What Caused the Financial Crisis

10. Credit-Default Swaps and the Crisis

Chapter 10 Credit-Default Swaps and the Crisis PETER J. WALLISON After the failure of Bear Stearns, Lehman Brothers, and AIG had signaled the global financial meltdown, Securities and Exchange Commission chair Christopher Cox was quoted in the Washington Post as telling an SEC roundtable: The regulatory black hole for credit-default swaps is one of the most significant issues we are confronting in the current credit crisis . . . and requires immediate legislative action. . . . The over-the-counter credit-default swaps market has drawn the world’s major financial institutions and others into a tangled web of interconnections where the failure of any one institution might jeopardize the entire financial system. (O’Harrow and Dennis 2008) Cox’s statement is puzzling for reasons both abstract and concrete. First, it is in the nature of credit markets to be interconnected. That is the way money moves from where it is less useful to where it is more useful, and why financial institutions are called ‘‘intermediaries .’’ Second, a credit-default swap (CDS) is, loosely speaking, a form of insurance.1 The seller of a CDS protects against loss the loans the buyer of a CDS holds. Far from being destabilizing, a CDS simply transfers risk. Credit-Default Swaps and the Crisis 239 Third, there is very little evidence that the failed financial institutions were the victims of their participation in credit-default swaps, or that their failure jeopardized their swap counterparties and, thus, the global financial system. Credit-Default Swaps in the Panic of 2008 Had the Treasury Department and the Federal Reserve really believed that Bear Stearns had to be rescued because the market was interconnected through credit-default swaps, they would never have allowed the failure of Lehman, which was a much bigger player in creditdefault swaps than Bear. Moreover, while Lehman was a major dealer in credit-default swaps—and a borrower on which many creditdefault swaps had been written—when it failed there was no discernible effect on its swap counterparties. Within a month after its bankruptcy, the swaps in which Lehman was an intermediary dealer had been settled bilaterally, and the swaps written on Lehman itself ($72 billion, notionally) were settled by the Depository Trust and Clearing Corporation (DTCC). The settlement was completed without incident, with a total cash exchange among all counterparties of $5.2 billion. There is no indication that the Lehman failure caused any systemic risk arising out of its CDS obligations— either as one of the major CDS dealers, or as a failed company on which $72 billion in notional credit-default swaps had been written. The fact that AIG was rescued almost immediately after Lehman’s failure led once again to speculation that AIG had written a lot of CDS protection on Lehman, and had to be bailed out for that reason. When the DTCC Lehman settlement was completed, however, AIG had to pay only $6.2 million on its Lehman exposure—a rounding error for this huge company. AIG’s failure was due not to its exposure to Lehman through credit-default swaps, but to its use of a credit model that did not account for all the risks it was taking (O’Harrow and Dennis 2008). The collapse of AIG, then, had nothing to do with credit-default swaps per se. The cause was the same as with the collapse of the financial system as a whole: the faulty evaluation of the risks of resi- 240 Peter J. Wallison dential mortgage-backed securities (RMBSs) that contained subprime loans. Apparently, AIG’s credit-risk model failed adequately to account for the risks of subprime RMBSs; for a sharp decline in the mortgage market; and for a downgrade in AIG’s credit rating, as a result of the first two failures. Initially, the counterparties in AIG’s credit-default swaps generally agreed that AIG did not have to post collateral, because its debt was rated AAA. When it was downgraded by the rating agencies, it was immediately required by its CDS agreements to post collateral. In addition, since AIG had written a great deal of protection on RMBS portfolios, as these declined in value, AIG was again required by its counterparties to post collateral to cover its increased exposure. When AIG could not do so, it was threatened with bankruptcy, and that is when the Fed stepped in with a rescue. This narrative highlights a fact that gets too little...