Here's How Messed Up Our Financial System Is

If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament."
-- Charlie Munger, May 2009

Credit default swaps (CDSes) are insurance policies on various debt products -- everything from subprime mortgages to U.S. government debt. A seller agrees to compensate a buyer if debt goes into default. It's not too different from car insurance: two parties swap risk for a premium. And just like car insurance, it can be a great tool to efficiently spread risk to those who want it from those who can't handle it.  

So why does Munger, Berkshire Hathaway's (NYSE: BRK-A) (NYSE: BRK-B) co-chairman, want them banned?

See, in everyday life, you can't insure things you don't own. Thankfully, your neighbor can't take out homeowners insurance on your house. If the entire town could buy insurance on one house, they'd have a huge incentive to make sure it was destroyed. They'd burn it down, blow it up, bulldoze it, what have you, pocket gobs of insurance claims for their trouble, and happily move onto the next town. For good reason, laws prohibit this.

With credit default swaps, there are no such laws. Investors can take out infinite amounts of insurance on debt products they don't own. This seriously distorts the motives and incentives between buyers and sellers. CDSes often don't act as insurance, but a tool to manipulate stupidly large amounts of money and rip gaping holes in the financial system, a la AIG (NYSE: AIG). 

The Wall Street Journal recently reported an almost comical example of this. It tells the story of a tiny Texas brokerage firm called Amherst Holdings which, likely along with other CDS underwriters, took a $27 million debt security and sold $130 million of credit default protection on it. Big banks like RBS (NYSE: RBS) JPMorgan Chase (NYSE: JPM) and Bank of America (NYSE: BAC) bought these CDSes. The debt, when reviewed, was total garbage and almost certain to default, so the banks had no problem paying up for the insurance.

Now, think about this for a moment: Amherst, and likely other CDS counterparties, pocketed $130 million to insure $27 million worth of bonds. So what do you think Amherst did? Exploiting a small loophole, it used the proceeds to have the underlying bonds bought back at par, which instantly rendered the credit default swaps worthless.

It was incentivized to do this because the amount it took in from CDS proceeds substantially exceeded the bond's par value, so it could burn millions of dollars buying out the bonds and still make a tidy profit. By making the bonds whole, there was zero chance of default, so Amherst's insurance obligation disappeared.

Of course, there really was no insurance involved. There wasn't even an investment. As Munger notes in the opening quote, it's simply a vast, unregulated game of poker. Spun the other way, CDS buyers have an incentive to make sure underlying debt defaults. They can achieve this by buying CDSes for multiple times a company's debt load and causing a run on its assets. Indeed, this is exactly what many believe ultimately pushed Lehman Brothers into bankruptcy.

In the utopic minds of those who created them, credit default swaps prevent meltdowns and mitigate risk. In reality, scarcely anything in our economy possesses a greater risk of bringing down the house. Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP. That's $126,000 for every man, woman, and child in America. This is quite literally a poker game multiple times the size of the entire economy.

Yet we've still done very little to fix it. CDSes are still sold, bought, and traded in staggeringly large sums based on rules dictated by those who created them. As Goldman Sachs' (NYSE: GS) annual report states, "The market for credit default swaps is relatively new, although very large, and it has proven to be extremely volatile and currently lacks a high degree of structure or transparency." Whoo-hoo!

Read that quote again, remind yourself what got us here in the first place, pound your head on the table, and ask yourself why we hold frequent congressional hearings to quibble over things like executive pay, but sweep issues like credit default swaps under the table and hope they fix themselves.