Below is an interview I did this week as part of the Greedy Bastards series with Dylan Ratigan. Enjoy -- Chris
Welcome to another episode of Greedy Bastards Antidote — a podcast series that zeroes in on “Greedy Bastardism” in our country, and highlights the people out there who are finding the “Antidotes.” Dylan will be talking to the heroes and the visionaries out there on the front lines of education, health care, the environment, trade, taxes, finance and government, all of whom are finding solutions to America’s biggest challenges — and doing it creatively and fearlessly.
This week, we’re focusing on the swaps market — not only to learn exactly what credit default swaps are, but why they’re one of the favorite financial products of Greedy Bastards. This is the one market that betrays every fundamental principal of American values — it is not transparent, it does not require collateral if you’re a AAA rated bank, and you can sell insurance globally on credit. This incentivizes clients to buy them by offering lower interest rates (and who doesn’t want that?)
To help define exactly what “swaps” are, we got to talk to someone who knows them inside and out — Christoper Whalen of Institutional Risk Analytics and author of the book Inflated: How Money and Debt Built the American Dream. You can chat with him on Twitter @rcwhalen.
What is a credit default swap? Here’s how Dylan explains it: “The credit default swap literally has that equivalency in which AAA rated financial institutions sell insurance, so to speak, on credit—they allow you to reduce your interest rates, they allow companies and countries and individuals to benefit from, in the short term, reduced borrowing costs because of the insurance that was purchased in the swap, as they like to call it.” These are not transparent, because they are not traded on any public exchange. Lack of transparency means that no one, exactly, knows where the risk is or how much risk there is.
Why do Greedy Bastards love swaps? Dylan explains it this way. “The genius of the Greedy Bastards maneuvering in the swaps market is the following: After collecting the revenue for all the insurance that you’re selling and all the credit and debt of the world—by the way, the more debt there is, the more insurance you can sell—when the insurance claims come from default on that credit, you don’t have to pay a penny because you, my friend, are too big to fail,” says Dylan. “This is a market that has been created to basically protect the profitability of these banks that could be put on exchange but the barrier to doing it is the threat to their profits and the ability to do that is from money and politics.”
What’s an example of how a credit default swap functions? Chris Whalen provides this example:
When JPMorgan does a credit default swap with a customer, they keep the collateral. There is no separate trust company that is part of the exchange that holds all the money the way you do in a good poker game.
So nobody knows if it’s fully collateralized or not because they’re trusting JPMorgan to operate their business in a prudential way. Until we had the minor reforms of Dodd-Frank and the Corrigan Group before that, the dealers weren’t posting any margin with one another. It was all naked. And so the first thing that Corrigan did when he started getting people focused on this was to force the dealers to require minimum margins from one another. That was the problem. The systemic risk was actually among the big dealers. They dealt with that somewhat but look at Dodd-Frank, they didn’t touch the bilateral relationship between the client the dealer bank.
So if I am the customer, and I’m dealing with JPMorgan, I can’t go to any other bank because all these contracts are bespoked, they’re all different. I can’t get another bank to net me out, so that’s the problem. On an exchange, all contracts are fungible—I want to go long, I want to go short, whatever it is, I do my trade, I don’t even know who the other counterparty is because I’m dealing with the exchange.
Swaps were just a new way for banks to generate income, even as they became less and less relevant: “As the U.S. economy and especially Wall Street and the banks were less and less focused on funding and financing real economic activity jobs, factories, commerce, the rise of the ersatz virtual world of credit faults swaps and over-the-counter derivatives, all of these gray markets—that are unregulated, that are not traded on exchanges, that have no transparency—were really a way for banks to generate income because they could no longer make their money on the real economy,” says Chris. “And the Fed encouraged this. If you go back to the ‘80s, the LDC debt crises when a lot of the big U.S. banks like Citi almost failed, they realized that between technology, innovation, deregulation of markets, the profitability of the old banking business, at least as far as big banks were concerned, was ebbing. So the solution, if you will, was for the Fed to encourage things like Basel II, this whole global regulatory mirage that we have, and at the same time they said, “Oh, it’s okay for you to create off balance sheet entities, it is okay for you to trade these derivatives that are not at all regulated or subject to disclosure,” and the banks have done exactly that,” he explains.
What is the “Antidote” to this form of Greedy Bastardism? You want to have an exchange traded product, you want to have full public disclosure of all trading every day so we can see all prices for all trades, and you want to require physical delivery of the underlying asset,” says Chris. “In other words, you own a bond, a loan, it could be commercial paper, even a vendor. Let’s say you are big vendor and you have credit exposure with a bank and you want to hedge it. That would be okay, you could deliver the accounts receivable for your insurance payment. That’s what we need. It’s to re-link this derivative market with the real world. And then we’ve got something,” he explains.
For the full conversation, check out the transcript below:
- Meg Robertson is a digital producer for DylanRatigan.com.