The Next Meltdown: How We Have Failed To Regulate Financial DerivativesAugust 16th, 2012 2:45 pm Howard Hill and Danielle Reed
The biggest story about the financial crisis that began four years ago is what still hasn’t been done to make sure that the same disaster doesn’t happen again — and why.
As the crisis unfolded and since, many Americans heard about credit default swaps (CDS), the arcane form of insurance that ruined the huge American International Group. Yet while we all paid many billions for AIG’s mistakes, the effort to control so-called derivatives such as CDS has been no more successful than the attempt to prevent future bailouts of banks that are “too big to fail.”
With $14 trillion outstanding at US banks as of March 2012, the CDS market is nearly equal to the gross domestic product of the United States. Even so, CDS represent just six percent of the overall derivatives market in the US banking system. The rest of the market – that is, the other 94 percent – is just as lightly regulated.
Yet it is hard to regulate a market few people — even experts — understand, especially when those who do understand it can still benefit by guarding its secrets.
Just ask the top managers at JPMorgan Chase.
The firm’s recent statements on its losses in the “London Whale” case show how poorly these financial wagers are understood. From the bank’s initial disclosure of $2 billion in losses, JPMorgan was estimating losses three to four times as large only a few weeks later. And JPMorgan is by far the largest player in the nation’s CDS business, with $6.1 trillion in contracts on its books. The net credit exposure of these swaps at JP Morgan in the first quarter of 2012 was more than 2.5 times the firm’s total risk-based capital.
In layman’s terms, a CDS — a two-sided contract — is insurance that protects against losses on, say, a specific bond. As with car insurance, the buyer pays a premium, and the seller covers the loss if an accident (in this case, a default) occurs.
But a CDS contract doesn’t require insurance buyers to own what they’re insuring. The reality is more like a casino bet — imagine neighbors taking out millions in collision insurance on your car. If you have an accident, they’re rich.
And unlike state-regulated auto insurance, there are currently no capital requirements for derivative insurers, and until recently, there was zero outside supervision. The little oversight created under the Dodd-Frank Act has barely altered the market because the rules are easy to circumvent.