Numerous politicians have used the financial crisis as an excuse for increased regulation of financial markets. For example, House Oversight Chairman Henry Waxman recently moved to regulate the credit default swap market.
Credit default swaps are a form of insurance against bond default, except that you can buy a CDS without actually owning the bonds in question. The problem with the idea that this market is in need of regulation is that it has not actually failed. For example, the CDS market weathered the 72 billion dollar Lehman storm well. The Credit Default Swap market did face a crisis when Lehman failed, but private investors in that market managed this crisis without any help from government regulators.According to Eraj Shirvani at Credit Suisse “over the last 18 months, the CDS market, not the bond market, has been the only functioning market that has consistently allowed market participants to hedge or express a credit view”. This is an interesting comment. In 1948 FA Hayek pointed out how competition “is a process of formation of opinion … It creates views that people have about what is best and cheapest”. Mr. Shirvani has pointed to the function of competition that Hayek detailed in his 1948 essay on The Meaning of Competition. Traders in financial markets, or any markets, form opinions based on their experience in these markets, based on their knowledge of the conditions that prevail in those markets. It is through unregulated competition that markets work efficiently to form prices that reflect the most astute interpretations of available data.
In contrast to the market process, the regulatory process works according to empty conjecture and perverse political incentives. Congressmen like Henry Waxman and Barney Frank are determined to enact more regulation, but who knows more about the markets in question, these Congressmen or the traders to buy and sell in these markets routinely? Mr. Frank and Mr. Waxman do understand a few points clearly: increased regulation increase their power as politicians. They surely also understand that increased power over markets translates into increased ability to raise campaign contributions.
Economist Fred McChesney has examined the phenomena of rent extraction in detail. Rent extraction is the practice of using regulatory powers to pressure private interests into donating money to politicians or political parties.
Some critics of credit default swaps claim that their unregulated nature is dangerous. One NPR story blames credit default swaps for the financial crisis. AIG bet on the wrong side of the housing market through credit default swaps, and lost. NPR business correspondent Adam Davidson claims that the size of the CDS market makes the failure of AIG a threat to the global economy. Mr. Davidson should take note of the relative stability of the CDS market during this crisis. Mr. Davidson also worries that ‘nobody knows exactly who has them (CDS’s) and where they got them from’. In reality the participants to CDS contracts each know exactly who they are and who they are trading with. There is no problem with identifying the participants to these contracts, at least as far as the market itself is concerned, and this market is functioning well.
AIG failed not because the CDS market failed, it failed because they made bad decisions in the CDS market. That is the way this market works, if you make the wrong bets, you lose.
The truth of the matter is that the credit default swap market does not need regulators or politicians; it is the other way around. Politicians and regulators see a need for regulation in the credit default swap market because it is in their political interests to extend regulation to as many markets as they can. The success of this market is also something of an embarrassment to them. Every time a market succeeds without regulation, it makes advocates of greater regulation appear foolish, and regulators themselves appear useless at best. This is not just a matter of concern to investors. Given the relative success of this relatively unregulated financial market, the usefulness of government regulators and activist politicians to the general public is questionable. It seems that we do not need to fear unregulated competition. The only thing we have to fear is the fear that demagogues like Henry Waxman want to instill in us. They want to scare us into accepting new regulations that serve their political interests at the expense of our economic interests.
The views expressed in this paper do not reflect official views of The Coast Guard.
Sources
The Meltdown that Wasn’t, in The Wall Street Journal November 15th 2008
AIG and the trouble with Credit Default Swaps. NPR September 18th 2008
The Meaning of Competition, by FA Hayek in Individualism and Economic Order 1948
Money for Nothing: Politicians, Rent Extraction and Political Extortion by Fred McChesney 1997
{ 15 comments }
Beware the unregulated regulators!
I was chided on a blog recently for mentioning that CDSs were ‘simply insurance contracts.’ I forgot to mention, according to the tirade that ensued, that they are also the devil’s tool to financial hell. Whoops! I kid, but the visceral reaction within the public at large against CDSs shows only the lack of understanding of financial markets and derivative instruments. The emotionalism being poured out of every media news-source is like sweet political nectar for men like Waxman and Frank.
I agree with the author, those who entered into the contracts knew exactly what they were doing. That their risk calculations led them to believe failure in the underlying investments was lower than reality, is not the job of the government or its taxpayers to correct.
Mr. MacKenzie:
You state: “Mr. Frank and Mr. Waxman…surely also understand that increased power over markets translates into increased ability to raise campaign contributions.”
I lived in Rep. Waxman’s Congressional district in Southern California for a number of years, and I do have to admit that I did vote for Mr. Waxman (in the 1990s). Rep. Waxman, as I recall, really faced very little challenge from Republican candidates, as the district has a very high percentage of voters that are registered as Democrats. (As an independent, I was not among them, and I voted for a mixed basket of candidates from different parties.) Therefore, in the case of Mr. Waxman, I might have to disagree with your assertion that “increased power over markets translates into increased ability to raise campaign contributions.” With that said, I do agree with your contention that, as Chairman of the HFSC Oversight and Investigations Subcommittee, “demagogues like Henry Waxman…want to scare us into accepting new regulations that serve their political interests at the expense of our economic interests.” The perception among 20th district constituents that Mr. Waxman is taking a stand on issues will certainly outweigh the fact that his stance may be antithetical to sound judgment and economic reality.
Thank you for publishing this article. As a supporter of Ron Paul, I think that your article serves as a valuable lesson to those who wish to understand why Ron Paul assembled the Liberty PAC. It is no accident that Rep. Waxman, even as Chairman of the HFSC Oversight and Investigations Subcommittee, is not included on the Liberty PAC. He voted yes on the bailout both times. I don’t see him taking a different course as more legislation regarding further bailouts reaches the House floor.
I have been reading mises.org to understand the financial crisis. What I find missing in this article is what happens to my savings/checking deposits if AIG and other financial instutions go under?
Vinod,
Your checking/savings accounts are protected by FDIC, if they are held at a bank covered by the FDIC insurance. In ideal world, such insurance will also be provided by a market agency, not a government bureaucracy.
…meaning you’ll have to worry about making sure your bank is insured (or buying insurance yourself). I know, it’s unthinkable that we don’t have the government baby sitting us! These free marketeers want us all to pay attention to our own lives! Outrageous!…
There is a very well-written article by Yuri Maltsev, “Change that You Can Believe In,” that appears today on Lew Rockwell.com. Maltsev shows Henry Waxman’s anti-free market side when he speaks of Alan Greenspan’s appearance before Waxman’s subcommittee. Maltsev writes, “Make no mistake about it – Greenspan was attacked by Waxman and the new socialist establishment because of his libertarian past and free-market rhetoric and not because of his job as chief inflationist and central planner. The show trial over Greenspan’s pro-capitalist past was turned by Waxman and his committee comrades into the trial against capitalism itself.” I wish I could have seen into the future a decade ago. I would have voted for Waxman’s opponent. It would have had no bearing on the outcome, but at least I would have felt I had done the right thing.
Suppose the market would have given its reign and AIG was in bankrupcy. Would that had no effect on how well CDS market functions?
CDS are not just used to bet on credit worthyness of companies. It is also used to reduce the regulatory capital ratio requirements of banks.
Basel II capital requirements ratio imply a bank have to have as capital 8% of the risk-weighted assets.
For example, in your assets, you have a US Tresory bond, it will be a safe asset, so, a low risk weight on it.
If you have a CDO square BBB tranche, you will have to have a big risk weight on it.
Then, you take a CDS from AIG on your CDO square BBB tranche, and by magic, you have a safe risk weigh on your CDO.
In banking industry, they call that “regulatory arbitrage”.
Then, as the risk on your CDO are higher, you do a margin call to AIG, all banks are doing that, AIG is in need of cash, rating agencies begin to be aware of that, AIG is downgraded, banks asks more margin call, the fed saves AIG.
That’s why the gov saved AIG. It was to save the banks. Because without AIG, the CDS from AIG would be woth nothing, so many banks would have become under the regulatory capital requirement ratio, so, they would be legally insolvent.
If banks were truly private company, banks do want they want with their money. But we are in a compulsory monopoly of a central banks in a fractional reserve banking system. So, CDS used that way push the system at more leverage, so more systemic risks.
For sure, we need free banking and/or gold banking. But until we get that, I think CDS would have to be excluded from capital ratio requirements. Each bank have to handle its own risks on their balancesheet.
This post is wrong on several levels. Clearly Mr. MacKenzie hasn’t the foggiest idea how the CDS market actually works.
“The problem with the idea that this market is in need of regulation is that it has not actually failed. For example, the CDS market weathered the 72 billion dollar Lehman storm well. The Credit Default Swap market did face a crisis when Lehman failed, but private investors in that market managed this crisis without any help from government regulators.”
Surely you jest. The CDS market was only able to handle the Lehman failure because the government bailed out AIG. Where do you think the $162 billion the government lent to AIG has been going? They’ve been posting collateral on their CDS portfolio like mad. So saying that the CDS market “managed this crisis without any help from government regulators” is patently untrue.
“AIG failed not because the CDS market failed, it failed because they made bad decisions in the CDS market. That is the way this market works, if you make the wrong bets, you lose.”
That’s actually NOT how this market, or any markets for that matter, are supposed to work. If you make the wrong bets in the CDS market, you’re not supposed to fail because you don’t have enough money to cover all your losses. In the Perfect Market that exists only in the heads of libertarians, self-interest-driven counterparties would never have purchased CDS protection from a company that couldn’t afford the payouts (without a government bailout) in the first place. But they did. Which is what we in the real world call a “market failure.”
“In reality the participants to CDS contracts each know exactly who they are and who they are trading with.”
False. You’ve obviously never read a CDS contract, or been involved in a CDS transaction in any way at all. The vast majority of CDS contracts don’t require a counterparty to give notice to the other counterparty before transferring his side of the CDS to someone else. There are VERY few limitations on who a broker can transfer its side of a CDS to, so the broker’s original counterparty can easily end up facing a less-than-creditworthy counterparty. It’s called “counterparty risk,” and it’s been a HUGE source of disruption in the CDS market. That’s the whole reason the government has been pushing for a central clearinghouse. Have you been living under a rock for the past 3 months, or are you really that ignorant about the CDS market?
I don’t know whether it’s more funny or sad when hard-core libertarians try to weigh in on the financial markets.
This contempt person should take notice of several facts.
First, Any secondary buyer of a CDS contract can still read the name of the other (original) party to the contract on the contract. The remaining original party will find out who the new owner is when they need to, when the contract is called in. IF they need to find out sooner they can obtain this information from the other original party who sold the contract by using a new invention called the telephone. There is no systematic lack of information about who holds these contracts. You claim that this is a huge source of disruption without explaining why. The people who deal with each other in these contracts do business routinely, so it seems rather unlikely that there is either a great lack of information of this kind or serious problems resulting from the lack of such data.
Second, the way all markets work is that if you make bets that you cannot cover, you go bankrupt, as did AIG. This is how the capitalist system work. This is why the capitalist system works well. It does not require perfect markets, it only requires bankruptcy law. You speak of market failure without knowing what it means. Market failure means severe bias towards inefficient results in the entire market. How is the demise of AIG the result of systematic market inefficiency? What is the source of this inefficiency? Is it a problem with adverse selection or moral hazard? These are the typical types of alleged market failures in insurance? Please explain, if you can. Your empty assertions are simply not good enough.
Third, the Feds proposed this AIG loan of 85 billion in mid September, rather late in this crisis. Another 38 billion was allotted in October. How much of this money has been disbursed in the past month? More to the point, how did the market manage prior to this money that you say was necessary to save the market? Your statement that the Fed Gov saved this market 162 billion is misleading because it neglets the time factor. People in the CDS market has been dealing with these problems for a while now.
You need to become better acquainted with the facts.
1 more thing, this contempt person should note the difference between government regulation and government finance. The market has and is dealing with this crisis wihout government regulation. The government loan does not constitute a form of regulation. These are two different thing. Consult a dictionary next time before your post, words like “regulation” and “loan” do not mean the same thing.
Economics of Contempt: “If you make the wrong bets in the CDS market, you’re not supposed to fail because you don’t have enough money to cover all your losses.â€
Why not? The whole point of competition is to cause bad decisions to have serious consequences. Why don’t companies have enough money to cover losses? Because they have borrowed too much and don’t have enough equity. Equity is the cushion to protect against losses. If you don’t have enough equity, your business should fail.
Economics of Contempt: In the Perfect Market that exists only in the heads of libertarians…â€
You have libertarians confused with mainstream economists. The “perfect market†exists only in textbooks and only socialist minded economists think we should strive to achieve it. Austrian economists have always criticized the “perfect market†because it is unrealistic and anti-competitive (It allows competition only in price, not in quality or service).
Economics of Contempt: “…self-interest-driven counterparties would never have purchased CDS protection from a company that couldn’t afford the payouts (without a government bailout) in the first place. But they did. Which is what we in the real world call a “market failure.”â€
Why did “self-interest-driven†companies purchase CDS’s from a company that couldn’t afford the payouts? That sounds rather stupid. Should the market protect people from their own stupidity? The market is a process of price discovery. If people are willingly stupid in their decision making, how is that a market failure?
Economics of Contempt: “The vast majority of CDS contracts don’t require a counterparty to give notice to the other counterparty before transferring his side of the CDS to someone else. There are VERY few limitations on who a broker can transfer its side of a CDS to, so the broker’s original counterparty can easily end up facing a less-than-creditworthy counterparty. It’s called “counterparty risk,” and it’s been a HUGE source of disruption in the CDS market. That’s the whole reason the government has been pushing for a central clearinghouse.â€
If the CDS contract hides the identity of the counterparty, why were businesses so stupid as to take them? Could it be that they expected the state to bail them out? If so, then state intervention has distorted the market. And why should the market protect them from their own stupidity? How would a clearinghouse improve the situation, other than forcing businesses to act in a less stupid manner?
Very naive argument….
The crisis had multiple causes, which is evident to anyone who had approached it in a objective manner. Some of those can be attributed to monetary policy of the US government, some to the investors the market, the banks for making bad investments, the housing industry for trying to push the value of homes high to increase their EPS, and even to irresponsible home owners.
The Democrats you blame for wanting more regulation don’t do it because they want the markets to fail, they simply want them to be more stable. Whereas you seem to prefer more risky markets, this is a simple difference of economic policy. It is does not entail two forces of good and evil battling over the future of the markets. Both lib and cons ppl need to understand they can be critical of people who have differing policy views without trying to demonize them. This straw man tactic is obvious and usually so baseless it makes many bright accusers appear dumb, as I believe is this case in
D.W. MacKenzie.
I do agree the
Your blog is really interesting to me and your topics are very relevant. I was browsing around and came across something you might find interesting. I was guilty of 3 of them with my sites. “99% of site owners are guilty of these 5 errors”. http://is.gd/8kynyd You will be suprised how easy they are to fix.
Comments on this entry are closed.