Economists, lawmakers and regulators have pinpointed the explosive growth in credit default swaps — complex, unregulated financial contracts often compared to gambling bets — as a central cause of the financial crisis, particularly the government rescue of AIG.
As Congress ramps up its investigation of why counterparties to some of AIG’s credit default swaps (or CDSs) were paid off in full with taxpayer money, one key question remains: How big is the outstanding CDS bill that must be settled by AIG’s infamous Financial Products unit? The answer could determine the extent of the outcry this spring when the firm is slated to pay $198 million in bonuses to the employees working to unwind its remaining CDS contracts.
The Treasury Department says that AIG is on the hook for more than $1 trillion in CDSs “and other derivatives,” according to a report issued on Thursday by the congressional bailout oversight panel. That number tracks with AIG’s testimony on Capitol Hill as well as media coverage pegging the global CDS market as larger than the entire U.S. economy.
But a footnote buried in the oversight panel’s report reflects a different view. Since many CDS contracts are written to partially cancel out in the event that one party defaults, “AIG’s net notional exposure is much smaller than the notional value articulated by Treasury,” according to the oversight panel.
How much smaller? The Depository Trust and Clearing Corporation, which tracks about 90 percent of global swaps transactions, values AIG’s outstanding CDSs at $82.4 billion in gross terms.
Yet that amount of money would only be paid out if every party in the market defaults. AIG’s net CDS bill, which takes into account trades that cancel out, is valued at $7.4 billion — or more than 100 times smaller than the number quoted by Treasury.
The difference between gross and net CDS may sound impenetrable, but it can be translated by thinking of swaps using the popular metaphor of gambling.
“Think of anyone who underwrites credit default swaps; they’re like a bookie,” Barry Ritholtz, chief of the financial research firm Fusion IQ and creator of the Big Picture blog, told The Daily Caller. “And if anybody who bets on the Colts also bets on the Jets — that’s a hypothetical — if I have $1 billion bet on the Colts and $1 billion on the Jets, that’s a perfect spread.”
CDSs, part of the broader category of deals known as derivatives, offer one party protection in the case of a debt default by another party. At the height of the housing bubble, CDS were routinely written in which neither the buyer nor the seller had a direct interest in the mortgages underlying the deal — a transaction likened to two neighbors taking out fire insurance on a house they don’t own.
Peter Wallison, a senior fellow at the American Enterprise Institute (AEI) and a member of the bipartisan Financial Crisis Inquiry Commission, criticized the public use of “frighteningly large” gross CDS totals in a little-seen paper written at the height of the financial crisis.
“The [gross] amount of CDSs outstanding — although suitable for scaring people — is not in any sense relevant to the size of the risks associated with CDSs,” Wallison wrote in December 2008.
The European Central Bank echoed that warning in September, noting that the use of gross totals to measure CDS risk “may be misleading” and that “external market commentators tend to pay too much attention to the gross market values in relation to other measures of the real economy, such as GDP.”
If AIG’s net CDS bill is as low as Thursday’s oversight report suggests, the total cost of letting the company’s Financial Products unit fail may also be less than advertised. After Lehman Brothers went under in September 2008, an estimated $400 billion in gross CDS exposure triggered less than $8 billion in actual payouts, according to congressional testimony in June.
“Credit default swaps have a legitimate role” in managing financial risk, New York University business school professor Joshua Livnat said in an interview. “As long as there is some mechanism to force you to close your bet if you don’t have enough capital, you’ll find things would not get out of hand.”
As for the AIG employees due to receive bonus checks this spring for unwinding the company’s remaining CDS, Ritholtz questioned the value of keeping them on the payroll.
“They’re not doing anything special,” he said. “There is a very simple set of things that could be done to resolve this.”
In an addendum to the report, the oversight panel’s two Republican members suggested that the Treasury retroactively cancel its settlement of outstanding AIG CDS and let the banks that got government payouts take a loss on the contracts.
But even as the $1 trillion-plus price tag for AIG’s risky deals continues ricocheting around the Web and the Hill, the oversight panel’s estimate of $7.4 billion estimate also remains impossible to confirm. AIG got permission from the Securities and Exchange Commission (SEC) in May to conceal the details of its swaps, and the assets underlying them, from public view until 2018.