Recent news about loans to Kazakhstan and credit default swaps illustrates the complicated and sometimes perverse incentives created by the esoteric financial instruments that sprang up over the last 15 years.
This particular case is not, in itself, of importance to the average American. But its broader implications are, as we struggle with how best to regulate financial businesses and markets.
The financial instrument in question, a credit default swap, essentially is an insurance policy in which one party contracts to pay an indemnity to a second party if some specific loan is not paid. The second party pays the equivalent of an insurance premium to the first for this protection. It sounds simple enough, but the real-life ramifications often are not. Our government now owns most of AIG, one of the world’s largest insurers, precisely because of that company’s losses on these swaps.
Gillian Tett describes the Kazakh case in a recent issue of the Financial Times. BTA, a bank in Kazakhstan, a Central Asian country of 15 million that was long part of the Soviet Union, borrowed from U.S. investment bank Morgan Stanley and other western lenders. Global financial problems hurt BTA and it was taken over by the Kazakh government, not unlike the way the U.S. government took partial ownership in AIG or Bank of America.
Morgan Stanley reportedly covered itself against losses on loans to BTA by purchasing credit default swaps. This is a legitimate business practice.
But Morgan Stanley reportedly bought more such swaps than needed to cover its actual loan exposure. And now Morgan Stanley and another bank have called in their loans from BTA.
The terms of the loan give them a legal right to do so, even though BTA was current on its debt payments. Little on the horizon indicates BTA would not be able to continue making payments. But a sudden demand for repayment pushed BTA into default, allowing Morgan Stanley to collect on its swaps.
Morgan Stanley refuses to disclose the total amount of swaps it holds on its Kazakh loans. But if, as alleged, they are substantially greater than its possible loan losses if BTA defaults, they create an incentive for Morgan Stanley to push its own customer into bankruptcy.
The key here is that credit default swaps are not exactly the same as insurance. Property insurance payouts do not exceed the property damage sustained. It is illegal to insure the same property with several different insurers. But it is entirely legal to buy credit default swaps from different sellers in amounts several times the value of the debt that is covered.
Moreover, unlike insurance, in which the purchaser of a policy must have an “insurable interest” in the property or life being protected, it is possible for any third party, without any role in the covered debt, to purchase credit default swap coverage. I cannot buy a life policy that will pay me when Bill Gates dies, but legally I can buy a credit default swap that will pay me if Boeing or Burundi default on a loan. Most of the $700 billion of credit default swaps on Kazakh debt are between parties that have no other financial stake in that nation’s borrowing or business.
That explains how the total amount of credit default swaps written on Kazakh debt in general that are registered with a New York clearing house exceeds $700 billion. That is five times Kazakhstan’s annual GDP of $140 billion. The comparable figure for our country would be $70 trillion.
If an investment or commercial bank can make a loan to a nation, corporation, or municipality, buy swaps totaling more than the debt, and then trigger a default on some technicality at a time when credit is short and refinancing difficult, then borrowing becomes a minefield.
There is no clean policy solution. One could require all parties to such swaps to publicly disclose their positions. There is a move toward having all credit default swap positions registered with a central clearing house without revealing the particular holdings of any individual company. This resembles commodity futures in which exchange clearing houses post the “open interest” or number of outstanding contracts in a specific category without disclosing the number held by Cargill, the Podunk Co-op Elevator or Josephine Farmer.
Such partial disclosure would ameliorate, but not erase, the perverse incentives in lenders reaching positions where they would benefit by defaults on their loans.
Morgan Stanley’s action also should chill those who write such swaps. For each of the $700 billion dollars that someone will get if Kazakhstan defaults, someone else has to pay a dollar. So traders who write such insurance policies may become wary of guaranteeing the debts of lenders.
Finally, there is the broader question of how much risk financial institutions should be allowed to take on if the failure of such institutions, as for Lehman Brothers, Bear Stearns or AIG, would hurt the economy as a whole. If two people in Calaveras County want to bet on which frog will jump the farthest, that is their business. But the $60 trillion business in default swaps that grew over the last decade is not so innocuous.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.