"60 Minutes" this past Sunday devoted its lead segment–"The Bet That Blew Up Wall Street"–to an indictment of how "casino capitalism" and a negligent Congress allowed unregulated trading in credit default swaps to trample our financial system in a stampede of blind greed, with AIG the poster child for all that went wrong.
New York Insurance Superintendent Eric Dinallo got plenty of face time in the devastating 12-minute segment about CDS derivatives, which CBS noted that Warren Buffet once called "financial weapons of mass destruction." (Click here to read the full transcript or view the video.)
One major point I learned from the broadcast, much to my chagrin, was how state regulatory barriers had been firmly in place to prevent such risky business. But Congress, in an act of pure folly and negligence, not only stripped away federal oversight, but prohibited the states from taking any action on their own. That left myopic traders like those at AIG free to go deeper and deeper into a credit default swap quagmire, the depths of which we still do not know for sure!
As CBS noted, once players packaged and passed along millions of shaky subprime mortgage loans in the form of collateralized debt obligations, buyers seeking to hedge their bets bought credit default swaps to transfer the risk of failure to others–such as AIG's ill-fated Financial Products Division. This was essentially an insurance deal on AIG's part, but no state regulator was permitted to oversee or restrict such transactions, and Uncle Sam didn't interfere, either.
That meant there were no reserving standards, so AIG was allowed to become heavily exposed without having any real funds on hand if they ever had to pay off on these big-time bets.
The problem was exacerbated by the fact that speculators who didn't even own CDOs started buying credit default swaps.
"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…," explained Mr. Dinallo. "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 holding company of AIG."
The fact that so many people bought credit default swaps from AIG and others without having any underlying security to "insure" was what really undermined the entire financial market, according to Mr. Dinallo. "It's legalized gambling. It was illegal gambling. And we made it legal gamblingwith absolutely no regulatory controls. Zero, as far as I can tell."
Congress is liable for the financial damages we're all enduring because of a section in the Commodity Futures Modernization Act of 2000, described ironically in the CBS report as "a big favorite of the financial industry it would eventually help destroy."
The bill, noted CBS, "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."
(Bucket shops were described by the report as establishments "where people could place wagers on whether the price of stocks would go up or down without actually buying them," noting that "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." Today, there is still options trading on stocks, but unlike credit default swaps, this market is regulated by the Feds.)
What's worse is the utter lack of transparency in the trading of credit default swaps, as we still don't know where the bottom of this pit lies. That's one reason why Uncle Sam might have to keep pumping billions of taxpayer dollars into AIG to keep the company afloat, since we don't know how much they might owe. It's the mother of all so-called "naked" options–a little like in the old days at Lloyd's, before corporate capital took over the market, when individual investor liabilities were open-ended.
Those trading in these subprime-related derivatives "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," reported CBS. "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."
The report noted that "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 peoples mortgage investments went south."
CBS reported that "Congress now seems shocked and outraged by the consequences of its decision eight years ago to effectively deregulate swaps and derivatives," while conducting an inquisition of sorts now to place blame.
While there is certainly plenty of blame to go around, those members of Congress who voted in 2000 to let derivative traders off the leash should be put on the hot seat as well, not only to ask what they were thinking when they passed the law (most will claim ignorance–who reads bills going through Congress, anyway? Certainly not members of Congress), but what they intend to do about it.
What a mess! What a disgrace! And what a black eye on the insurance industry–to have its most prominent player right in the middle of this debacle, with taxpayers on the hook for over $130 billion and counting!
Is anyone out there still prepared to say the free market knows best? That less government is the best government? That the Invisible Hand can be trusted to slap down anyone who steps out of line?
State insurance regulators come out smelling like a rose in all of this. More on that subject in my next blog entry.
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