Treasury Misunderstands Credit-Default Swaps and Taxpayers Foot the Bill
By Jeremy Weltmer
Tuesday, July 6, 2010 12:05 pm
In the dark days of 2007 and 2008 when investment banks began closing their doors, the financial products division of the insurance giant AIG began to receive collateral calls on their credit-default swap contracts to the tune of tens of billions of dollars. This is the point at which the government stepped in to settle the situation and prevent a collapse of the system by closing out the complex insurance-like contracts, or so the official story goes.
Gary Gensler, Chairman of the Commodity Futures Trading Association, disagreed with that analysis in nuanced, but significant ways in testimony before the Financial Crisis Inquiry Commission. Most importantly, the inherent danger of both AIG and credit-default swaps were vastly misrepresented. Much of this stems from a general misunderstanding of what precisely a CDS does. Basically, it allows the seller to issue it based on an underlying asset and insure that it will not default. The defining differences between a CDS and an insurance contract have to do with the possession of the underlying asset; normally, to insure an asset, one must own the underlying and collateral must be posted at the front end of the deal.
So, to demonstrate the differences between the two scenarios, one can trace each kind of deal. If Goldman Sachs owns a set of residential mortgages and wants to hedge its risk on those mortgages, it could purchase an insurance policy on which it pays over time, and if the mortgages default, it could redeem its contract that it had made with AIG. But, from Goldman Sachs’ position, if the mortgages lose most of their value but do not enter default, then its insurance policy is useless. Likewise, AIG makes the money parceled out over time and has little ability to predict the amount of insurance that would be purchased in the future. Plus, AIG must have immediate access to the full insured value in the event of emergency.
By contrast, a credit-default swap is sold upfront for a cash value, so both parties know precisely the cost of the deal for the time defined in the contract. In the meantime, Goldman does not have to worry about future costs to insure, and AIG can use the capital upfront to invest, leverage, and compound its value. Most significantly though, a CDS requires the issuer (AIG in this case) to post capital if the investment loses value. From Goldman’s perspective, this hedges two kinds of risk: the risk of default, for then the insurance-like benefits would trigger, and the risk of declining value, for then the counterparty would have to post collateral. It allows Goldman to pay a fixed, upfront fee to guarantee the safety of its investment. Likewise, the contract allows AIG the opportunity to leverage itself farther, for it does not need to hold as much capital for an immediate payment as it would for under an insurance policy. Because it would have been posting collateral in the weeks and months leading up to a default as the underlying asset declined in value, AIG would not need to have the entire lump sum available at once; it would need the lump sum over a protracted period of time.
Likewise, whereas one buys an insurance policy to protect an asset that one owns, a credit-default swap is a contract derived from an underlying asset, but neither party must own the asset. So, if Goldman expects that a decline in this set of residential mortgages would pose a risk to its portfolio (even though it does not own this particular set), it could purchase a CDS contract from AIG to protect against that larger risk without the added deployment of capital required to own the underlying asset. Plus, either party can trade its end of the contract to someone willing to buy its interest. This would be impossible with an insurance policy.
Now, Gensler’s appraisal of AIG’s situation reflects a more complete understanding of both the instruments and the players. Because of the decline in value of the collateralized debt obligations (the mortgage bundles), AIG had to make collateral payments to all of the parties to whom it had sold CDSs. Now, the financial products division of AIG benefited from AIG’s “AAA” credit rating, but because of the way in which AIG was structured, the financial products division did not have access to any of the capital in the other divisions, even though that capital factored into its credit rating. So, it met those obligations for collateral by opening and using credit lines, but just as it needed to use its rating to borrow, the credit markets froze. This resulted in the crisis into which the government entered.
As much as the action is now lauded as the prompt and efficacious action needed to prevent a financial apocalypse, Joseph Cassano, the man who led the division of AIG responsible for the mortgage trades, testified that
“I think I would have negotiated a much better deal for the taxpayer than what the taxpayer got.” He argued that when the Treasury stepped in, they unloaded the derivatives as fast as possible for whatever price they could get. To analogize, imagine that an elderly parent’s retirement portfolio crashes, so their children come in and sell everything at the absolute lowest point rather than evaluate which assets will regain value. Cassano asserted that when the Treasury took over, it paid the counterparties to the contracts whatever they deemed fitting to close them out. As Gensler had discussed earlier, the CDSs represent a market product with a value that markets assign, whereas insurance represents a banking product that has a very calculable value. Basically, the Treasury assumed that AIG misunderstood their own products and that those with the most to gain by overestimating the value of the contracts could best evaluate the situation. They might as well have handed Goldman Sachs a blank check and told them, “Figure it out yourselves.”