The truth about credit default swaps
Regulators have long feared a derivatives blowup, but the CDS market held up despite the collapse of Bear and Lehman. Still, some worries remain.
NEW YORK (Fortune) -- A year after the government rescued Bear Stearns, the economy has stumbled badly.
But one market that regulators were deeply concerned about when Bear hit the wall -- the one for unregulated over-the-counter derivatives called credit default swaps -- has defied fears of a meltdown.
What wounded Bear was a cash crunch that ensued as investors fled from risky mortgage-related assets. But officials acknowledged their decision to keep the brokerage firm from defaulting was driven by the threat a bankruptcy may have posed to Bear's trading partners.
"The sudden discovery by Bear's derivatives counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets," said Tim Geithner, then the president of the Federal Reserve Bank of New York and now the Treasury Secretary, in congressional testimony last April.
Geithner wasn't alone in worrying about so-called counterparty risk in the markets for derivatives such as credit default swaps, or CDS, which allow one party to pay another to take on the risk that a company will default on its bonds.
Regulators and market participants have been warning for years about the dangers of the unchecked growth of the credit default swap market -- and about the difficulty of assessing who could be at risk for derivatives blowups.
Yet the events of the past year -- including the collapse of Lehman Brothers six months after Bear -- suggest regulators may have overestimated the risk of counterparty failures.
A report earlier this month from the senior financial supervisors of the G-7 nations concluded that the credit default swap market functioned well in the second half of 2008, despite "an unprecedented 12 credit events" -- or actions that obliged the sellers of credit protection to make payments to those who had bought protection.
The credit events included the government takeover of U.S. mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500), the collapse of Icelandic bank Landsbanki and, most notably, the bankruptcy of Lehman, a broker-dealer that was even bigger than Bear.
"Overall, the review confirmed the effectiveness of the existing auction-based settlement mechanism," the report said.
The fact that CDS settlements have worked largely as advertised doesn't mean the worries have dissipated. To the contrary, the fiasco at AIG (AIG, Fortune 500), the insurer that has been propped up by the government at a cost to taxpayers of more than $160 billion, has led to a new round of scrutiny for the credit derivatives market.
AIG was pushed to the brink of bankruptcy last fall when a credit downgrade allowed swap counterparties to demand tens of billions of dollars of collateral AIG didn't have. Rather than risk another blow to already fragile markets, policymakers chose to rescue AIG.
It's worth wondering how the CDS market would have handled an AIG bankruptcy, which might have led to losses at counterparties such as Goldman Sachs and some big European banks.
But a more pressing question is whether there are other AIGs out there -- a worry that is impossible to dispel in part because there is no way of telling whether a firm has failed to make sure it has the cash on hand to honor its swap obligations.
"Clearly there have been institutions that wrote CDSs that didn't expect to honor them and didn't have the recourse to cover them," said Charles Taylor, a fellow at the Wharton Financial Institutions Center at the University of Pennsylvania. "It would appear these things did contribute to credit market stresses."
Those stresses have prompted some notable responses.
House Agriculture Committee Chairman Collin Peterson, D-Minn., proposed legislation that would restrict the use of credit default swaps. And Myron Scholes, a Nobel prize-winning economist, said this month regulators should "blow up" the derivatives markets because they have stopped providing useful information.
But even some longtime critics of over-the-counter derivatives markets say the AIG case isn't a reason to take drastic action.
"Credit default swaps are not the centerpiece of this crisis," said Benn Steil, director of international economics at the Council on Foreign Relations. "AIG was just greedy and irresponsible."
To be sure, substantial reforms are still necessary. The International Swaps and Derivatives Association trade group says it is working on refining procedures governing how credit default swaps are documented and settled.
But observers say introducing clearinghouses into the CDS markets, which could happen by year's end, should eventually eliminate the counterparty risk problem.
Earlier this month, the Federal Reserve made an IntercontinentalExchange (ICE) unit a member of the Federal Reserve System. That will enable this entity to act as a central counterparty.
Exchange companies such as Intercontinental, Chicago's CME Group (CME) and NYSE Euronext (NYX) are eager to set up clearinghouses for CDS trades because their days of go-go growth from existing products appear to have come to an end.
Meanwhile, installing central clearing could ensure that parties to CDS trades have the wherewithal to make good on their obligations.
Howard Simons, a strategist at Bianco Research in Chicago, added that the CDS market is useful as a source of information about the health of credit markets. One popular CDS-based indicator of credit market stress - the Credit Derivatives Research counterparty risk index - recently surpassed the peak it reached the week of Lehman's failure, though it has since eased off those highs.
Establishing central clearing won't end all the questions about the derivatives markets, and the fear that another big financial company will emerge as the new AIG may continue to lurk.
"People have been warning about the CDS market for years," said Simons.
But with the economy and the markets reeling, investors have bigger problems than the CDS market, Simons said.
He points instead to the deflation of an asset bubble that was created in part by easy monetary policy that started in earnest when Alan Greenspan took over the Fed. So no matter what policymakers do, Simon thinks it will take a long time to heal the economy.