Financial Arms of Mass Destruction

Financial Arms of Mass Destruction (1)
By Sean Hayes (Korea Times 1/1/2009)

Warren Buffett, who used to utilize credit-default swaps (CDS), called them “financial weapons of mass destruction (WMDs).”

I love Warren Buffett and was a student of his every word during my pre-attorney stockbroker days, but blaming CDS for our present financial difficulties is as logical as blaming the Iraq War on oil or skin cancer on the sun.

The $55 billion CDS market is certain to be regulated, since they are perceived by the vast majority of the public as the very epicenter of our problems and the cause for the spread of U.S. difficulties overseas.

This perception is far from the truth and probably originated from a fear and anathema, in America and throughout much of the world, of everything even remotely considered “complex.”The CDS derivative market, however, is not the heart of the problem and if we leave the math out of it, is even not so complex.

For us to learn from our mistakes we need to put the credit where the credit is due and not vilify poorly understood financial tools.

The blame must be placed on our government; a government that was determined to facilitate the extension of every imaginable type of home loan to the most unqualified of borrowers.CDS, in essence, are nothing more than insurance policies on bonds and securities. CDS are not, as often noted, “some kind of speculative wager by people who are betting money they don’t have, it’s an orderly process that provides a credit insurance to a market that uses it and needs it” as stated by Prof. Roy Smith from NYU Stern School of Business to Reuters at the end of last month.

For example, at the end of 1997, JP Morgan pooled over 300 loans worth over $9.5 billion and cut the loans into different slices (tranches).

JP Morgan then sold the riskiest 10 percent tranche to investors. The tranche was entitled the Broad Index Securitization Trust Offering (Bistro).Most of the underlying loans were to financially secure companies such as IBM and Wal-Mart. Therefore, even Bistro was considered, by most, a safe investment.

The reason for the creation of this financial instrument was to increase liquidity in the credit market. Banks, because of government regulations, were mandated to reserve a percentage of their capital.Banks wishing to free up this reserve capital created CDS. These CDS were sold to investors, thus the third party investor would assume the risk of default, in exchange for regular payments from the banks.

The banks were able to free their books and thus were able to lend more.The problems in the CDS markets began when mortgages went south, not by “complex” financial instruments such as derivatives and securities, but the same bone-headed government that intends to fix these troubles with more regulation.

The government, hell-bent on distorting our markets, created distortions that motivated all to ignore market realities, which led to loans to credit unworthy borrowers.These market distortions were caused by the Federal Reserve, the unmitigated backing by Congress of Fannie Mae and Freddie Mac, the Federal Housing Administration loosening of down-payment requirements, the strengthening of the Community Reinvestment Act, and the Department of Housing asserting pressure on lenders to lend.

Without the government’s hand in the markets few would have ever known, or even questioned, the soundness of these financial tools.