The Atlantic has a new business channel, which features an interview with Michael Lewis — author of Liar’s Poker, Moneyball, and The Blind Side, and editor of the recent Panic — in which he attacks certain financial innovations as tools for obfuscation:
Well, there’s probably no innovation that’s entirely useless. But there are some innovations whose use value is so trivial — except as a tool for disguising risk and enabling reckless innovation. A really good example of this is credit default swaps, which everyone has seen mentioned. Credit default swaps are not that complicated on the surface. On the surface they’re just bond insurance. If you buy a credit default swap from me, you’re buying insurance against a municipal bond or a corporate bond or a subprime bond or a treasury bond going bust.The difference, I guess, being that a third party can buy the swap.
That’s right. And that the value of the insurance can be many times the value of the original bond. So let’s say there’s some really dodgy subprime bond out that everybody knows is going to go bust but that the market is still pretending is a triple-A bond. You might have insurance that is 100 times the value of the actual bond. So lets say there’s a million dollars in a bond out there. You might have 100 million dollars in insurance contracts on it. So it’s obviously not insurance at that point. It’s something else. It’s a way to bet on the bond. And it’s a very simple and clean way to bet on the bond.
And one of the really weird things about this instrument is — well, back away from it and think about it for a second. Lets take a bond, let’s say a General Electric bond. A General Electric bond trades at some spread over treasuries. So let’s say you get, I dunno, in normal times, 75 basis points over treasuries, or 100 basis points over Treasuries, over the equivalent maturity in Treasury bonds. So you get paid more investing in GE. And what does that represent? You get paid more because you’re taking the risk that GE is going welsh on its debts. That the GE bond is going to default. So the bond market is already pricing the risk of owning General Electric bonds. So then these credit default swaps come along. Someone will sell you a credit default swap — what enables the market is that it’s cheaper than that 75 basis point spread — and he’s saying that in doing this he knows GE is less likely default than the bond market believes.
Why does he know that? Well, he doesn’t know that. What really happened was that traders on Wall Street have the risk on their books measured by their bosses, by an abstruse formula called Value at Risk. And if you’re a trader on Wall Street you will be paid more if your VaR is lower — if you are supposedly taking less risk for any given level of profit that you generate. The firm will reward you for that.
Well, one way to lower your Value at Risk as a trader is to sell a lot of credit default insurance because the VaR formula doesn’t count it as risk. Because it’s so unlikely to happen, the formula doesn’t grab it. The formula thinks you’re doing business that is essentially riskless. And the formula is screwed up. So this encouraged traders to sell lots and lots of default insurance because, while they get a small premium for it, it doesn’t matter to them because the firm is essentially saying, “Do it, because we’re not going to regard this risk you’re taking as actual risk.”
It’s insane. That market is huge as a result. But if people actually had to have the capital, like a real insurer, to back up the contracts they’re riding, the market would shrink by — who knows? Who knows what would be left of it?