Greedy Bastards Antidote: The Swaps Market with Gretchen Morgenson

Welcome to another episode of Greedy Bastards Antidote — a podcast series that zeroes in on “Greedy Bastardism” in our country, and highlights the people out there who are finding the “Antidotes.” Dylan will be talking to the heroes and the visionaries out there on the front lines of education, health care, the environment, trade, taxes, finance and government, all of whom are finding solutions to America’s biggest challenges — and doing it creatively and fearlessly.

This week, we’re focusing on the swaps market — not only to learn exactly what credit default swaps are, but why they’re one of the favorite financial products of Greedy Bastards.  As Dylan explains, “this is the one market that betrays every fundamental principal of American values — it is not transparent, it does not require collateral if you’re a AAA rated bank, and you can sell insurance globally on credit. This incentivizes clients to buy them by offering lower interest rates — and who doesn’t want that?”

To help define exactly what the major issues with the swaps market are, we spoke to Gretchen Morgenson.  Gretchen is a business reporter/columnist at the New York Times where she also serves as Assistant Business and Financial Editor.  She is co-author with Josh Rosner of the bestselling book Reckless Endangerment: How Outsized Ambition, Greed and Corruption Led to Economic Armageddon.

What is a credit default swap? Here’s how Dylan explains it: “The credit default swap literally has that equivalency in which AAA rated financial institutions sell insurance, so to speak, on credit—they allow you to reduce your interest rates, they allow companies and countries and individuals to benefit from, in the short term, reduced borrowing costs because of the insurance that was purchased in the swap, as they like to call it.” These are not transparent, because they are not traded on any public exchange. Lack of transparency means that no one, exactly, knows where the risk is or how much risk there is.

Here’s a condensed transcript of Dylan’s conversation with Gretchen Morgenson:

DYLAN:  Why on earth would our politicians want to be advocating against a more transparent swaps market where we would actually have the ability to see where the risk might be and, in fact, maybe manage it a little bit better?

GRETCHEN: A wonderful question, Dylan, and put beautiful as always.  You know, I think that the main reason that some of the legislators have come out against this is that some of their constituents, who have a lot of money to throw around, are the very banks, the very institutions that really profit from the fact that these still trade in the dark.  When you have a market that is limited where investors don’t know what the full panoply of bids and offers on trade are, you can add a lot of vig, you can a lot of profit to those prices, and your customer doesn’t even know the difference.  So if you shine a little light on it, profits disappear.

DYLAN: At the same time, the existence of a dark market—imagine a stock market where you couldn’t check the stock price; you just had to go to a local guy and ask him how much he would sell the stock for or a commodity market like that.  The American people would never tolerate it, they would feel that there is clearly something corrupt going on, not to mention a capital market.  In this case, that has more incentive to get involved with this dark swaps market than to invest or lend money in America is the reason why this continues to be ordained beyond the bribing and purchasing of both political parties by the banking sector.  Is that because people don’t really understand this, what this is as there seems to be an educational barrier?

GRETCHEN: I think that’s true but, you know, Dylan, it’s like anything, there are people willing to buy at a certain price and people willing to sell at a certain price and if you, as an investor, want to know what you should pay or what you should receive, then you’ve really got to see the full array of prices, you’ve got to see a variety.  That is how the bond market works, that is how the most liquid markets work across the world.  So I totally understand why they want to keep it profitable and keep it sort of under wraps, but it really is part of the Dodd-Frank law that was instituted to try to erase this sort of advantage.  It’s an information advantage that these banks have and it’s time that that went away.

DYLAN: I interviewed Richard Grasso for the book to ask him specifically what he would do or whether it was possible to put the swaps, put credit default swaps on an exchange.  And he had a very interesting answer.  “I believe regulators should require the product,” being swaps, “be registered with the central clearing agent like an exchange and thus be able to be monitored globally to prevent contracts being written in excess of the debt obligations they are designed to ensure corporate or sovereign. This is easily accomplished by regulators and Treasury issuing a cross-markets rule adopted by non-U.S. counterparts.”  He goes on to say, “Any contracts written outside these requirements would be deemed null and void by regulators simply as online gaming.”  Your thoughts?

GRETCHEN: I think that’s a great idea.  One of the problems has been that there has been far in excess of the underlying bonds or the underlying securities.  The insurance written on it has exceeded it by sometimes factors of five and ten times.  And so it no longer becomes a hedging device; it then is a betting device, and so when you have ten times the amount of bets that you have actual underlying securities that the insurance is supposed to be written on, you know, it’s like have ten times the amount of insurance on a house that burns down.  Somebody is going to get, you know, their head handed to them.

DYLAN: Because it’s not on an exchange and there’s $600 trillion worth of swaps and no one knows where the risk is, the world’s taxpayers, and largely the U.S. taxpayers, are being asked to pay off all of those insurance claims even if the vast majority of them really should be just declared null and void because we can’t tell the difference between the valid credit insurance that we need to protect around heating oil and food supply and totally frivolous speculation.  Is that correct?

GRETCHEN: Absolutely, and that was no more clear than in the AIG bailout which was really a back door bailout of its counterparties.  The major banks, both foreign and domestic, who had been on the other side of the trades where AIG insured disastrous mortgage securities.  So, yes, that’s precisely – you are precisely correct.

DYLAN:  The antidote for dealing with the Greedy Bastards that are able to exploit the swaps market seems remarkably simple by simply driving it towards an exchange.

GRETCHEN: That is absolutely right.  It is the design of the Dodd-Frank legislation, the CFTC has proposed a rule that would do that, the Commodity Futures Trading Commission has written a rule, it has of course received incredible pushback from the entities that now make so many profits by the way things are, the status quo, and so the CFTC is really, you know, has to stand tall on this one.  I think that they will try to do that but it’s very difficult when you are facing a sea of opposition and very well funded lawmakers who then create laws that are to circumvent the very rule the CFTC is trying to put into place.

DYLAN: If we were having this exact conversation — but instead of it being about a credit default swap it was about the stock market, how do you think folks would react to a bunch of people that wanted to make sure that stocks were not traded in public?

GRETCHEN:   I think they’d say, “What?”

DYLAN: Like it’s good for America to trade stocks secretly.

GRETCHEN: It sounds arcane and, you know, credit default swap, what is that?  It’s just people will kind of zone out or glaze over when these arcane instruments are discussed, but it really is the same thing as you point out.

DYLAN: And am I again missing something in looking at the simplicity of American capitalism that says in the financial markets, we know that we get the best behavior, the best incentives, the actual production of investment when there is transparency and an exchange, it’s the reason why we spend so much creating them.  Am I missing something?

GRETCHEN: No, that’s absolutely right, Dylan.  And you know it often happens that in the early period, early trading of a new instrument, whether it’s a futures or you know an option or something, it often happens that there are you know opportunities for mischief, opportunities for a lot of profits.  But then sunlight ultimately is shed on these markets and they begin to operate like the stock market, like the government bond market, these deep and liquid markets that really allow people to see the prices in a very upfront and straight forward way.  So I think we are still at that point but what is happening is the pushback is very strenuous from these banks that find this to be one of their few profit centers now.  That’s the important detail here.  They aren’t making a lot of money on MNA, they aren’t making a lot of money on investment banking.  They are making money on these – trading these kinds of instruments in the dark and they want to keep it that way.

DYLAN:  But keeping it that way at the expense of the western investment structure and capital market and the employment of tens of millions of people, I can understand where perhaps self interested individuals could care less about all that, but it doesn’t make sense to me how the government that we pay for would agree with it.

GRETCHEN: Well, what they do is they trot out these arguments that, “Oh, jobs will go overseas.  If our markets are more transparent than they are overseas, then all of these things will trade overseas and we will lose jobs and we will lose opportunities.”  Well, my answer to that always is that I don’t think that America ever set itself out to be the lowest common denominator.  I think on the alternative it should be the highest common denominator, it should have the highest bar set for integrity of markets and for transparency.  So I would argue don’t make it a race to the bottom; make it a race to the top.

DYLAN: And is that lost in our politicians?  This rational thought that is so insane is frustrating because it’s like trying to convince a goldfish that it’s in water.

GRETCHEN: It’s very frustrating because it’s hard to boil it down simply to are you going to get more money for your re-election campaign by really doing something that could harm very, very many people and could keep something, a market from developing into the kind of transparent market that it could.  Is it really all about your re-election campaign?  It seems bizarre.

DYLAN: Yeah.  If it wasn’t actually happening, you would think somebody was making it up.  Gretchen, it is always a pleasure.  Thank you very much.

Meg Robertson is a digital producer for DylanRatigan.com.