When you were a kid did you ever get in trouble for merely hanging around with the wrong kids?  Did your friends ever drop a water balloon on your teacher and run away, leaving you behind to suffer detention for a week and an enduring reputation as “that little brat”?  Well, according to a paper to be published in the forthcoming edition of the Entrepreneurial Business Law Journal, that’s pretty much what happened to the CDS market over the past year.

The paper (“Guilty by Association?  Regulating Credit Default Swaps“) is written by AllAboutAlpha.com contributor Houman Shadab, a Senior Research Fellow at George Mason University (see AAA guest post).  Shadab applies his unique ability to simplify complex issues affecting the intersection of law and finance to this article.  He argues that CDS’s aren’t nearly as evil as they are made out to be.   Instead, they just happened to be hanging around with CDOs when CDO’s got in trouble.

Writes Shadab:

“…failing to distinguish between CDS and the actual mortgage-related debt securities, entities, and practices at the root of the financial crisis may hold CDS guilty by association…Unmanageable losses from CDS exposures were largely symptomatic of underlying deficiencies in mortgage-related structured finance and do not primarily reflect fundamental weaknesses in the risk management and infrastructure of the CDS market.”

He goes on argue that the growth in CDS’s on CDO’s was an “effect”, not a “cause” of the growth of the CDO market.  As a result, he recommends against knee-jerk regulation of the CDS market.  A US bill aimed at creating a central clearinghouse of CDS’s would, he writes, “undermine bilateral risk management” (a central tenant of the current OTC market).

“Born of Regulatory Sin”

…Not that CDS’s are angels or anything.  Shadab acknowledges that they were…

“…in a sense born in regulatory sin:  They were first used by commercial banks in the last 1990’s in part to decrease the amount of capital that regulation required banks to hold in reserves.”

Not surprisingly then, regulation ignored CDS’s in their time of need at AIG:

“Regulation did not properly limit, and regulators did not diligently supervise, AIGFP’s (AIG Financial Products) use of CDS. In particular, mis-priced asset-backed security risk seems to have been a root cause of the regulatory oversight failure. OTS regulators stated that they failed to adequately recognize and act upon the risk posed by AIGFP’s multi-sector CDS on CDOs primarily because they failed to appreciate the risk of the CDOs’ underlying mortgage-related collateral.”

AIG

In fact, much of Shadab’s paper focuses on the role of CDS’s in the near-demise of AIG.  According to AIG’s financials and various related documents, the firm’s financial products group was exposed to a notional value of $527 billion in debt through CDS’s (about 1% of the $58 trillion CDS notional exposure at the time):

“AIG failed in September 2008 because of a liquidity crisis. AIG was not able to meet its short-term obligations with the cash the company had available or was able to raise. These obligations stemmed primarily from being required to post approximately $39.7 billion pursuant to the CDS that AIGFP had written on multi-sector CDOs, so named because the CDOs contained different types of residential and commercial mortgage-backed securities as collateral. In part because AIG was unable to meet the collateral obligations, the U.S. Department of the Treasury and the Federal Reserve Bank of New York arranged loans and other types of federal assistance for AIG.”

Without absolving AIG from any of its responsibilities to use CDS’s appropriately, Shadab recommends that new regulations should prevent over-concentration of CDS risk in individual companies.

AIG Not a “Hedge Fund”

In March Ben Bernanke famously called AIG a “hedge fund”.  But as Shadab points out, AIG did not in fact, use CDS’s in the same way a hedge fund might have:

“This description does not seem apt, however, because AIGFP’s CDS activities were fundamentally different from how hedge funds typically utilize CDS.  AIGFP utilized CDS as a type of long-term fixed income asset or insurance product not subject to reserve requirements, principal funding, daily marking, or oversight by regulators. This in part explains why AIGFP executives viewed CDS as “free money” compared to their traditional business lines and used flawed mathematical models focused only on the long term cost of default and not the short-term variables of collateral risk and contract pricing. Hedge funds, in contrast to AIGFP, typically view CDS as instruments with both long-term and short-term risk and actively trade CDS as part of a strategy involving other credit instruments.”

Hedge fund or not, this in-depth, yet easy-to-follow telling of an infamous story in financial history makes for great reading.