[Here’s a piece of fiction I received in a brown unmarked envelope in my snail mail box, along with a copy of a special issue of Critical Review on “The Causes of the Crisis,” Vol. 21, Nos. 2-3, 2009.]
Now it can be told. The story of the credit default swap is by itself uninteresting. But combined with lax or incompetent financial market regulation, it sits at the center of the Street’s perfect crime of 2008-09, what we now call the Great Financial Crisis, as opposed to the Great Depression of the 1930s.
Here’s an imaginary give-and-take between the perpetrator (P) and his conscience bartender (C).
C: Whazzup dude? (He gives P his usual Martini on the rocks, shaken of course, not stirred.)
P: I pulled a perfect crime but no one knows.
C: No such thing as a perfect crime, if it gets known.
P: Yup, but even if I told you you wouldn’t believe it.
C: Try me.
P: You know that banks, including central banks, can create money the way God created the universe.
C: I didn’t know that. I thought they had to at least print the stuff. But I once had an economics professor who quoted Adam Smith – something to the effect that money is just a matter of belief.
P: Yea, yea. But it can cost 1 cent, maybe 2, to print a piece of paper you call a check on which I put in one million dollars.
C: And you can buy up my old Mercedes for that? That would be a good deal for me. The clunker is worth maybe 4 grand.
P: No, I give it to my fellow banker, who does the same thing for me.
C: I see, you both write out $1 million and give it to each other. It’s a wash. It’s still just paper, worthless at that.
P: See, you don’t get it.
C: (after a Bill Gates-like pause) No, but I do. I read up on them credit default swaps (CDS) last night. It’s a derivative that’s really an insurance contract to make sure the loans you have on your books can’t go bad. The insurer pays up if the original borrower defaults; of course, you pay an ongoing premium while the CDS is in force. If the loans are always good, you don’t have to put much reserve capital against them; after all they never go bad.
P: You’re that smart?
C: No, I once learned economics and accounting before I dropped out of an Ivy League place. So I know what a credit default swap is. But some economists have cottoned up to how the banks have played the sub-prime mortgage market with the use of CDS . If you have a mortgage loan, the Feds demand you set aside real cash just in case Roger Homeowner defaults. But if you get a CDS on the loan, you’re in the clear.
P: Guess who writes out the CDS for me?
C: You mean the other guy who makes good if Roger H goes bad? I guess it’s some other bank. The Feds don’t oversee derivatives, so CDS is fair game for banks.
P: And the criminal trick is this. I’d do the same for the other bank.
C: (scratching his head with a dirty barkeep napkin) So, you take in each other’s laundry so the Feds won’t require you to put up cash, and you can do this as much as you like?
P: Yup, yup. It’s a money machine. The mortgages pay 7%, the CDS points (also per annum) are 2%. I clear 5% on nothing. If I do $1 billion of the biz, I earn $50 million a year for the bank, and they give me $5 million of that as bonus. That’s real money, so I can have a yellow Ferrari and not a clunker Benz like yours.
C: Wow, that’s cool. And it’s legal. So it’s a perfect crime. Hmm, but what happens when Roger H loses his job and walks away from his mortgage?
P: That’s not the question to ask. It’s what happens when my other bank’s Rhoda Homeowner also goes belly up. We two banks now have two bad mortgage loans, but since we wrote CDS’s to each other, we can tell the world our balance sheets and income statements are good. I write checks to the other bank in place of Rhoda, and he writes checks to me in place of Roger. It’s as though nothing happened.
C: Yea, but what happens when your CEO gets wind of this?
P: Well, he did, and now he’s in on it, except he won’t tell the Feds ‘cause he thinks he might lose his job. And the Feds know, but if they admit knowing, they’d also lose their jobs. So, the higher ups all the way to the Fed have their traps shut. Super shut.
C: So, you can do this forever?
P: Not really. All hell breaks loose when the mortgage loans go to foreclosure and we sell the homes for less than the loans.
P: The accountants will then tell us to wipe out the loans and the attached CDS’s. So it is indeed a wash as between my bank and the other bank as far as the CDS part is concerned – we both give and get 100 cents on the dollar on the mortgage loans but now we have the proceeds from the foreclosure sales which are less than the book value of the loans. The accountant guys will tell us we’re kaput.
C: But that’s not what’s happening.
P: For now you’re right. The Feds are in on it so they gave us money, lots of money, to keep on pretending we’re okay, and not to press for foreclosures. And with the very low interest rates, we’re actually earning real income from the usual spread from our other banking business. We cross our fingers that that extra income will cover the losses down the road, and that’s if it ever comes to pass. Of course, for now, we don’t do much other banking business, so that the fear in the eyeballs of our CEOs has led us to tank the economy and to keep it that way in 2009.
C: Why? You think you can stave off foreclosure forever?
P: No, but some. If home values start to come back up, the potentially bad mortgage loans become good. If the economy revives, the other Rogers and Rhodas get to keep their jobs or get re-employed and they can actually repay their mortgage loans.
C: And you will sin no more?
P: That’s our collective marching order so we can keep our jobs.
C: But what’s to keep you from doing it again when times are good?
P: Now, you’re asking too many questions (finishing off his drink and looking relieved). I gotta go home to the wife and tell her she can have a new Benz from my mid-year bonus. If things go bad I need her by my side, and a Benz for her is our security blanket.
C: (to himself) Of all the gin joints in all of the world, this banker walks into mine. Hoo hah! I should tell the Prefect of Police to round up the usual suspects. And trade my Benz for a Harley.
On the Bloomberg News channel, it is announced that the US economy has bottomed out of the 2009 recession. And C goes home telling himself the best hedge is real estate, even if there are huge transactions costs. The trick is to buy now before another bout of inflation is engineered by the Feds so that the US public debt (bloated by the Keynesian fiscal deficits of 2009-2010, so ardently favored by Paul Krugman) gets paid.
Disclosure: The author of this piece is a quasi-Austrian economist.
 Acharya Viral V. and Matthew Richardson, “Causes of the Financial Crisis,” in Critical Review, Vol. 21, Nos. 2-3, 2009, pp. 195-210.