDS. What should be considered for regulation is: (1) should CDS be traded on a open market and (2) should naked CDS be allowed.
Naked CDS are those wherein the buyer of the CDS has no underlying stake. Think of this as buying fire insurance on someone else’s house because you notice that he does not take good care of it. While this could be a motivation for arson it could also serve as a red-flag to an insurance company that the market is telling them that one of their policy holders is not taking adequate care of the insured property.
The mortgage mess/Great Recession has provided a very large dose of reality to those who gambled with CDS After the Lehman BK there was a total of $400 billion (notional) in CDS Most of the $400 billion involved entities that had money both coming and going on Lehman CDS so that the total net amount after balancing funds coming and going was about $7.2 billion. The big loser from CDS was AIG which had unwisely held an unbalanced portfolio.
Interest Rate Swaps
Before there were credit swaps the common swap of concern to the mortgage industry was the interest rate swap. An interest rate swap is the exchange of a fixed rate loan for an adjustable rate loan. If I hold assets such as fixed rate mortgages but my liabilities are of much shorter duration than the weighted average maturity of those mortgages they I may want to buy a swap to protect against a rising cost of funds.