The Bet That Blew Up Wall Street
On Credit Default Swaps And Their Central Role In The
Unfolding Economic Crisis
By Steve Kroft;
60 Minutes Documentary, Oct. 26, 2008
This is a script of the video about Credit Default Swap or CDS.
It is one of the best explainations of what CDS is,
how it works and its impact on the world economy.
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Reference Web:
http://www.cbsnews.com/stories/2008/10/26/60minutes/main4546199.shtml
Video 12 mns:
http://www.cbsnews.com/video/watch/?id=4546583n
CBS)
The world's
financial system teetered on the edge again last week, and anyone
with more than a passing interest in their shrinking 401(k) knows
it's because of a global credit crisis. It began with the collapse of
the U.S. housing market and has been magnified worldwide by what
Warren Buffet once called "financial weapons of mass
destruction."
They are called credit derivatives or
credit default swaps, and 60
Minutes did a story on the multi-trillion dollar market
three weeks ago. But there's a lot more to tell.
As Steve
Kroft reports, essentially they are side bets on the performance
of the U.S. mortgage markets and the solvency on some of the biggest
financial institutions in the world. It's a form of legalized
gambling that allows you to wager on financial outcomes without ever
having to actually buy the stocks and bonds and mortgages.
It
would have been illegal during most of the 20th century, but eight
years ago Congress gave Wall Street an exemption and it has turned
out to be a very bad idea.
While Congress and the rest of the
country scratched their heads trying to figure out how we got into
this mess, 60 Minutes decided to go to Frank Partnoy, a
law professor at the University of San Diego, who has written a
couple of books on the subject.
Asked to explain what a
derivative is, Partnoy says, "A derivative is a financial
instrument whose value is based on something else. It's basically a
side bet."
Think of it for a moment as a football game.
Every week, the New York Giants take the field with hopes of getting
back to the Super Bowl. If they do, they will get more money and
glory for the team and its owners. They have a direct investment in
the game. But the people in the stands may also have a financial
stake in the ouctome, in the form of a bet with a friend or a bookie.
"We could call that a derivative. It's a side bet. We
don't own the teams. But we have a bet based on the outcome. And a
lot of derivatives are bets based on the outcome of games of a sort.
Not football games, but games in the markets," Partnoy explains.
Partnoy says the bet was whether interest rates were going to
go up or down. "And the new bet that arose over the last several
years is a bet based on whether people will default on their
mortgages."
And that was the bet that blew up Wall
Street. The TNT was the collapse of the housing market and the
failure of complicated mortgage securities that the big investment
houses created and sold around the world.
But the rocket fuel
was the trillions of dollars in side bets on those mortgage
securities, called "credit default swaps." They were
essentially private insurance contracts that paid off if the
investment went bad, but you didn't have to actually own the
investment to collect on the insurance.
"If I thought
certain mortgage securities were gonna fail, I could go out and buy
insurance on them without actually owning them?" Kroft asks Eric
Dinallo, the insurance superintendent for the state of New York.
"Yeah," Dinallo says. "The irony is, though,
you're not really buying insurance at that point. You're just placing
the bet."
Dinallo says credit default swaps were totally
unregulated and that the big banks and investment houses that sold
them didn't have to set aside any money to cover their potential
losses and pay off their bets.
"As the market began to
seize up and as the market for the underlying obligations began to
perform poorly, everybody wanted to get paid, had a right to get paid
on those credit default swaps. And there was no 'there' there. There
was no money behind the commitments. And people came up short. And so
that's to a large extent what happened to Bear Sterns, Lehman
Brothers, and the INSURANCE holding company of AIG," he explains.
In other words, three of the nation's largest financial
institutions had made more bad bets than they could afford to pay
off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar,
Lehman Brothers was allowed to go belly up, and AIG, considered too
big to let fail, is on life support to thanks to a $123 billion
investment by U.S. taxpayers.
"It's legalized gambling.
It was illegal gambling. And we made it legal gambling…with
absolutely no regulatory controls. Zero, as far as I can tell,"
Dinallo says.
"I mean it sounds a little like a bookie
operation," Kroft comments.
"Yes, and it used to be
illegal. It was very illegal 100 years ago," Dinallo says.
"I know people personally who have taken away more than $1
billion from having been on the right side of these transactions,"
says Jim Grant, publisher of Grant's Interest Rate Observer and one
of the country’s foremost experts on credit markets.
"If
you can and you could lay down cents on the dollar to place a bet on
the solvency of Wall Street, for example, as some did, when Wall
Street became evidently insolvent, that cents on the dollar bet went
up 30, 40, and 50 fold. Not everyone who did that wants to get his
name in the paper. But there are some spectacularly rich people who
came out of this," Grant says.
"
Who got richer,"
Kroft remarks.
"Who got richer, who became, you know,
fantastically richer," Grant says.
A lot of them were
hedge fund managers. John Paulson's Credit Opportunities Fund
returned almost 600 percent last year, with Paulson pocketing a
reported $3.7 billion.
Bill Ackman, of Pershing Square
Capital Management, said he plans to make hundreds of millions. Both
declined 60 Minutes' request for an interview.
Congress now seems shocked and outraged by the consequences
of its decision eight years ago to effectively deregulate swaps and
derivatives. Various members of the House and Senate have hauled in
the usual suspects to accept or share the blame.
"Were
you wrong?" Rep. Henry Waxman asked former Federal Reserve
Chairman Greenspan.
"Credit default swaps, I think, have
some serious problems with them," Greenspan replied.
It
appears to be the first step in a long process of restoring at least
some of the regulations and safeguards that might have prevented, or
at least mitigated this disaster after the damage has already been
done.
Where do we go from here?
"We need the
most dramatic rethinking of the regulatory scheme for financial
markets since the New Deal. If anything has demonstrated that
imperative, it's the economy right now and the tragic circumstances
we're in," Goldschmid says.
Asked how much danger he
thinks is still out there, Goldschmid says, "We don't know. Part
of the problem of the lack of transparency in these - in these
markets has been we don't really know."
In the early part of the 20th century, the streets of New York and
other large cities were lined with gaming establishments called
"bucket shops," where people could place wagers on whether
the price of stocks would go up or down without actually buying them.
This unfettered speculation contributed to the panic and stock market
crash of 1907, and state laws all over the country were enacted to
ban them.
"Big headlines, huge type. This is the front
page of the New York Times," Dinallo explains, holding up a
headline that reads "No bucket shops for new law to hit.”
"So they'd already closed up 'cause the law was coming.
Here's a picture of one of them. And they were like parlors. See,"
Dinallo says. "Betting parlors. It was a felony. Well, it was a
felony when a law came into effect because it had brought down the
market in 1907. And they said, 'We're not gonna let this happen
again.' And then 100 years later in 2000, we rolled them all back."
The vehicle for doing this was an obscure but critical piece
of federal legislation called the Commodity Futures Modernization Act
of 2000. And the bill was a big favorite of the financial industry it
would eventually help destroy.
It not only removed
derivatives and credit default swaps from the purview of federal
oversight, on page 262 of the legislation, Congress pre-empted the
states from enforcing existing gambling and bucket shop laws against
Wall Street.
"It makes it sound like they knew it was
illegal," Kroft remarks.
"I would agree,"
Dinallo says. "They did know it was illegal. Or at least
prosecutable."
In retrospect, giving Wall Street
immunity from state gambling laws and legalizing activity that had
been banned for most of the 20th century should have given lawmakers
pause, but on the last day and the last vote of the lame duck 106th
Congress, Wall Street got what it wanted when the Senate passed the
bill unanimously.
"There was an awful lot of, 'Trust us.
Leave it alone. We can do it better than government,' without any
realistic understanding of the dangers involved," says Harvey
Goldschmid, a Columbia University law professor and a former
commissioner and general counsel of the Securities and Exchange
Commission. He says the bill was passed at the height of Wall
Street and Washington's love affair with deregulation, an infatuation
that was endorsed by President Clinton at the White House and
encouraged by Federal Reserve Chairman Alan Greenspan.
"That
was the wildest and silliest period in many ways. Now, again, that's
with hindsight because the argument at the time was these are
grownups. They're institutions with a great deal of money. Government
will only get in the way. Fears it will be taken overseas. Leave it
alone. But it was a wrong-headed argument. And turned out to be, of
course, extraordinarily unwise," Goldschmid says.
Asked what role Greenspan played in all
of this, Professor Goldschmid says, "Well, he made clear in his
public speeches and book that a Libertarian drive was part of the way
he looked at the world. He's a very talented man. But that didn't
take us where we had to be."
"Alan was the most powerful
man in Washington in a real sense. Certainly a rival to the president
and had enormous influence on Capitol Hill," Goldschmid says,
"And he was at the height of his power," Kroft
adds.
Within eight years, unregulated derivatives and swaps
helped produce the largest financial services economy the United
States has ever had. Estimates of the market for credit default swaps
grew from $100 billion to more than $50 trillion, and you could bet
on anything from the solvency of communities to the fate of General
Motors.
It also produced a huge transfer of private wealth to
Wall Street traders and investment bankers, who collected billions of
dollars in bonuses. A lot of the money was made financing what seemed
to be a never-ending housing boom, selling mortgage securities they
thought were safe and credit default swaps that would never have to
be paid off.
"The credit default swaps was the key of
what went wrong and what's created these enormous losses,"
Goldschmid says.
"Is it your impression that people at
the big Wall Street investment houses knew what was going on and knew
the kind of risks that they were exposed to?" Kroft asks.
"No.
My impression is to the contrary, that even at senior levels they
only vaguely understood the risks. They only vaguely followed what
was going on," Goldschmid says. "And when it tumbled, there
was some genuine surprise not only at the board level where there
wasn't enough oversight but at senior management level."
They
didn't know what was going on in part because credit default swaps
were totally unregulated. No one knew how many there were or who
owned them. There was no central exchange or clearing house to keep
track of all the bets and to hold the money to make sure they got
paid off. Eventually, savvy investors figured out that the cheapest,
most effective way to bet against the entire housing market was to
buy credit defaults swaps, in effect taking out inexpensive insurance
policies that would pay off big when other people’s mortgage
investments went south.
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