Will Hutton in the Observer last weekend said:
“What needs to happen is an assault on the dark heart of the global financial system – the $55 trillion market in credit derivatives and, in particular, credit default swaps…”
The size of the market is huge – more than twice the size of the combined GDP of the US, Japan and the EU.
As Hutton explains credit derivatives grew in response to the growth of the $10 trillion market in securitised assets, the packaging up of such things as office rents, port charges, mortgage payments and sports stadiums, and their sale as a ‘security’ to be traded between banks.
In response to the growth of this market the finance houses created what was originally a system of insurance to protect purchasers of securitised bonds against default. Unlike insurance on your car or your house, the credit default contracts could be bought and sold on to others. Hence these ‘instruments’ became a source off speculation in betting on who was or wasn’t going to default. Hedge funds became the wildest speculators.
The collapse of Lehman Brothers meant that they were unable to honour $110 billion of bonds and $440 billion CDS’s the company had written. These contracts have recently been auctioned, with buyers paying just over 8.625 cents to the dollar for them. Hutton explains:
“…there is now a $414 billion hole which somebody holding these contracts has to honour.”
In other words sellers of insurance against a debt default by Lehman Brothers will have to pay over 91.375 cents in the dollar to settle the contracts. The Washington Post estimates that banks, hedge funds, insurance companies and other writers of swaps will have to hand over $365 billion for buyers of the protection. This represents only a small section of the market.
The three failed Icelandic banks are unable to honour $50 billion worth of bonds and $200 billion of CDS’s. According to Hutton the two British banks Barclays and RBS hold a staggering $2.4 trillion of CDS’s each!
From this game of pass the toxic parcel somebody gains and somebody loses. Given the complexity of these ‘financial instruments’ nobody knows what proportion of the $55 trillion of credit default contracts that have been written will be honoured and who will bear losses that could run into trillions of dollars. Of course, the greater the depth and length of a recession the more defaults there will be, impacting on the settlement of CDS contracts.
Hutton asks the question:
“So will compensation for the near valueless and this now uninsured debt ultimately be made and by whom?”
This is what is politely described as the “lack of transparency” in this market. Nobody knows the level of ‘exposure’ of the banks and finance houses on these contracts. That is why the US government tried to take these ‘toxic debts’ out of the market and quarantine them. But untangling who owns what, and is liable for how much, is an incredibly complicated job and may be beyond them.
In the current circumstances securitisation and insurance against risk of default has almost entirely ceased. Nobody knows who will end up with big losses, and that is why the banks are not prepared to risk lending to each other.
The Brown government’s recent package is aimed at handing over to the banks sufficient money for them to get through the crisis, and the £250 billion backstop on inter-bank lending is aimed at unfreezing this market which the real economy relies on. Whether this dose of anti-freeze works remains to be seen. But even if it does create a temporary easing of the situation, the derivatives market hangs over the whole economy like an approaching hurricane. It is literally fictitious capital.
Hutton suggests that even nationalised banks and countries “could be overwhelmed by the size of the losses now emerging”. Curiously, whilst the market in securitised assets and credit default contracts has closed down, Hutton proposes that the Bank of England as well as being the lender of last resort, becomes the insurer of last resort. Governments, he says, should issue credit defaults themselves. But isn’t this just a means of maintaining an unsustainable inflated bubble?
The credit derivatives markets have been a means of bank and finance houses making a fast buck from pieces of paper, such activity entirely unrelated to productive activity. It has been a means of achieving profit levels which could not be achieved in real economic activity. As Hutton himself says:
“For 30 years, greedy, callow, ignorant financiers, supported by no less callow politicians from all the political parties have proclaimed the wonders of financial innovation and how proud we should all be of the City of London. The price tag for their behaviour is an economic calamity. We should never have bought such snake oil. The consolation in these dark times is that we never will again.”
So why keep the snake oil in circulation? And why should governments produce more of it? Any rational response to this crisis would begin by banning the securitisation of mortgage debt and closing down the market in credit default swaps which is truly a gambling den, only the participants are gambling with our lives.
In a paper in the Bank of England’s 3rd Quarterly Bulletin, Nigel Jenkinson, the Bank’s Executive Director for Financial Stability wrote that almost one year into the credit crisis
“…it is an opportune moment to review whether the financial innovation of recent years that created such structured products has indeed been a positive force as argued by Alan Greenspan…or whether a malign development producing ‘financial weapons of mass destruction’ in the words of Warren Buffet.”
Jenkinson says there is “clearly some force in both arguments”.
With masterly understatement he writes:
“On balance, we continue to see considerable benefits to households and companies from the broadening of choice in financial products and improvements in the completeness of financial markets. But equally the severe pressures and strains of the past year have highlighted the pervasiveness of some market frictions that have a major bearing on system-wide behaviour and dynamics, amplifying and transmitting shocks. Action to lower these frictions is consequently important to capture the full-benefits of innovation and to ensure that these are durable.”
Since he wrote this there has been a great deal of “amplifying and transmitting” of shocks. Despite the reluctance of supporters of neo-liberalism to recognise the consequences of their sophisticated “innovations”, Buffett has been proved right. It is time for the ‘financial weapons of mass destruction’ to be decommissioned.
Martin Wicks 