The Making of a Financial Crisis Part III

Previously we explained how the underwriting guidelines of lenders on main-street are merely a reflection of the kinds of bonds the secondary market wants to purchase.  Also how the advent of credit default swaps led to an increase in demand for subprime debt in the secondary market, which engendered looser underwriting guidelines on main street, which ultimately led to many more subprime loans being originated and funded.

It is worth noting that from the year 2003 to 2007 the number of credit default swaps increased by nearly 450%. During that same time period, the number of subprime loans originated increased by nearly 300%. Coincidence? I don't think so.

In the last article I asked how simple insurance policies could cause such a dramatic rise in demand. After all, wouldn't the credit default swaps become prohibitively expensive if the assets they insured were becoming more and more risky?

To answer this, I need to explain a crucial difference between a credit default swap and an insurance policy.

One requirement for purchasing, say, hazard insurance on your house is that you have to own the house. With credit default swaps you don't have to actually own the bond or be invested in the loan to buy insurance on it. 

But why would you want to pay for insurance on something you don't own? Consider that if you saw a hurricane coming toward Miami. You could buy insurance on every single house there, knowing that a few of them would get wiped out and you would rake in the cash. 

Conversely, say you had information that told you the hurricane was actually going to miss Miami. You then could sell insurance on the houses and you would just make boat loads of premium off of all the scared people buying unnecessary insurance. This is what's happened with the credit default swap market.

The credit default swap has become a way to bet on our against certain bonds, or the market in general. Now we see that the credit default swap market isn't a simple market of insurance policies the way car insurance is, but a fully fledged derivatives market. 

But isn't this still ok? Derivatives have their place. Options and futures are traded everyday. The crucial difference is one I alluded to last week: the credit default swap is subject to zero regulation. Zip. Nada. Many credit default swap transaction are done behind closed doors or by email. Throughout the past few articles I have been comparing credit default swaps to insurance policies. In fact the reason they are called "swaps" instead of "insurance" is to keep them from being subject to any sort of regulated bodies!

The credit default swap market is huge. If all the policies were to be payed out at once it would equal a monetary amount far greater than the GDP of the entire planet. At it's height it was estimated that the credit default swap market was around $50 trillion in size. The stock market is estimated to be worth around $37 trillion. The stock market is of course subject to many regulations. Even casinos are subject to certain laws. But not the credit default swap market. In that market, as we shall see next time, anything goes.