Lehman Brothers Crash: Inside the Accounting Trick That Destroyed the Economy

MBS, CDO, CDS ... As we approach the five-year anniversary of the financial crisis, you will at some point be subjected to a series of acronyms for obscure financial instruments (MBS, CDO, CDS, etc.). One problem with this is that is reduces the financial crisis to alphabet soup. The real problem with this that these products are still sold. 

The most important one of these abbreviations is the CDS, or Credit Default Swap. It remains the most dangerous, and possibly least understood aspect of the financial crisis. What is a Credit Default Swap? 

A CDS is just insurance, much like health insurance that you may buy for yourself. People buy health insurance to protect themselves from the remote possibility of getting very sick. In such cases, the expense of your hospital stay and medical treatments are paid by the insurance company. The insurance company doesn't charge you very much because the likelihood of you getting very sick is very small. It is a bet on your health.

Financial companies have the same concern. When a bank buys a bond ("What Is A Bond"), it wants to insure that the bond doesn't get sick. In terms of bonds, getting sick is a relatively unlikely event called default. If a bank buys a bond from Coca Cola, it might buy insurance that Coca Cola does not default on its bonds. That insurance is called a credit default swap, or CDS.

In theory, credit default swaps are a lot like health insurance. In practice, there is a big difference. The market for these instruments was in 2008 completely unregulated. That difference, in part, caused the financial crisis.

The first difference with an unregulated market, is that I can buy health insurance on anyone. So a credit default swap, phrased in terms of health insurance, would allow me to buy health insurance on you, where I get paid if you get sick. Moreover, I can do everything in my power to make you sick. So, I would be allowed to buy insurance on your health, and then loosen the lug-nuts on your car tires.

For example, hedge-fund manager Bill Ackman could buy a credit default swap on Fannie Mae or Freddie Mac even though he had no interest in the success of either company. There is nothing to stop him from going on CNBC to suggest that both companies were completely bankrupt, nor is there anything to stop a financial news agency like Bloomberg from repeating the story and passing Ackman's self-interested lies off as truth. 

The problem is a little worse than it sounds. Companies are legally required to provide financially accurate reports to the public. There is no corresponding requirement that "investors" in destruction who profit on the demise of a company have to provide accurate information at all. They are free to spread fear-mongering speculation. For example, Bill Ackman could say, "It doesn't matter what the rating agencies say about their capitalization. Implicit guarantees don't work in the market that we're in now. What matters is capital." He isn't saying that these companies are broke, but rather that his credit default swaps are worth more than what the market thinks.

The second biggest difference between health insurance and CDS's is that in a regulated market the insurance company must maintain a reserve with which to pay claims. In an unregulated market companies keep collateral, the value of which isn't precise — say the bonds of Lehman Brothers. This presents a major problem because it is very possible that the bills that the insurance company has to pay (bankruptcies) rise at the exact same time when the ability of the insurance company to pay (value of the collateral) is falling.

This leads us to another difference in unregulated insurance: There is nothing to stop a complete fool from selling financial insurance. Investment and risk are something like nuclear power and nuclear waste. In an completely unregulated market, you would find that the company that stores the nuclear waste is run by the person who knows the least about the half-life of spent uranium rods. In the case of credit default swaps, the company that understood the least about risk was AIGFP, or American Insurance General Financial Products.

This was unfortunately the company that insured a large part of our sub-prime mortgage loans. The company had underpriced the cost of the insurance it sold. It was a bad bet which it had no way to pay. Beyond charging too little, it is possible for the insurer — if foolish enough — to see all of the revenue as profit, and pay it out as bonuses. Yet, the companies which bought the insurance thought it was safe.

The credit default swap is not a sound investment unless the owner has an offsetting interest in the success of the company. Absent that, it is an investment in destruction and crises like the 2008 collapse are the inevitable outcome. The only surprise of 2008 was the degree to which the government was surprised.

Related Reading:

-CNBC Explains Credit Default Swaps

-"Credit Default Swap ETFs Coming To Market"