Congress advised to duck regulation of credit swaps – quack, quack

The Senate Agriculture Committee must have sounded like Old McDonald’s Howey’s Farm given the news from the hearing reported by the National Underwriter.

New York State Superintendent of Insurance Eric Dinallo…appearing before the Senate Agriculture Committee…explained that credit default swaps can be divided into two categories. The first he noted are transactions in which the holder of an obligation, such as a bond, “swaps” the risk of default with another party, who guarantees it for a fee.

That transaction, he noted, can be seen as similar in nature to an insurance transaction.

Similar? If it looks like a duck, acts like a duck, and sounds like a duck it must be a duck.

A second form, which Mr. Dinallo referred to as a “naked credit default swap” differs in that no party involved has ownership of the obligation, and is effectively a “directional bet,” he said.

However, regardless of what was said, naked or fully dressed, if a transaction meets the three-part test established  in SEC v Howey (1946), the duck is a security and subject to regulation accordingly:

1. investment of money due to an expectation of profits arising from
2. a common enterprise
3. which depends solely on the efforts of a promoter or third party.

Before going further, let’s talk a minute about what the ducks are swapping as it’s shocking – it’s risk and they’re swapping it for money on the come. 

If the concept sounds familiar, it’s because we’ve been talking about insurers selling policyholder risk in a variation of this same three-step process for months now.  The graphic in that case would look something like this – but be sure to check the comments for corrections in case my labels are in the wrong position.

Now, we’re talking duck (insurance) and ducklings (credit-default swaps, cat bonds, and hedge funds) all swimming in the capital market.

With that in mind, let’s return to reports of testimony from the hearing on Capitol Hill and the Howey test to determine if an investment is actually insurance. Mr. Dinallo indirectly addressed the Howey test when explaining, Two crucial developments contributing to the increase in credit default swaps took place in 2000…

The first was the enactment of the Commodity Futures Modernization Act under President Bill Clinton.That law, he said, created a “safe harbor” for credit default swaps by preempting state laws that would have barred them and exempting them from regulation under the Commodity Futures Trading Commission.

During the same year, Mr. Dinallo noted that the New York Department of insurance, under a different administration, was asked what he called a “very carefully crafted question,” inquiring if naked credit default swaps were considered insurance contracts.

“Clearly, the question was framed to ask only about naked credit default swaps with no proof of loss,” he said. “Under the facts we were given, the swap was not ‘a contract of insurance’ because the buyer had no material interest and the filing of a claim does not require a loss.

“But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the department’s opinion on a subset of credit default swaps as a ruling on all swaps and, to be fair, the department did nothing to the contrary.

You will see below that Chairman Harkin states “swaps were designed not to fall under insurance” – and correctly so.  However, it should noted that some contend the design was intended to circumvent the requlatory requirements of insurance and claim that according to the Howey test, swaps are the insurance in the form of reinsurance.

”Because of these developments, witnesses and committee members noted, credit default swaps were allowed to go unregulated. Noting that such swaps were designed not to fall under insurance or futures regulation, Sen. Tom Harkin, D-Iowa, the committee chairman noted “they need not be traded on open, transparent exchanges, and as a result, it is literally impossible to know whether swaps are being traded at fair value or whether institutions trading them are becoming over leveraged or dangerously overextended.”

The option of creating an exchange for credit default swaps, or another mechanism such as a clearinghouse of central counterparty, were depicted as potential solutions to help get a hold of a market that Sen. Harkin noted has, in some ways, grown to an estimated $62 trillion in face value last year. “That roughly equals the gross domestic product of the entire world for 2008,” he said.

While implementing some form of regulatory scheme was discussed, witnesses cautioned against extreme measures such as an outright ban on “naked” swaps, and noting that there are legitimate reasons to engage in such transactions.

One of those witnesses was Richard Lindsey, president of the New York-based Callcott Group.

Lindsey countered Sen. Harkin’s characterization of swaps as “casino capitalism” by noting that they are not entirely dissimilar to futures or other investments. “While credit derivatives are often pejoratively described in the media as a ‘bet,’ it is important to realize that one could equally describe all investments as ‘bets,’” he said.

Mr. Dinallo also noted that “naked” swaps can also help companies hedge against exposures that are not directly related to them. As an example, he noted that a company may seek protection through a credit default swap if they have a large number of receivables from another entity, and are the exposed to a possible downturn in that entities ability to deliver.

Ultimately Mr. Lindsey proposed that the best solution for ensuring that credit default swaps are conducted responsibly is to make that those executives whose companies are involved know exactly what they are undertaking.

Understandably, Lindsey would have that position. According to his biography, in addition to serving as president and CEO of the Callcott Group, LLC, a quantitative consulting group…he is the Chairman of the International Association of Financial Engineers – and former president of Bear, Stearns Securities Corporation. However…before joining Bear Stearns, Dr. Lindsey served as the Director of Market Regulation for the U.S. Securities and Exchange Commission and as the Chief Economist of the SEC…and a finance professor at the Yale School of Management before joining the SEC.

Given his background, perhaps Dr. Lindsey can swap $700 billion with someone other than his fellow citizens who would, no doubt, find his suggested solution to be the very problem that created the need to bailout the market – assuming, of course, he doesn’t continue to suggest sub-prime mortgages, not credit-default swaps, are the problem.

In testimony before the Senate Committee on Agriculture, Nutrition and Forestry, International Swaps and Derivatives Association Chief Executive Officer Robert Pickel and the former president of Bear Stearn’s (BSC) brokerage arm, Richard Lindsey, both suggested that problems from subprime loans, and not credit-default swaps, are the root cause of the country’s economic woes.

The Lindsey-Pickel suggestion is a pretty hard sell IMO.  Take a look at another chart from this presentation on real estate derivatives and the growth of cash and synthetic credit-default swaps from 1998 – 2003.

The incredible thing about all this to me is that when you’re selling synthetic swaps, you’re selling  nothing but risk – they’re totally naked of assets as the seller keeps those.

In a synthetic CDO, no legal or economic transfer of bonds or loans take place, with the underlying reference pool of assets remaining on the balance sheet of the originator. Instead, the CDO gains exposure to credit risk by selling protection to others through a CDS, which functions very much like an insurance contract. In other words, the CDO is still being paid for bearing credit risk, just as it would do if it physically owned a bond or loan.

As I was pulling this information together, I thought about the “pretend play” stage of early childhood and wondered how some carried the concept into adulthood and the world of finance – and how much of what we’re going through is “pretend” as well. Quack, quack!