Sunday, November 23, 2008

When Even Good News Worsens a Panic

Despite hysteria, credit default swaps won't wreck the economy.

So it should have been reassuring that one of the most nerve-racking of the unknowns turned out to be benign.

We now know that we should not have feared huge losses in the multitrillion-dollar, unregulated market for esoteric instruments called credit default swaps. Transactions in this market have been orderly, and the losses have been modest.

Instead of cheering this happy news and reassuring investors, Washington last week pilloried these swaps and set out to regulate or even ban them. Bankers know this puts at risk one of the few remaining smoothly functioning parts of the credit market. Markets reacted to this new unknown unknown: How much damage will be caused by regulators creating new problems and distracting attention from the real ones?

To be fair, credit default swaps are complex and poorly understood. These swaps let investors buy insurance against a company or a country defaulting on its debt payments. If a bank decides it has too much exposure to, say, the oil industry, it can insure against the risk of companies in this industry defaulting.

Last week, banking expert Peter Wallison of the American Enterprise Institute walked the sophisticated audience of the Exchequer Club through how these swaps work. He offered the example of bank A making a $10 million loan to company B. Bank A can eliminate most of the risk of B from its books by going to C, a dealer in these swaps, who agrees to pay the $10 million to A if B defaults, in exchange for A paying an annual premium to C for the protection. A will want collateral from C to be sure it's good for the debt. As a dealer, C will hedge its exposure, entering into a swap with D, which also hedges through E.

The three swaps in this example total $30 million, but the actual credit risk is the same $10 million. "The notional amount of all the CDSs is a meaningless figure for the purpose of assessing the risk in the system," Mr. Wallison concluded. More than that, "one of the keys to effective risk management is diversification, and CDSs make diversification easy."

Contrast that with comments by Sen. Tom Harkin, who has proposed banning these swaps and last week introduced a bill to regulate them. "With the value of swaps at a high of some $531 trillion for the middle of this year -- eight ?189 times the world GDP of $62 trillion -- it is long past time for accountability in the markets," he said. The notional amount of the credit default swaps got as high as $62 trillion, with the rest of Sen. Harkin's estimate coming from other financial transactions. "Shouldn't we just outlaw all of these fancy little things?" he asked.

No. Credit default swaps reduce risk for those who buy protection. They stabilize markets. Indeed, these swaps are now the best way to price credit. Making the level of corporate credit risk clear is key to getting lending back into the system.

Mr. Wallison focused on these swaps to make an important point about Washington. "If the searchlight is turned on credit default swaps," he said, "it won't be focused on the government policies that encouraged the production and distribution of the junk loans that are at the root of an unprecedented world-wide financial crisis." Congress has still not focused on how its policy of making mortgages too available led to unsustainable mortgage loans through Fannie Mae, Freddie Mac and the Community Reinvestment Act that were the proximate cause of the credit collapse.

The swaps market should be more transparent. This will show that it is faring better than the mortgage-related debt on which it's based. Some propose a central clearinghouse, but this runs the risk of another too-big-to-fail institution. Or we could have decentralized electronic execution of swaps, with greater disclosure of trades. The market can work out the best approach.

The credit crisis reflects many failures, but a central theme is people not knowing what they were doing and the panic that results in an Information Age when we lose confidence that we have the information we need. Financial professionals didn't understand that models based on prior experience would fail when confronted with a housing bubble, or that bundling bad mortgages together only made the rocks sink faster.

For regulators, too, some humility is now in order. In the case of credit default swaps, there's no reason to fix what's not broken.

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