Barry Ritholtz
Washington Post
March 10 2012


Last week, Greece officially defaulted on its debt. (Unofficially, it defaulted long ago.) This formal default on about $100 billion triggered payment of $3 billion in credit-default swaps. These are the non-insurance insurance products that pay off in the event of a default.Let’s take a closer look at the tortured history of the swaps and see why they should be regulated as commercial insurance policies.

Our story thus far: CDS obtained their favored status as unregulated insurance policies courtesy of the Commodity Futures Modernization Act of 2000. It was sponsored by then-Sen. Phil Gramm (R-Tex.) — and benefited Enron, where his wife, Wendy, was a director on the board. The energy company had discovered the fast profit of trading energy derivatives, which was much easier to achieve without those pesky regulations. Late in the year, the CFMA was rushed through Congress. Passed unanimously in the Senate and overwhelmingly in the House, it was mostly unread by Congress or its staffers. On the advice of then-Treasury secretary Lawrence H. Summers, the bill was signed into law by Bill Clinton.

No one associated with this awful legislation has yet to be rebuked for it. Anyone who actually read this debacle and recommended it should be banned for life from having anything to do with public policy or economics.

Why? The act was a radical deregulation of derivatives. It was an example of the now widely discredited belief that banks and markets could self-regulate without problems. Management would never do anything that put the franchise at risk, and if it did, it would be suitably punished by the shareholders.

It didn’t quite work out that way. Across Wall Street, nearly all senior management involved escaped with their bonuses and stock options intact. Lehman chief executive Dick Fuld lost hundreds of millions of dollars and now must scrape by on the mere $500 million or so he squirreled away.

The act did more than change the way derivatives were regulated. It annihilated all relevant regulations. First, it modified the Commodity Exchange Act of 1936 (CEA) by exempting derivative transactions from all regulations as either “futures” (under the CEA) or “securities” (under federal securities laws). Further, the CFMA specifically exempted credit-defaults swaps and other derivatives from regulation by any state insurance board or regulator.

Hence, the law created a unique class of financial instruments that was neither fish nor fowl: It trades like a financial product but is not a security; it is designed to hedge future prices but is not a futures contract; it pays off in the event of a specific loss-causing event but is not an insurance policy.

Given these enormous exemptions from the usual rules that govern financial products, you can guess what happened with the swaps. A very specific set of economic behaviors emerged: Companies that wrote insurance typically set aside reserves for expected risk of loss and payout. When it came to swaps, the companies that underwrote them had no such obligation.

This had enormous repercussions. The biggest underwriter of default swaps was AIG, the world’s largest insurer. Without that reserve-requirement limitation, it was free to underwrite as many swaps as it could print. And that was just what it did: AIG’s Financial Products unit underwrote more than $3 trillion worth of derivatives, with precisely zero dollars reserved for paying any potential claim.

Though this may sound utterly absurd today, circa 2005 it was considered brilliant financial engineering. Consider this quote from Tom Savage, the president of AIG FP: “The models suggested that the risk was so remote that the fees were almost free money. Just put it on your books and enjoy.”

Ahhh, free money — how could that dream ever go wrong?

As it turns out, quite easily. Underwriting swaps was enormously lucrative — so long as you don’t count that unpleasant crashing and burning into insolvency at the end.

Oh, and that massive $185 billion AIG government bailout. Aside from those tiny hiccups, there was some good money to be made.

It was more than just AIG. While the radical deregulation wrought by the CFMA led to AIG’s self-directed collapse, it also helped steer two of the largest securitizers of mortgages — Bear Stearns and Lehman Brothers — into insolvency. Perhaps they were lulled into complacency, believing (wrongly) that they were hedged against losses. The CFMA led to their demise, and it was indirectly responsible for the collapse of Citigroup, Bank of America and Fannie and Freddie. It also was a significant factor in the near-death experiences of Goldman Sachs, Morgan Stanley and quite a few others.

Despite the CFMA’s horrific fatality toll, it has never been overturned. Parts of it were modified by Dodd-Frank regulations, but not the insurance exemptions. Today, these swaps are cleared through exchanges or clearinghouses — but they are still exempt from all insurance regulatory oversight. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement.

Which brings us more or less up to date — and onto more topical issues, such as Greece. Two weeks ago, the International Swaps and Derivatives Association said that “based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”

That is an odd statement about a tradable asset — based on evidence? Typically, an option or futures contract expires, and it either is in or out of the money. Any tradable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year. No interpretation is required. Why on earth would anyone need a committee ruling for a trade?

On Friday, the ISDA committee ruled that Greece formally defaulted. Thank goodness that was cleared up. Had they failed to do so, it would have fatally damaged the swaps market and made sovereign debt financing much more expensive.

What makes this issue so fascinating is not whether Greece has or has not technically defaulted. Rather, it is that there is a committee of conflicted interested parties rendering a verdict on that issue.

Funny, no sort of group declaration is required when a futures contract or an option must settle. No committee decision is required. Which (again) is why credit-default swaps look, sound and act a lot more like insurance than they do other tradable assets.

Why does it matter if swaps are not insurance? In a word, reserves. That is the key difference between insurance and swaps. State insurance regulators actually require reserves from insurers — a lot of reserves — to ensure payments can be made in the event any payable event occurs. The swaps industry does not require reserves. Not even one penny against billions in potential losses.

I think you can see why this matters so much. Swaps are a lot less profitable as an insurance product than they are as a trading vehicle. That is the primary issue that we all should be concerned about. It is exactly how AIG blew itself up. There is nothing that prevents the marketplace from doing it again. We could very well see a repeat unless this gets resolved. Indeed, the odds heavily favor such an event occurring, unless we collectively do something to stop it.

Credit-default swaps are insurance products. It is well past time we regulated them as such.


Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, the Big Picture at Twitter @Ritholtz

Category: Apprenticed Investor, Derivatives, Regulation

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

18 Responses to “Credit default swaps are insurance products. It’s time we regulated them as such.”

  1. CTB says:

    Barry, out of curiosity, do you know of any influence these articles have had with policy makers or regulators? I hope you can have a more direct impact (beyond just swaying public opinion).

  2. AtlasRocked says:

    Can’t multiple people buy the same CDS, meaning if it triggers, multiple payments have to be made? Sounds more like gambling on a horse race than insurance.

    Doesn’t it make it a profitable event for all the buyers of CDS’s to work insidiously to cause the failure of the insured ?

    Seems like they should be illegal, to me. It’s like allowing NFL players to bet on their own games.

  3. Bill Wilson says:

    Is there any social value to create insurance for an asset that can be hedged with options or futures? Is there any cost savings for the insured if underwriters like AIG are forced to hold reserves?

    There’s no such thing as a free lunch. My guess is the cost of credit default swaps would increase if underwriters were forced to hold reserves, and hedging through options and futures would come back into fashion.

    This all ties in with TBTF. The people who are underwriting CDS know it’s not sustainable, and the people who are buying CDS know it’s not sustainable. Who cares about sustainability when Uncle Ben will save you with a bag of money. Collect your bonus now, the FED will pay later.

  4. nofoulsontheplayground says:

    I believe that $3-Billion payment is the net, not the gross. Furthermore, in 2008 there should have been a moratorium on new swaps until the laws were changed to make derivatives regulated as insurance policies. This would have had most of the swaps wound down by now instead of at historic highs.

  5. louis says:

    It was all laid out before. She didn’t have a chance against them.

  6. DeDude says:

    Now if the CEO, CFO and top management that harvest big fat bonuses during the “free money” years were held financially and criminally liable for paying out the insurance if the company can not – then it would be a different story. Problem is that those vultures at the top are perfectly well aware that eventually the company will go down with its unsecured insurance promises. But they are sure that by then they will be long gone, with all their bonuses, and the clean up will not be their problem.

  7. One of these daze..We’ll realize that there is, indeed, a huge difference between Individuals like Brooksley Born, and ‘People’ of Sherron Watkins’ ilk..

    ’til then, make sure to keep Voting, anyway…it’s obvious that We don’t care how/if they’re ‘Counted’, either..

  8. Tarkus says:


    Creating paper that you claim has a value but has no real value backing it?

    Isn’t that called….counterfeiting?

    (Oh wait – the Main St economy can back it with bailouts. :D )

  9. zdog says:

    Atlas. Short answer yes.

    Regardless of your political leanings this is the best explanation I’ve heard (see Act II).

  10. sellstop says:

    So the buyers of the CDS’s could then go to their bank and say “look, we’ve got insurance against failure. Lend us some money”. And the banks lent against the insurance. That is printing money. No wonder they were such a stimulus to the economy. Now that disaster has occured I doubt that banks are placing such trust in these instruments. They now know there may be no financial backing to the instruments. At least none is required. So they don’t trust and they don’t lend.
    Trust is the bedrock of prosperity and co-operation. It was trust that enabled the first cave dwellers to trade with one another. And trust is the result of rules. Societys set rules that allow strangers to trust strangers and make deals to the benefit of both. “Good fences make good neighbors”…….

    We need regulation to get lending going again….


  11. bear_in_mind says:

    The biggest absurdity is that these parties KNOWINGLY created these products, WILLINGLY ignored the risks, GLEEFULLY reaped huge profits, then SHEEPISHLY plead they get a mulligan (from prosecution)?

    I can hear their story now, “Gee wiz, I didn’t INTEND to cheat, lie and steal from all my neighbors and fellow American citizens… it just kinda worked out that way.”

    This is Romper Room logic, writ large.

    When did the rule of law become so flimsy that purported ignorance by adults possessing Master’s degrees and Ph.D.’s has greater standing than the judgement borne of a reasonable seven year-old child? Does this feeble logic stand in other realms of the legal code, such as burglary, larceny, theft, fraud, assault, battery, embezzlement, hijacking, kidnapping, or murder?

    How besotted have our thought and belief systems become that these subversive actors are allowed to stand without any responsibility or repercussion for the enormous damage they wrought? Have not the actions of these scoundrels undermined the very foundations of civil polity in our country?

  12. theexpertisin says:

    I think BR presents an excellent reflection on this issue.

    Unfortunately, we are cursed with thousands (tens of thousands?) of government regulations that are political agendas wrapped in harrassment. If we had far fewer of these type regulations (such as forty six+ regulations from eleven governmental authorities to build a dock through a stinkhole swamp and dredge a small chunk of channel for shipping or smoking a cig outdoors, alone) and put emphasis on regulations that actually accomplished an important objective such as BR advocates, we’d be better off.

    And folks would respect rather than resent faceless bureaucrats.

  13. socaljoe says:

    Seems to me, CDS’s used to hedge your own risk should be subject to insurance law, but CDS’s used to bet on another party’s risk should be subject to gaming laws… or better yet, outlawed.

  14. flu-cured says:

    “It was an example of the now widely discredited belief that banks and markets could self-regulate without problems. Management would never do anything that put the franchise at risk, and if it did, it would be suitably punished by the shareholders.”

    I remember Greenspan saying basically that he thought the large financial institutions’ desire for self preservation was an underlying fundamental assumption.

  15. bonderman says:

    While the Senator was busy making derivatives profitable for AIG, Wendy Gramm was busy at Enron. Slate has the story. It isn’t pretty.

  16. DeDude says:

    “I remember Greenspan saying basically that he thought the large financial institutions’ desire for self preservation was an underlying fundamental assumption”

    Amazing, but the head of the Fed had failed to understand that the CEO culture had changed to “rob, rape, and get the heck out of there before it collapses”. He still lived in some la-la-land where those in charge of companies actually cared about their long-term health.

  17. msaroff says:

    I would note that the CDS, more specifically the naked CDS has upended 266 years of established law by allowing people to insure items where they have no interest in their continued existence. (

  18. As a former counter party credit risk analyst at US Bank for OTC derivatives, I can attest to the fact major banks traditionally analyzed how much risk was acceptable to a given counter party. One was entering into “financial contracts” for foreign currency swaps and forwards or for interest rate swaps. If the counter party failed, the banks had to absorb the loss. Outstanding credit exposures on OTC contracts, by entity, and the underlying asset volatility was measured repeatedly.

    In the AIG situation, its counter parties, such as Goldman Sachs, Deutsche Bank and Societe Generale were well aware of the risks they were taking with AIG. In AIG’s 2007 Balance Sheet, this was disclosed:

    “It appears economic conditions will not be any better in 2008, we continue to see many opportunities to deliver quality insurance and financial products and services to customers around the world.

    “Included in 2007 net income and adjusted net income was a charge of $11.47 billion pretax ($7.46 billion after tax) for unrealized market valuation losses related to the AIG Financial Products Corp.(AIGFP) super senior credit default swap portfolio. Based upon its most current analysis, AIG believes any losses that are realized over time on the super senior credit default swap portfolio of AIGFP will not be material to AIG’s overall financial condition, although it is possible that realized losses could be material to AIG’s consolidated results of operations for an individual reporting period. “

    Further, Martin Feldstein, Harvard Economist, stated at the 2007 Jackson Hole Economic Summit, Shiller’s dire predictions for the U.S. housing market. Martin S. Feldstein, who served on the AIG Board of Directors in 2007 publicly stated “that the assets that formed the basis for the credit default swaps would potentially decline over 50% in 2008. It goes without saying, that AIG, based on that knowledge, would be wiped out, given their credit default swap positions at that point in time.

    In sum. I agree with you that derivatives require an underlying asset, like foreign currencies and interest rates that are not subjective, like a “credit event”, which is subjective. However, what I do disagree is the issue credit default swaps should have been regulated like “insurance.” AIG and its counter parties, like Goldman Sachs, both entered into financial contracts representing they both had the financial capacity to make good on those contracts. This is the basis of financial contract law. There are current laws on the books that address fraud and misrepresentation.

    If one enters into a financial contract without the capital to make good on that contract, knowing they do not have that capacity, that is by definition fraud. The Department of Justice stated this was “stupidity” on AIG’s part. We all know a homeowner that enters into a financial contract, a mortgage, that represents they have the capital to back up that mortgage and does not is deemed “fraud” and misrepresentation. Even if the Department of Justice believes that AIG did not understand the nature of the risk, it has been brought to light that Goldman Sachs did when it entered into these contracts with AIG.

    Thus, the taxpayer funding of the AIG collateral calls on these contracts in 2008 is the biggest taking and fraud of the 2008 financial crisis, yet to be dealt with by the Department of Justice. It is hoped that your take “these contracts should have been regulated as insurance” will open the broader investigation that these were valid financial contracts, were one party(AIG) mis-represented they had the financial capacity to make good on that contract, when they did not. The investigation needs to reopen on whether or not AIG’s credit default swap contracts were entered into fraudulently. If they were, all taxpayer dollars employed to fund AIG’s credit default swap collateral calls must be returned to the U.S. taxpayer.