December 6, 2011 Dylan Ratigan

What Are Swaps, and Why Do Greedy Bastards Love Them?

Swaps!

As you know, this week we’re adding another theme to our Greedy Bastards glossary — we want to introduce you to the world of swaps, because it’s the Greedy Bastards’ favorite financial innovation of the past decade.

The whole topic of credit default swaps may sound a little daunting. To boil it down, swaps are basically unregulated insurance, betting on people & businesses and countries will default on future loan payments.

It’s made a little more complicated because bets are made in secret — we can’t see who bet what with whom. And if you’re a AAA rated financial institution, like JP Morgan, then you’re not even required to put any collateral down when you bet.

Now, the global swaps market totals $708 trillion!

As Dylan explained on the show, “investment bankers created the idea of swaps back in the 1990’s so they could sneak around the strict regulations on traditional insurance.  This market was created as a new profit center for banks whose traditional business of stocks and bonds were becoming remarkably less profitable because of technology.  So now the bankers literally bet with no money down by the *trillions* on which company or country will or will not be able to pay its bills,” says Dylan.

But because these swaps are secret and unregulated, no one (no bank CEO, no one at the Treasury, and no one at the Federal Reserve) can make sure bankers are actually able to pay those insurance claims that they’re betting.

We watched this last week when the central banks paid out through the swap lines effectively using Western taxpayer currency to prop up the European financial system.  This happens while the banks continue to collect premiums on insurance they are selling — but cannot pay for!

To dig in on the issue of swaps, Dylan spoke with Bill Fleckenstein of Fleckenstein Capital and Dan Gross from Yahoo! Finance.  Here’s the video and full transcript:

BILL FLECKENSTEIN: Let’s be clear. Swaps are a slightly more generic term than the Credit Default Swaps, which you are describing, where this has sort of betting on someone else’s house burning down. In a swap, let’s say you had a mortgage that was a floating rate mortgage, Dylan, and it was 1% and it was going to go up every time the Fed raised rates. Let’s say I had a mortgage that was 5% and it was fixed, and I became concerned that I was being stupid for paying 5% when you were paying 1, and you became fearful that your 1% rate was going to go to the moon, because you thought rates were going to rise. We could enter into an agreement whereby I would pay your mortgage and you would pay mine, and we would have a swap. That’s kind of how it started.

And then the “fun” began and all sorts of various derivations of that happened. We could swap lottery tickets and decide how much we could pay to own the other person’s lottery ticket and all of that. The area that you’re particularly focused on — Credit Default Swaps — is a derivation of that and there are lots and lots of type of swaps out there, but probably the most dangerous is the one you’re talking about.

DYLAN: And what’s most dangerous about it, Dan, forget what we’ve already discussed, there’s no exchange for this, so you can’t call the Federal Reserve, you can’t call the Treasury, you can’t call the ECB, you can’t call Jamie Dimon, Lloyd Blankfein. there’s no one you can call who will tell you what the exposures are. That has to be an act of insanity. Is there another financial market out there that’s invisible like this?

DAN GROSS: I think there might be a gold market somewhere in Bahrain that acts on that lack of transparency. But we really solved this in 2008, when all of a sudden, AIG — we just thought AIG was a sponsor of the Manchester United Soccer team and this big insurance company. Boom, it turned out they were — had sold, you know, hundreds of billions of dollars of insurance, credit default swaps on subprime mortgages. And when it came time to collect, they hadn’t put aside any reserves, and investors in AIG were not clear what the exposure was. So that is a big problem. I think one of the most absurd components of this is the idea of credit default swaps on sovereign governments, including the United States. People are trading credit default swaps on whether, you know, the United States will make good on its bonds. And why is that absurd? Well, in a world in which the government is not making payments on its bonds, what financial institution would be alive and function? We would all be in the hills digging potatoes or something.

DYLAN: To that end, it’s something i talk with Dick Grasso who used to be the chairman of the NYSE bill in the book, how do you discuss all these swaps that Dan Gross was just referring to, where there is no underlying loan, there is no underlying coal purchase or pork purchase or anything. It’s purely a bet. And Mr. Grasso suggested we reclassified all those types of agreements as online gaming, because they’re not really an investment product. Do you believe that that’s too harsh?

BILL FLECKENSTEIN: It probably is, because, let’s say that — let’s take Greece’s credit default swaps, for instance. three or four years ago, you could buy them at ten basis points over, and of course, that was when there was hardly any spread. Let’s say i had legitimate business interest in Greece as a foreigner and I might want some type of protection, I might want to do something like that. there is a legitimate basis for some of these things. If we had some regulation and some daylight on the issue, we might be able to say — yeah. If you had a legitimate business interest, it might not really be gambling, and you might want to treat that one way. If you wanted to be a gambler, the guy on the other side of your gambling might need a different amount of credit. But if we had some daylight on it, it might be a lot better.

DYLAN: Just to wrap it up, Dan, a first step would simply be the daylight that Bill speaks of, just moving to this an exchange-type environment, so we can talk about it without being so ignorant of it.

DAN GROSS: Right. and we’ve seen this with every other product out there, whether it’s stocks or bonds, when you put something on a centralized exchange, buyers and sellers meeting, it tends to lower transaction costs and takes a fair amount of the friction out of this, as well as a lot of the secrecy.

DYLAN: Yeah, so listen, as you can tell, we talk a lot about in the book about putting swaps on exchanges and thanks for helping enroll others in understanding why a crazy sentence like that could be helpful if our economy. Bill, Dan, thank you so much.

SUBSCRIBE
NOW!!

Get Email Updates

Stay connected with Dylan