Credit Default Swaps

How Credit Default Swaps Could Reverse the Economic Recovery

While the entire U.S. housing market was on the verge of collapse and corporate America was being systemically undermined, regulators purposely looked the other way.

Why would they do this?

The truth is that U.S. regulators believed the American public couldn’t handle the truth that what had been allowed to happen, on their watch, was actually happening.

Unfortunately, we now face the same situation with credit default swaps, a derivative security that has the ability to destroy otherwise healthy companies with the virulence of a full-blown plague.

Until the American public understands this, and forces the government to take action, the odds of a repeat performance of what we refer to as the global financial crisis remain very high.

This is not an “Origin of the Species” seminal epic. Rather, it is a short story about the failure of evolutionists to recognize that, while creationism actually starts somewhere, it is actually the failure of regulators to evolve as institutions and markets change that makes monkeys of us all.

Let’s start by looking at the Federal Housing Finance Authority (FHFA), the current regulator of Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE), two players who were central to the start of the U.S. housing crisis, which became the contagion that grew into a full-blown global crisis.

It’s bad enough that the regulators who came before the FHFA were inept, but what is happening now under the FHFA is far worse, and actually has the potential to exacerbate a crisis that most taxpayers believe is being resolved.

For more than six months, the U.S. Justice Department and the Securities and Exchange Commission (SEC) have been investigating the accounting practices of the two mortgage behemoths. And now the FBI has gotten into the act. It seems that, not long ago, the FHFA hired renowned investigative firm Kroll Inc. [One of the powerful, one-named, spook-like firms – not unlike Blackwater Security Consulting – Kroll is a unit of New York-based insurance powerhouse and “risk advisor” Marsh & McLennan Cos. Inc. (NYSE: MMC)].

Kroll’s confidential report to the FHFA concluded that “inappropriate application” of accounting rules “enabled Freddie to defer billions of dollars of losses incurred from 2001 through 2004.” The source of those losses, according to a Wall Street Journal article, was derivative contracts based on interest-rate swaps.

What’s the big deal you ask? While it’s no surprise that Freddie used an inappropriate set of rules – known as “hedge accounting” – to stretch out losses over several years, rather than just take immediate hits to its profit-and-loss statement, what is frightening is that the FHFA, after hiring Kroll and uncovering the accounting inaccuracies, said it had decided “not to take issue with the accounting,” the Journal reported.

The FHFA labeled it as a “disagreement among the experts.” Call it what you want, but I call it fraud.

Here’s the problem. Fannie and Freddie are incredibly “fragile” right now (the correct financial term is probably “insolvent”). That means that the very two institutions being used by government to halt the catastrophic slide of the U.S. housing industry are so crucial to the bailout of the mortgage industry that to force these two institutions to write off more losses would only spook the financial markets even further.

As large as Freddie and Fannie are in the U.S. housing and mortgage markets, even their combined portfolio value – estimated at about $13 trillion – is dwarfed by an exponentially larger and even more insidious monster running over regulators like they’re not there. I’m talking about the $40 trillion stranglehold that the credit default swap market has on corporations all around the world.

Credit default swaps brought insurance giant American International Group Inc. (NYSE: AIG) to its knees. It was also one of the key catalysts that helped transform a housing bubble into a full-blown global financial crisis.

But here’s the rub: After all that, credit default swaps still aren’t regulated.

Of course that doesn’t mean that regulators don’t try and insert a hand here and there, it just means that the hand they insert has been feeding the monster rather than taming it. But, just recently, a good faith public relations effort was made to show the new interest the revitalized SEC has in reining in the monster from Hades.

In what amounts to a minor case with major worldwide implications, the SEC has brought insider trading allegations against a credit default swap trader and his source of inside information. It is alleged that Renato Negrin, formerly a trader at hedge fund Millennium Partners LP, received inside information from Jon-Paul Rorech, a salesman at Deutsche Bank AG (NYSE: DB). Supposedly, Rorech provided inside information to Negrin about the potential value of certain credits of VNU NV, a Dutch holding company that owns Nielsen Media and other media businesses

It doesn’t matter that Negrin no longer works at Millennium, or that both men say they are innocent, or that the alleged ill-begotten gain was a measly $1.2 million, or that the two men’s lawyers say the SEC has no jurisdiction over derivative contracts, period – let alone derivative contracts tied to European bonds.

What matters is that the SEC has finally put its toe into the muck. According to ABC News, it’s the first insider-trading case involving credit default swaps.

Nothing may come of it. But I, for one, will be watching.

It strikes me as tragically ironic that after the credit-default-swap market has been allowed to grow from a few wispy hairs into the tail that wags the dog, the SEC is just now trying to be more than a flea on the tail of this monster.

The real reason we are not hearing more about the catastrophic systemic danger unleashed by credit default swaps is that even the regulators who would like to be overseeing this huge market – if for no other reason than for the regulatory-driven fee income these securities could generate – are afraid to admit this market is still poised to unleash a capitalist plague unlike any that’s ever been seen.

Just as we saw with the role Fannie and Freddie played in the housing market, the credit default swap market has gotten so large and out of control that to admit there is a problem is to admit that the problem is so big and will be so difficult to unwind that the threat can’t be thwarted anytime soon.

But until the public recognizes that credit default swaps can be used to manipulate the credit characteristics, ratings and creditworthiness of corporate borrowers – and also be used to intentionally push down stock prices in a way that destroys good companies, this derivative security will continue to hang over Corporate America and the U.S. stock market like a capitalist sword of Damocles.

It happened with AIG. And it can easily happen again.

The tarnish dulling the prospects of America’s recovery needs to be wiped clean and in its place clear transparency into the workings of the U.S. financial markets needs to be implemented. It’s bad enough that we are in this mess and afraid to admit how deep the hole is. But one thing is for sure, if we don’t create a level playing field, if we don’t expose fraud, if we don’t rein in swashbuckling traders slicing and dicing up America’s corporate backbone, we will discover that this particular hole is bottomless.

But if we’re honest about the problems we still face – as well as what needs to be done – we will find that everyone can see a clear path to steer, and will navigate our way back to economic high ground.

Our leaders might be surprised, if they would only accept one basic fact: We can handle the truth – if we know what it is.