A licence to print money?

I don't know a lot about the operation of financial markets. I've watched Trading Places, so I know that if you buy Pork Bellies when the pigs are flying then you'll end up losing your seat, or something. But I was listening to a BBC World Service documentary about the financial markets the other day and it struck me that Credit Default Swaps might have a lot to answer for.

This docco was recorded in the early autumn - before everyone finally admitted that the global economy was effectively floating on a cloud of superheated gas emitted from the bottoms of the besuited peakcocks who flock around Wall Street, Bay Street and the City of London. So it was interesting to listen to it with the 20/20 vision that comes from hindsight.

The comment that struck me hardest was that credit default swaps are almost entirely unregulated and that there are no capital reserve requirements for the organisations that write the contracts.

Here's some background, as I understand it:

Banks lend money to companies by buying bonds.

Bonds constitute an obligation buy the company to pay back an amount of money at a certain point in the future, and to pay interest regularly until then. For every $100 the company promises to pay in the future, the bank will pay them some amount now - usually less than $100. The difference between the amount the company promises to repay plus the interest they will pay, and the amount paid by the bank, is the profit on the deal and will vary according to how likely the company is to meet its future obligation.

The amount of money banks make by lending money is dictated by the risk level they take on. If the company makes good on its obligations, the bank will make a tidy profit. If the company goes bankrupt and cannot make its payments, the bank loses out. The overall riskiness of the debt obligations they hold will impact a bank's own credit rating and hence it's ability to borrow money itself to lend out to more companies.

Credit default swaps are basically a way for a bank to reduce the risk that they will lose out. In a credit default swap, the bank buying the debt makes a contract with another bank - the insurer. The insurer promises to pay an amount of money to the bank in the event that the company defaults on its debt. In return, the bank pays a premium. This premium is also dependent on the risk that the company will be unable to repay their debt.

The idea is that the premium paid by the bank to the insurer is less than the profit the bank will make on the debt and so there is still some net profit for the bank. The bank is still making money, but the risk has been reduced because the insurer will cover them if the company goes tits-up. The insurer is happy because they're making the premium. If they want, they can go out and buy more CDS contracts from another insurer to offset their risk.

This all goes along quite well while everyone's behaving and paying off their debt. The system can generally survive the odd corporate bankruptcy along the way - the insurers pay the bank the difference betweent what the bank paid for the debt and what it's worth after the bankruptcy and everything goes back to normal.

However, what's happening now is that banks are starting to collapse. These are the very institutions who are the insurers in CDS contracts. What this means is that the CDS insurance is effectively worthless. Imagine if you are a bank who bought a bunch of sub-prime debt and then insured it with CDS contracts with Lehman Bros or RBOS. Your debt is worthless and your protection is worthless.

What seemed particularly astonishing is that because credit default swaps are unregulated (thanks to an act of Congress passed in 2000 - the same one that allowed Enron to fiddle the books so effectively) there are no capital reserve requirements for insurers. For real insurance - life insurance, car insurance, business continuity insurance etc. - there are laws that state how much capital an insurance company must hold to cover its potential liabilities in case of a spate of claims. For CDS contracts, there is no such requirement.

If banks buying debt are treating these CDS contracts as an effective form of risk mitigation, it seems to me that CDS is enabling a huge increase in the amount of money a bank will lend. It seems also that the banks would be able to fund that additional lending through issuing their own debt at a faster rate because of the apparent reduction in risk the CDSs provide.

With no obligation to actually back up CDSs with real capital, it seems also that there is no real limit to the number of CDS contracts an insurer can write. The more CDSs, the lower the apparent risk of the real debt, the more lending, the more money circulates. Isn't the CDS basically just a licence to print money?