Credit Default Swaps (CDS) are one of the primary reasons for the crash of the American financial system. Given their impact, one would expect to see a political backlash against the practice through the various media outlets that report on Washington’s finger pointing, but the backlash hasn’t happened. What reprimands have been handed out have been quietly conducted so that the average taxpayer, now suffering in a broken economy, hasn’t heard about the CDS scandal or its implications. Politicians don’t want taxpayers thinking about Credit Default Swaps because congress is responsible for making them legal after 91 years of their being a felony offense. It is not incidental that Warren Buffett famously described CDS and other derivatives that are bought speculatively as “financial weapons of mass destruction.”
Though there are a number of different varieties of Credit Default Swaps, and all are fairly complex, the easiest way to think about them is that they are like betting without any assurance that either party has the money to cover their bet. The impact of a Credit Default Swap (or a bet) can be collectively illustrated by this simple example: imagine some Company A makes a $1 million bet with Company B that “John Smith” will default on his $200,000 mortgage. When the mortgage is defaulted, Company B owes Company A $1 million. The financial problem, ignoring for a moment the Credit Default Swap, is that the bank holding John’s mortgage is $200,000 out of pocket. The CDS compounds the problem because, not only is the bank out $200,000 but Company B is also out another $1 million. In the end, the $200K mortgage had a $1.2 million impact. If Company B had money on the side specifically to cover the bet, then this financial crisis would simply be Company B’s to handle, but our elected representatives did not bother to ensure that these companies had the money to cover their bets.
Free market economy is based off of assumed risk. The investor risks their money buying stock just as an entrepreneur risks their capital by opening up a shop. This kind of “gambling” allows for the free market to operate efficiently but only if those who lose out in these wagers are held accountable for their losses; without accountability and the right incentives for success, the free market crashes. For the past 9 years, however, no regulation has existed to make sure that Company B has the money to cover its bet. Now that these bets are being called in, the various companies practicing CDS have turned to taxpayers for government bailouts. So far, Lehman Brothers has gone under, Bear Stearns tanked and was bought out by J.P. Morgan, and the government has pumped 163 billion into AIG. Overall, the credit default market was allowed to grow to a completely unregulated $50-$60 TRILLION market.
Who is responsible for all this? Who allowed these companies to make wagers without the funds to cover their losses? A lot of attention is being focused on ex-chairman of the FED Alan Greenspan and the flurry of deregulation that characterized the height of his power throughout the 90s, but Greenspan didn’t make the law that allowed for the CDS market. This deregulation required legislation to be approved by congress to repeal ninety year old laws that made the process of CDS illegal – laws that protected the U.S. economy from what Warren Buffett described as “financial weapons of mass destruction.”
The authors and sponsors of the 2000 House of Representatives bill making Credit Default Swaps legal and directly contributing to the current devastation of the American economy were:
- Thomas W. Ewing (R. from Illinois, no longer in office)
- Tom Bliley (R. from Virginia, no longer in office)
- John J. LaFalce (D. from New York, no longer in office)
- Larry Combest (R. from Texas, no longer in office)
- James A. Leach (R. from Iowa, no longer in office)
In the senate, the bill was authored and sponsored by:
- Richard G. Lugar (R. from Indian, still in office)
- Peter Fitzgerald (R. from Illinois, no longer in office)
- Chuck Hagel (R. from Nebraska, still in office)
- Tim Johnson (D. from South Dakota, still in office)
- Phil Gramm (R. from Texas, no longer in office)
- Tom Harkin (D. from Iowa, still in office)
And of course this bill would not have made it into law had it not been approved by President Bill Clinton 30 days before he left office.
The 60 Minutes story on this subject can be watched here.
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