WASHINGTON — It can be a fine line between investing and gambling. But in Las Vegas, you know the odds. On Wall Street, that’s not always the case.
Especially when it comes to the $62 trillion market in arcane financial contracts known as “credit-default swaps.”
“Moreover,” adds Michael Greenberger, former director of trading and markets for the Commodity Futures Trading Commission, “Las Vegas is regulated.”
These swaps are increasingly being blamed for the near-collapse of insurance giant American International Group Inc., the bankruptcy of investment bank Lehman Brothers and the downfall of other investment houses and financial institutions.
Members of the House Oversight and Government Reform Committee on Tuesday accused AIG of opening “a casino in London” when it began dealing in these complex derivative contracts. The Federal Reserve came to AIG’s rescue three weeks ago with an $85 billion line of credit; so far, the company has tapped it for $61 billion.
So what are credit-default swaps, and how have they caused all this trouble? The swaps are a form of insurance, but they aren’t regulated that way.
Say a big investor buys a bond from a company. But the investor is worried about the company’s ability to pay off that bond. The investor turns to a third party like AIG, for example, and buys protection in the form of a credit-default-swap contract. AIG agrees to pay the investor the value of the bond in the event the company defaults on it.
The issuer of the credit-default swap doesn’t write this insurance for free. It gets a fee, usually a percentage of the value of the bond. The transactions are not regulated by any public exchange.
And since these contracts are not considered “insurance,” Greenberger says, the companies that guarantee the bonds are not required to keep enough capital on hand to pay them off in the event of a default.
The swaps have given those invested in all manner of debt, including mortgage-backed securities, a false sense of security.
“Everyone walked around saying, ‘We’re insured,’ ” said Greenberger, a University of Maryland law professor.
As housing prices rose and more people could get mortgages despite questionable credit records, mortgage- backed securities were an attractive place for pension funds and other investors to park their money.
“Were it not for that insurance, it certainly wouldn’t have reached this manic state of growth,” Greenberger said of the questionable investments.
