Credit Default Swaps (CDS) Are Insurance Products, Not Tradeable Assets

Our story thus far:  The Commodity Futures Modernization Act of 2000, sponsored by Texas Senator Phil Gramm as a favor to his wife Wendy (who sat on the Board of Directors of Enron, which wanted to trade energy derivatives without oversight) was rushed through Congress in 2000. Unread by Congress or their staffers, it was signed into law by President Bill Clinton on the advice of his Treasury Secretary Lawrence Summers.

The CFMA radically deregulated derivatives. The law changed the Commodity Exchange Act of 1936 (CEA) to exempt derivatives transactions from regulations as either “futures” (under the CEA) or “securities” under federal securities laws. Further, the CFMA specifically exempted Credit Defaults Swaps and other derivative products from regulation by any State Insurance Board or Regulators.

This rule change exempting CDS from insurance oversight led to a very specific economic behavioral change: Companies that wrote insurance had to explicitly reserve for expected losses and eventual payout in a conservative manner. Companies that wrote Credit Defaults Swaps did not.

Hence, AIG was able to underwrite over THREE TRILLION DOLLARS worth of derivatives, reserving precisely zero dollars agianst potential claims. This was enormously lucrative, except for that whole crashing & burning into insolvency thingie.

The radical deregulation the CFMA generated led directly to the collapse of AIG, Bear Stearns and Lehman Brothers; indirectly to the collapse of Citigroup, Bank of America, and Fannie/Freddie. It was a significant factor in the near death experiences of Goldman, Morgan Stanley and others.

Despite the horrific impact this legislation had, it was never actually overturned, only modified. Obama made the personnel error of bringing back Larry Summers (he apparently had not wrought enough damage to the nation yet). Rather than admit the error of CFMA, and overturn it, Summers instead downplayed its role. Thus, the CFMA was merely modified somewhat. The same risk the CFMA presented to the economy still exists. Swaps now must be be cleared through exchanges or clearinghouses — but they are still exempt from Insurance regulations. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement. Counter-parties may or may not demand one, but the dollar amount is negotiable.

Which brings us to today.

The Greek government has been declared in default by S&P; most common sense definitions of default — failing to make payments on a timely basis, declaring your intention to default, involuntary change of loan terms by borrower, etc. — have already occurred.

That last point is especially important in light of the Greek Sovereign Debt default — which International Swaps and Derivatives Association, in a nonpublic meeting of derivatives bankers, declared to be a NONDEFAULT.

I’ll be damned if I can figure out why.

Any tradeable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year.  No interpretation required.

Yet with Greek CDS, we have a committee of bankers, lawyers, accountants and other interested (not unbiased) parties interpreting the details, weighing the circumstances, describing what happened.

Does that sound like a tradeable asset to you?  To me, it sounds more like an insurance policy dispute. Because in reality, these CDS are in fact, nothing more than an unreserved and unregulated insurance productts.  That is the legacy of the CFMA, and one that apparently has not been overturned.

The banks, hedge funds, and securities firms who are the prime dealers of these products  greatly prefer to have their derivatives supervised by Federal regulators. Why? Because the standards they use — general safety and soundness — are empty-headed nonsense, easily evaded.

The State Insurance Boards and Regulators are far more exacting, far more specific — and require boatloads more money in reserve.

Hence, this is how the Greeks have managed to default, yet an insurance-like product will not (yet) payout. With insurers or their regulators involved, this would never have happened.