Congress continues to discuss financial reform, but so far have come up with nothing.
Last fall, Senator Dodd of Connecticut introduced long and elaborate legislation to reform America’s financial system, but the law and regulation is essentially the same as it was during the 2008 financial collapse.
Lately, though, I keep reading short reviews about the legislation and efforts by the finance industry to exempt derivative contracts like swaps from the legislation.
Until 2008, swaps were something I read about in a finance book. It was like reading a cookbook full of recipes because it was only defined as an insurance contract that reduces risk of financial loss.
How a Credit Default Swap Works
As an insurance policy, a credit default swap buyer pays periodic premiums over the years of the contract to insure against the default of a financial instrument like a bond.
Suppose a pension fund owns a $5 million bond, but wants to insure against default losses. They buy a credit default swap from a bank for 2 percent per year, which means they pay a premium of $100,000 to insure against the loss of $5 million in bond principal.
If a financial default occurs, the insured party presents the defaulted bond in exchange for the predetermined payment like any insurance loss.
Credit default swaps are not regulated as insurance, so it is up to the buyer and seller to discuss the seller’s reserves or ability to pay if there is a default. But that’s a problem: credit default swaps proliferated as speculators began to create them without having a bond to insure.
Here’s the Problem
To see the risk in this, think of managing a hedge fund that decides to speculate on the ability to make debt payments by a corporation.
The hedge fund does not need to insure against a debt they own, but they can enter into a contract to BUY a credit default swap because they expect, or hope, a company will default.
Say the contract is worth $5 million at 2 percent, which means they pay $100,000 a year for the right to receive $5 million in a default. If nothing happens, they pay $100,000 and get nothing, or they get a $5 million payoff from a default.
But there’s another possibility.
If, over time, others in the market decide the corporation named in the credit default swap is more likely to default, then the premium price will be bid up above 2 percent. If it goes to 3 percent, the hedge fund could SELL a credit default swap at the higher premium.
On $5 million, they would receive $150,000 in premiums as they pay $100,000 for the other contract. The difference is their profit: $50,000.
Of course, the premium price could drop below $150,000 and speculators would only be able to reduce their loss below $100,000.
When Insurance Turns Into Speculation
Because there has never been a requirement for a credit default swap buyer to be insuring themselves against the default of a bond they actually own, the notion of insurance turned into speculation on the credit risk of default.
Speculating got so popular for a time there were more credit default swaps than bonds and debts to default. However, some banks sold swaps to collect premiums while pledging to use their reserves to pay speculators in the event of default. Hedge funds borrowed money to buy swaps.
A labyrinthine maze of trillions in unregulated default swap obligations got so big some began to worry it would all collapse. It did, which is why financial reform requires that swaps should be regulated as insurance.
About the author: Fred Siegmund covers America's jobs as part of work doing labor market analysis and projections for a client base of recruiters, trainers and counselors. Visit him at www.americanjobmarket.blogspot.com
