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Peter Crabb: Why swaps need regulating, and why there's good news in the markets

It’s the $62 trillion question. What are credit default swaps, and how did they lead to the financial mess we find ourselves in now?

The problems at Lehman Brothers, American International Group (AIG), and others that brought about the first round of financial institution bailout programs stem, at least in part, to large unfunded liabilities for credit default swaps.

Credit default swaps are financial contracts whereby lenders protect themselves against losses when a bond issuer goes into default. If the bond issuer fails to make the agreed interest or principal payments, the issuer of the default swap contract has to cover the payments.

In this manner, credit default swaps are just another form of insurance. By insuring against these potential losses, the bond buyers are more willing to accept lower interest payments, and bond sellers are more willing to borrow.

Unlike traditional insurance, however, credit default swaps are unregulated financial contracts, most commonly between just two parties. In traditional insurance, the insurance company writing the contract will spread its risk over many different parties (drivers, homeowners, etc.). The credit default swap market is a case where often just one bond holder “swaps” the credit risk with a single other investor.

If the bond never defaults, as has been the case for years with the vast majority of bonds, the default swap issuer makes out well. But in these crazy times that began with the mortgage problem, many bonds are going into default. More importantly, fewer and fewer institutions will issue new credit default swaps, drying up the market for not only swaps, but bonds themselves.

To add insult to this injury, most of the credit default swap issuers posted little collateral to support their guarantees of payment. The collateral amounted to just a few percentage points on the total dollar commitment. Therefore, as the crisis led to panic and the bondholders called for their guaranteed payments, financial institutions like Lehman Brothers didn’t have the cash to fund these liabilities.

Many estimate the size of this market at $62 trillion, but no one knows for certain. This is an unregulated market with no central clearinghouse. Earlier this month, the Federal Reserve Bank of New York met with banks and investors in this market around the idea of creating a clearinghouse, which would go a long way toward reducing risks in the market.

Bloomberg reports that this group has set an end-of-year deadline to have such a central system in place. Previously, an existing clearing house, The Clearing Corp., began setting up such as system but was told it would have to obtain a banking license and come under federal regulations.

Somehow a clearinghouse will get started, creating more transparency (who’s buying, who’s selling, and at what price) in this very large market. Good news may be coming. The bond market prices on Monday reflect better conditions in the lending market. There was significantly more unsecured overnight lending, commercial paper trading, and more swap market activity. Interest rates on cash positions like Treasury bills rose as investors moved to more risky debt like corporate bonds, and the Dow rose more than 4 percent.

As it has been said, “honesty is the best policy.” More transparency in all financial contracts, including credit default swaps, will go a long way to reducing risks and keeping markets open.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.

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