The recent meltdown in the US financial markets has been attributed to subprime lending practices that, along with low interest rates, had fueled a housing bubble since the mid-90s. In a feeding frenzy of sorts, lenders kept lowering the bar for home mortgages. As adjustable interest rates kicked up, defaults and foreclosures began and the bubble finally burst. Housing demand and prices fell, leading to a liquidity crunch for financial institutions. Thanks to economic globalization, the malaise quickly spread across the pond.

Many pundits have adequately explained the crisis (especially listen to George Soros—video below) and why the US government had to devise a massive bailout for Wall Street and recapitalize the banks (think of it as an emergency liver transplant for one who had turned to a reckless, binge drinking lifestyle). It also brought home another fact of modern capitalism: bankruptcy is only for the little folks; those big enough can't be allowed to fail for their irresponsibility, lest they bring down the whole house. Neat, aye?

But now, having traded a pressing liquidity crisis with a higher national debt, is the worst finally behind us? In other words, do we now simply need to hunker down and ride out an economic recession that may be, at worst, longer than usual (say, lasting up to 18-24 months, instead of the average 10 months) and wait for the eventual market rebound?

Not so fast, Speedy Gonzales. Besides the long-term fiscal instability from a $10+ trillion debt that is set to rise by $1-2 trillion next year with no end to annual deficits in sight, there may be more ticking time-bombs just ahead. Enter credit default swaps and other derivatives. Invented in the mid-90s by math and physics PhDs, these financial instruments were designed and adopted by money lenders to mitigate risk but have managed to achieve the precise opposite due to some shockingly naive assumptions about economics and human nature. Their advent encouraged subprime loans by giving lenders an (ultimately illusory) instrument for reducing their risk from loan defaults.

Credit default swaps (CDS) are contracts between private institutions that trade in a completely unregulated market. They "resemble an insurance policy, as they can be used by debt owners to hedge, or insure against a default on a debt. However, [unlike insurance,] because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can also be used for speculative purposes." Since 2000, the CDS market has grown from near $0 to a staggering $55 trillion, i.e., about four times the combined worth of all companies traded on the NY Stock Exchange! CDS trading has added huge, unaccounted-for liabilities and exposure to corporate balance sheets. Their deleterious impact surfaced with the recent subprime crisis, but this may well be just the tip of the iceberg.

A significant and ominous, if also brave, admission came last week from none other than the godfather of US capitalism in the last two decades: Alan Greenspan. An economist of the libertarian, Ayn Rand stripe, he admitted that he is shocked to have found a flaw in his model of how the world works and that he had been wrong in resisting regulations for these new-fangled instruments. Known for his cryptic-diplomatic phrases (recall "irrational exuberance"?), the sage simply predicted, “The financial landscape that will greet the end of the crisis will be far different from the one that entered it little more than a year ago.” Whoops! Sorry, people. Hope you don't have to spend your retirement years working at Walmart.

Here is a primer on credit default swaps that explains why Warren Buffet has called CDS the "financial weapons of mass destruction" and why others call it "the dark matter" of the financial universe. "Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions." (Read more overview articles here, here, and here.)

(Video: George Soros in conversation with Bill Moyers, 25 mins.)

Posted by Namit Arora in Economics | Comments