Infectious Greed

by Frank Partnoy

  In a typical insurance policy, two parties bet on whether a particular event would occur: a car accident, a fire, a death. In a credit default swap, two parties bet on whether a company would default on its loans. The party betting yes was “buying protection,” like an individual buying insurance. The party betting no was “selling protection,” like an insurance company. If the company they were betting on remained healthy, the buyer of protection would pay the seller an amount resembling an insurance premium. If the company failed to make its loan payments, the seller of protection would pay the buyer a prespecified amount, like the payout on an insurance policy.

  Banks used credit default swaps to transfer credit risk, the risk that they would not be repaid money they had loaned to other companies. They bought credit protection from investors by agreeing to pay a fee in exchange for the right to receive payment if a particular company defaulted on its debts. Credit default swaps were ideal for commercial banks, because they enabled them to cut their risks while reducing the regulatory charges they had to pay for loans they already had made. When the Federal Reserve issued guidelines in June 1997 making these regulatory benefits clear, and the Asia crisis followed immediately thereafter, banks such as J. P. Morgan and Citigroup rushed to do credit default swaps, to lower their risks and regulatory costs.64

  The market for credit default swaps was tested in 1998, when Russia announced a “rescheduling” in its local debt market, and parties disputed whether that announcement was a “default” according to the ambiguous language in some credit default swaps. But the swap dealers tightened the language in response, and the market doubled and then doubled again. By 2002, banks had done hundreds of billions of dollars of credit default swaps based on various borrowers throughout the world. This was why the banks were reasonably safe, even though they had loaned hundreds of billions of dollars to those companies.

  For example, banks had done an estimated $10 billion of credit default swaps related to WorldCom.65 That meant that even though banks still held loans to WorldCom and were owed money in WorldCom’s bankruptcy proceeding, they had sold the risk associated with those loans to someone else. The banks didn’t have to worry about WorldCom’s bankruptcy, because whatever they lost on WorldCom’s loans, they made up for with credit default swaps. Whatever happened, they were hedged.

  There also were approximately 800 credit default swaps involving $8 billion of bets on Enron.66 J. P. Morgan did many of them, just as it did credit default swaps based on Global Crossing and Kmart, which also declared bankruptcy in 2002. As a result, J. P. Morgan Chase recorded “only” $456 million in losses on loans to Enron.67

  Citigroup did even better with respect to its exposure to Enron, albeit in a slightly more complex way. From August 2000 to May 2001, Citigroup created a series of Special Purpose Entities that held AAA-rated bonds and issued a special type of credit derivative that depended on whether Enron defaulted.68 If Enron paid its debts, the investors would keep the AAA-rated bonds. But if Enron did not pay, Citigroup would take the AAA-rated bonds and replace them with Enron’s bonds. By using these transactions, Citigroup hedged its entire $1.2 billion exposure to Enron. Citigroup lost nothing when Enron defaulted in December 2001. Instead, the investors in Citigroup’s SPEs were left holding the bag.

  From their narrow perspective, bankers and bank regulators undoubtedly were correct. The risk associated with corporate credit no longer stayed with the banks lending corporations money. Instead, these credit risks were passed around the globe like a hot potato. The hundreds of billions of dollars of losses didn’t disappear merely because banks had reduced their risks. Instead, someone else bore the losses. The question was: who?

  Bankers and bank regulators applauded credit default swaps for their ability to shift risks away from banks. Before credit default swaps, the collapse of Enron alone might have brought down a major bank. The simultaneous bankruptcies of Enron, Global Crossing, and WorldCom would have decimated the banking industry. But even after the myriad defaults of 2001 and 2002, the banks were doing just fine. In a speech on April 22, 2002, Alan Greenspan said credit derivatives “appear to have effectively spread losses from recent defaults by Enron, Global Crossing, Railtrack, and Swissair [other bankrupt companies] in recent months. In particular, the still relatively small, but rapidly growing, credit derivatives market has to date functioned well, with payouts proceeding smoothly for the most part. Obviously, this market is still too new to have been tested in a widespread credit down-cycle. But so far, so good.”

  Unfortunately, the credit default swaps market was opaque and unregulated, and because disclosure was not required, no one could be sure where the risk had gone. Even the banks pitching credit-derivatives deals made widely different estimates about who was involved in the market. Ten years earlier, companies such as Enron and WorldCom might have had at most a dozen creditors—institutions they owed money. Instead, the bankruptcy filings of those firms listed dozens of pages of creditors. But even that list didn’t provide much of a clue about the parties to credit default swaps related to Enron, because those parties typically were looking to each other for payment, not to Enron.

  As early as 1997, experts within the financial industry had warned that the sellers of credit protection—the institutions betting that companies would not default—might not fully understand the risks of credit default swaps. E. Gerald Corrigan, the former head of the New York Federal Reserve who had issued warnings about derivatives before he joined Goldman Sachs, cautiously remarked, “The unbundling of credit risk probably should be a good thing, assuming that people picking up the elements of credit risk understand what they’re doing and the risks they’re incurring.” Tanya Styblo Beder, a derivatives consultant, warned that the risk models used in evaluating credit default swaps were based on historical default data that could prove invalid.69

  By 2002, there was evidence that many of the supposedly sophisticated institutions doing credit default swaps had not understood their risks any better than Gibson Greetings had understood its complex swaps with Bankers Trust. The biggest sellers of protection were insurance companies, some in the United States, but also in Europe and Japan. Life insurance companies invested in credit default swaps as assets. Property and casualty insurance companies and reinsurance companies took on credit risk as a liability, and booked the payments as premiums. By one estimate, insurance companies had exposure to one-third of WorldCom’s $35 billion of debt.70 Pension funds and some hedge funds also did credit default swaps.

  Insurance companies had an incentive to use credit default swaps for the same reasons banks did: legal rules. In particular, insurance companies could use credit default swaps to avoid legal rules that limited their investments and penalized them for taking on too much risk. For example, insurance companies could use credit default swaps to make leveraged investments they otherwise would not be permitted to make due to rules restricting their ability to borrow money to buy securities. Just as Japanese insurance companies had used derivatives to buy over-the-counter options a decade earlier—arguing that the options fell outside the scope of legal rules—insurance companies throughout the world made the same arguments for credit default swaps. On its face, a credit default swap would appear to a regulator to be a simple transaction with a major U.S. bank. Financial regulators might not even know that behind an insurance company’s swap with J. P. Morgan was a leveraged bet on Enron.

  Bank regulators, by tightening their focus on banks to reduce their risks and prevent a banking crisis, had pushed credit risks onto other, less regulated institutions. Whereas the United States regulated banks separately, British regulators covered both banks and other financial institutions, and seemed to have both a broader perspective and a stronger grasp of the risks of credit default swaps than U.S. regulators (just as they had better grasped the risks of other over-the-counter derivatives during the mid-1990s). Howard Davies, chairman of the British Financial Services Authority, warned that credit derivatives were being
used for “regulatory arbitrage,” to shift risks from regulated banks to less regulated insurers,71 and that “we may be creating, not reducing market instability.”72 Although British banks, which previously had been plagued by bad loans, were now in reasonably good shape, the same was not true of Britain’s insurance companies. One of the biggest losers from the defaults of 2002 was Prudential plc—the 150-year-old United Kingdom insurance conglomerate, not the U.S.-based “piece of the rock” company—which announced losses of half a billion dollars on positions related to Global Crossing and other defaulted borrowers.73 Because U.S. insurance companies were regulated by state insurance commissions, and did not mark to market their positions in the same way as federally regulated securities and banking firms, no one knew with certainty if some of those insurance companies had become insolvent.

  Other major players in the credit-derivatives market included non-financial corporations, such as Enron and General Electric.74 During the 1990s, as banks used financial innovation to lighten their risks, industrial companies began to look more like banks. Yes, the banking system had become stronger, but that was because the risks were no longer held by banks. Morgan Stanley estimated that one-third of financial activity in 2000 occurred at non-financial companies, such as Enron and General Electric.75 Even companies such as Ford received more than a sixth of their revenue from financial activities.76

  By 2002, Enron already had died, and there were serious questions about the health of General Electric. General Electric was one of just eight companies retaining a AAA rating from the credit-rating agencies in 2002, but that was little comfort, given the agencies’ track record.

  In the previous two years, General Electric’s shares had dropped by half, wiping out nearly $300 billion of value. The decline was roughly the same as the decline that had immediately preceded Ken Lay’s conference call about Enron in October 2001. And although General Electric was rated AAA, its credit default swaps had fallen to values in line with a low double-A rating at best.

  In March 2002, Bill Gross of PIMCO—one of the leading bond managers in the world—announced that he no longer would buy General Electric’s short-term debt, because he believed the company had too much debt and too little disclosure. General Electric’s financial statements certainly looked suspicious. There was one $14 billion entry on the firm’s balance sheet for “All other current costs and expenses accrued.” As Doug Skinner, an accounting professor at the University of Michigan, said, “Goodness knows what’s in there.” In addition, General Electric had grown by acquiring huge numbers of companies—more than 100 per year—much more than Cendant or even Global Crossing and WorldCom.77 With that kind of acquisition growth, it was impossible to understand what really was happening at the company.

  Before 2002, investors had simply trusted chairman Jack Welch. But now that Welch had resigned—and had been tarnished not only by the plunge in the stock, but by negative publicity surrounding a high-profile affair he had with the former editor of the Harvard Business Review—investors were less trusting of General Electric and, especially, its financial businesses. When investors learned from documents filed in Welch’s divorce proceedings that GE was giving him tens of millions of dollars in retirement benefits—including a wine budget of more than many investors’ salaries—they wondered if Welch had been truthful about GE’s performance.

  General Electric was really two companies: GE Industrial and GE Capital.78 GE Industrial made lightbulbs, airplane engines, and gas turbines, and “brought good things to life”—as the company advertised on television. GE Capital borrowed and loaned money, and was an active player in derivatives. GE Industrial was the General Electric most people knew. But GE Capital was the engine that drove the firm’s profits.

  GE Capital was created during the Great Depression, with the modest aim of helping consumers finance their appliance purchases. But by 2002, GE Capital essentially had become a bank. It had more assets than all but two U.S. banking conglomerates, six times more than its assets in 1990.79

  In its 2001 annual report—issued in 2002—General Electric comforted its investors by stating, “As a matter of policy, neither GE nor GECS [GE Capital] engages in derivatives trading, derivatives market-making, or other speculative activities.” But in a footnote, General Electric noted that, because of changes in the way it accounted for its derivatives operations, it had reduced its earnings by $502 million, and reduced shareholder equity by $1.3 billion.80 These numbers were roughly the same as the restatement Enron had made in 2001, yet investors didn’t seem to care. General Electric noted, “This accounting change did not involve cash, and management expects that it will have no more than a modest effect on future results.” The rating agencies continued to give General Electric a rating of AAA, and Bill Gross remained one of the few investors to express a loss of faith in General Electric. Fortunately for the credit-derivatives market, General Electric did not appear to be in any danger of default.

  Some commentators argued that if insurance companies and industrial corporations were taking on credit risk from banks, that was a sign that these companies must be in a better position than banks to hold and monitor such risks. If markets were efficient, the hot potato, by definition, would be passed to the party best able to handle it. As the argument went, Enron, General Electric, and Prudential were in a better position to monitor and bear the risk of corporate loans than the major Wall Street banks.

  There were two flaws in this argument. First, because credit default swaps reduced the regulatory costs of banks and insurance companies, both types of firm benefited from swapping positions, regardless of which was in a better position to evaluate and examine the loans underlying the credit default swaps. From a regulatory perspective, both banks and insurance companies lowered their costs by doing credit default swaps with each other. Because credit default swaps were off balance sheet, industrial corporations also achieved regulatory benefits. Second, and more fundamental, banks were in by far the best position to monitor corporate loans. They were the firms that had made the loans, they had relationships with the borrowers, and they uniquely had access to the data and personnel necessary to keep tabs on the company’s prospects.

  In other words, banks were passing much of their credit risk to insurance companies and industrial corporations, even though banks were in a better position to monitor that risk. Just as interest-rate risk had flowed from Wall Street to Main Street during the early 1990s, now credit risk was being passed to parties less able to bear it. And, once again, the culprit was financial innovation designed to take advantage of legal rules.

  According to Martin Mayer, a leading banking expert, credit default swaps sacrificed the greatest strength of banks as lenders: their ability to police the status of a loan.81 An insurance company—especially one outside the United States—couldn’t do much more than look at a borrower’s public financial statements. Nor would it have an incentive to monitor the borrower, because each credit default swap represented only a small portion of the borrower’s overall debt. Moreover, an insurance company that bought credit risk from a bank might pass it along to another institution, which might pass it on to another, and so on. Because there were no disclosure requirements for credit default swaps, it was impossible to know who ultimately held the risk associated with a particular company’s loans. But it required a fantastic leap of faith to assume that the holder of the hot potato was in the best position to keep tabs on the borrower.

  Thus, credit default swaps distorted global investment by leading parties to misprice credit risk. Borrowers who were not being monitored tended to take on greater risks, which meant that the banks making new loans to these borrowers would charge higher interest rates. As the cost of capital in the economy increased, companies would take on fewer projects at higher cost, and economic growth would suffer. Moreover, because banks didn’t bear the risks associated with loans, they had an incentive to lend more money than they otherwise would. The International Monetary Fund conclu
ded, “To the extent that regulatory arbitrage drives the growth of the market, banks may be encouraged to originate more credit business than they would have done otherwise and then to transfer the risk to non- or less-well-regulated entities . . . such as insurance companies and, to a lesser degree, hedge funds.”82 Regulators in the United Kingdom expressed concern that, with credit default swaps, “There is a risk of mispricing by less sophisticated market participants.”83 And a top credit derivatives expert, Satyajit Das, worried that investors did not understand the risks associated with these instruments: “Unlike other financial products that have remained largely in the professional markets, one of the most alarming things about credit derivatives is the way they have been packaged into numerous deals that have been sold to relatively small institutions and even occasionally to high-net-worth individuals, which I think has the potential to cause problems.”84

  One final problem with credit default swaps was that, as with any insurance policy, payment hinged on the language describing what was covered—the definition of a default. A loan agreement was a lengthy document that typically specified numerous standard events of default. Loan agreements had evolved over decades, based on the experience of parties, under various market conditions. In contrast, credit-swap agreements were slim documents that allowed parties to use any definition of “default”—ranging from the borrower’s failure to make payment to the appearance of a newspaper article suggesting the borrower might default. Over time, credit default swaps had become more standardized, and bankers tightened contract terms after Russia’s “default” in 1998; but, parties to credit default swaps still could, and did, change the terms for particular deals. In their effort to develop highly customized credit default swaps, banks had created unforeseen difficulties. Having done hundreds of billions of dollars of credit default swaps based on simple documentation, the banks finally understood why the underlying loan agreements had been so lengthy.