The CDS: The Weapon of Wealth Extraction
What’s critical, of course, is that any change protects the core principle: ‘Thou shalt not gamble with the public’s money”. -Paul Volcker, Former Head, The Federal Reserve Bank
The tanking of the mortgage market did not result in the banks needing a bail out. The banks had gotten most of those mortgages off their books through CDOs into the hands of investors.
The credit default swap (CDS) caused the banks to need a bailout. Thus, understanding what a CDS does is essential to understanding not only what happened in 2008— but how they make the financial system subject to the same risks today.
- Because of the CDS, the bailout of $350 billion went to the banks and flowed through to the multimillionaire and billionaire members of the hedge funds in a massive upward transfer of wealth.
- It was the bank customers who paid back the bailout in higher than necessary administration fees and loan rates.
As we will see next chapter, the reforms of 2008, such as Dodd Frank, did nothing to reduce the risks caused by the CDS.
The Credit Default Swap can be pure betting-hence casino capitalism. The Big Short book and movie contain excellent examples of the use of the CDS for betting. The heroes (better thought of as antiheroes) were hedge fund managers who did independent research. They did not rely on assurances by the banks or rating agencies as to the quality of the CDOs.
These antiheroes, and other hedge funds, then bet with the banks that the value of the Residential Mortgage Back Securities would tank by buying CDSs from the banks.
The term Credit Default Swap means that the risk of default has been swapped, i.e., taken over by the issuing party. However, that is not accurate here. The hedge funds had no risk. They didn’t own any RMBSs and so would be unaffected when that market tanked.
There are two kinds of swap:
- Where a buyer has an interest in an asset and would suffer a loss, called a covered swap.
- Where a buyer has no interest in the asset referenced and so is betting, called a naked swap.
The CDS is called ‘shorting’ because shorting means betting against the success of another investment, e.g., betting the mortgage market would decline. Hence, The Big Short.
This Alice in Wonderland investment will become clearer If we look at the history of how the credit default swap originated.
An investor, say a pension fund, would buy an RBMS worth say $1 billion. It would plan for some expected defaults of say $1 million but would obtain default insurance to cover that loss. A bank would be willing to provide this protection for a premium but not call it insurance, rather a CDS.
* Regular insurance is required to keep most of the premiums in a reserve fund that is inspected by the government to ensure its adequacy.
* Applicants are required to have an ‘insurable interest’. A person must have a potential loss to insure for it.
Otherwise, a mafia Don could insure a life that he picked randomly from a telephone book and have that person wacked. We will see that the CDS can be used to do exactly that in a financial sense.
However, as the contract was not called mortgage default insurance but by the obfuscating term, Credit Default Swap-disguising its real nature and risks-it was not regulated in the least.
Additionally, there was no requirement of an insurable interest. As noted above, the hedge funds that were taking out this insurance did not own any RMBS’s. They were not going to suffer any loss if the mortgage market tanked.
And there was no requirement that the issuer set aside some of the premiums or have any reserve fund whatsoever. The premiums flowed directly into bigger banker bonuses.
Deposit money is not held in trust and can be seized by bank creditors.
When the banks lost their enormous bets, they needed a bailout from the government
- So banks had liquidity and could continue to make loans;
- So depositors did not lose their uninsured savings; and
- So the bankers would get to keep their bonuses.
Next, we will look at some very creative uses of the CDS in action.
Acknowledgement: Roulette Wheel image, Anna Shvets, Pexels.
Originally published at https://jandweir.substack.com.