“$50 Trillion Worth of Obscurity”

Are credit-default swaps potentially the next big financial crisis? Gary Aguirre thinks so.

JUST WHEN YOU THOUGHT IT WAS SAFE to go back in the market, along comes a lawyer named Aguirre who’s warning of the next financial meltdown. No, it’s not Mike; it’s his brother, Gary, a former Securities & Exchange Commission lawyer in Washington now in private practice in San Diego. (For a full profile of Gary Aguirre, see our article the August issue of San Diego Magazine.)

“We have a regulated [securities] market that is relatively transparent — it exists side-by-side with a second market that is unregulated, opaque and massive,” Aguirre says.

The market he is describing is in credit-default swaps. In a credit-default swap, one party agrees to pay a premium to another to protect against a potential default on a company’s or municipality’s bonds, or to bet on a company’s success. In the event of a default or other credit crisis, the holder of the credit-default swap is entitled to the bond’s full value. Credit-default swaps were invented by investment banks in the 1990s to offset risk to their bond portfolios.

Frank Partnoy, a former investment banker at Morgan Stanley in New York and now a professor of law at the University of San Diego, likens credit-default swaps to “side bets” found in Las Vegas sports books around the Super Bowl. Except that the amount bet on a Super Bowl — about $90 million — is microscopic compared to the trillions being thrown at credit-default swaps. Because little disclosure is required of the hedge funds and investment banks who are the quarterbacks in the Credit- Default Swap Super Bowl, Professor Partnoy calls the market “$50 trillion worth of obscurity” — or about twice the $25 trillion value of the entire U.S. stock market.

Aguirre and others worry that even a partial “unraveling” of the credit-default swap market could trigger another Bear Stearns. Recall that Bear Stearns’ buyout in March had to be underwritten by the Federal Reserve Bank to the tune of $35 billion to prevent a global liquidity crisis. Aguirre says credit-default swaps could turn into a super-size Bear Stearns — or something worse.

“The risk is that before Bear Stearns went down, it reported $397 billion in assets and $385 billion in liabilities; that’s $12 billion in net worth,” Aguirre explains. “That was the transparent part. But it also had $33 billion in off-the-balance-sheet, mortgage-backed securities.” Because Moody’s, the bond-rating agency, decided to downgrade a mortgage class called Alternative A — only slightly more secure than subprime — Bear Stearns’ exposure on its mortgage-backed securities eventually exceeded its net worth.

“When Alternative A was downgraded, the impact dropped its value more than $15 billion,” says Aguirre. “Those who understood [the situation], fearful that Bear Stearns was going south, all ran for the exit, and Bear Stearns was insolvent. If Bernanke didn’t pony up the $35 billion, we would have had a global meltdown. If you look at what collapsed markets in the past, the 1929 crash occurred because of multiple layers of leverage, and a speculative fervor moved by investment banks that allowed investors to speculate by creating multiple securities on the same assets. Fast-forward to today, and we’re re-creating those 1929 conditions.”

In February, less than a month before Bear Stearns’ meltdown, Aguirre wrote to Senator Christopher Dodd, chairman of the Senate Committee on Banking, Housing & Urban Affairs, warning that the unregulated, off-the-balance-sheet market in credit-default swaps dwarfed the exposure banks experienced due to subprime mortgage securities.

“The opaque (unregulated) market has its own players and its own playing field,” Aguirre wrote Dodd. “The players are hedge funds ... and ... investment banks. As investment banks own more and more hedge funds, their players also become unregulated and opaque. The playing field is the over-the-counter derivatives and instruments, such as subprime debt, which are off the balance sheets ... Hedge funds love to play with the most dangerous forms of derivatives, credit-default swaps. There are now $42 trillion in credit-default swaps.” (Aguirre says the market is north of $50 trillion today.)

“These guarantees differ little from gambling,” he wrote Dodd. “The potential rewards for insider trading are nearly unlimited, as is the negative impact on the capital markets.”

AGUIRRE ISN’T EXACTLY A LONE WOLF howling in the wilderness about credit-default swaps. A story in The New York Times by Gretchen Morgenson noted, “The market’s popularity raises the possibility that undercapitalized participants could have trouble paying their obligations ... Investors are already reeling from the recognition that major banks inaccurately estimated losses from the mortgage debacle. If further write-downs emerge as a result of hedges that did not work, investor confidence could take another dive.”

In addition, the government’s chief regulator of national banks, the Office of the Comptroller of the Currency, commented in a 2007 report on the difficulty in keeping up with the credit-default swap market: “[O]perational issues became a supervisory concern in the credit derivative market in recent years,” noting that the increase in credit derivatives’ value in last year’s third quarter “put a strain on processing systems.”

Whether an unraveling of the credit-default swap market could cause another, exponentially larger Bear Stearns situation is still a matter of conjecture. Analysts say a lack of information prevents an informed guess.

“Because the market is largely unregulated, there’s very little information about individual companies’ exposure,” Partnoy says. “So if you look at a bank like JPMorgan Chase [the leader in credit-default swaps, with about $8 trillion outstanding], you cannot tell what risk the bank is exposed to through these swaps. There are dozens of pages of disclosure but nothing that will help you answer the question of ‘How bad can it get?’ or whether one of these banks, or many, might be exposed to a potential meltdown. No one knows, and no one can know, because the markets are opaque.”

Since regulators do not require participants in credit-default swaps to verify whether they can live up to their obligations, there is little chance to gauge whether the market could withstand the kind of pressure that ultimately did in Bear Stearns. A lack of sunlight also hampers a dispassionate analysis of the quality of these side bets.

“An outsider who looks at the financial statements for a bank can’t figure out to what extent or what the nature of their side bet is,” says Partnoy. “Imagine the bank has made trillions of dollars of side bets on baseball games, and they are not just straightforward bets on who will win or lose, they’re more complicated, proposition bets — like whether a certain player will be injured. So a company Like JPMorgan will tell you ‘We made a trillion dollars worth of these bets,’ and you can’t tell whether they will win or lose, just like somebody in Vegas can tell you they just bet a million dollars on baseball. But they might have bet this money on a bunch of games, or a million dollars on one game, or a proposition on whether someone will hit a home run. They could have bet the worst team in the majors to win the World Series.”

Warren Buffett recently told the Associated Press that even he can’t cut through the fog of banking. “There are some financial institutions I can’t value,” he admitted.

There are caveats to note. For every loser of a side bet, there’s a winner, and often the winning and losing offset, so that JPMorgan Chase does not face $8 trillion dollars of exposure because they are involved in $8 trillion of credit-default swaps. Recently, the default rate on high-yield junk bonds is about 1 percent, near-historic lows.

Even so, both Aguirre and Partnoy favor the government’s shining a light on the credit-default swap market to bring it out of the shadows of investing. “Regulators should encourage the industry to increase the amount of transparency so the banks will have to disclose more details about their side bets,” says Partnoy. Failing that, class-action shareholder lawsuits brought against investment banks over the subprime mess may also shine a light on credit-default swaps. “I think judges are increasingly aware of this risk,” he says.

Aguirre says the stakes are high: “If this thing went down, it would make Bear Stearns look like a kid’s Kool-Aid sale.”

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