The Next Wave

We are truly experiencing a post modern financial crisis. Uncertainty abounds. No one knows when the next wave is going to hit, or how big it's going to be. A front runner for churning out the next financial tsunami is the turbulence in the credit default swap market caused by the Lehman Brothers bankruptcy. Credit default swaps are a form of insurance sold to protect the buyer of a fixed income product from a default. In Lehman's case a buyer of Lehman's bonds could, as many apparently did, buy credit default swaps to insure against a Lehman default. By declaring bankruptcy Lehman has essentially defaulted on its bonds and the parties that insured those bonds now have to pay up. But no one knows how big a payment those parties have to make or whether they have the money.

This unknown liability on the part of the insuring parties could in turn set off a chain reaction of defaults by the parties if the combination of their credit default swap liabilities and their other liabilities exceed their assets and they are unable to get credit to meet their obligations because the credit markets are frozen. And if those defaulting counter parties' liabilities are in turn insured by credit default swaps, the next wave is going to get bigger. Lehman's default could lead to the default of parties that insured the Lehman debt, and the default of those parties could lead to the default of additional parties who insured the debts of the Lehman parties. This is one of the reasons the government is bailing out AIG: the concern that the failure of one party in the credit default swap market would lead to a wave of defaults .

It doesn't help that you don't have to own the underlying bond to buy a credit default swap for it. This fact results in the possibility that the liabilities of the Lehman credit default swap counter parties could be greater than the actual debt that Lehman issued if more than one party bought a credit default swap on the same bond.

What makes this whole thing post modern is that no one knows the extent of the Lehman credit default swap party liability because there is no central clearinghouse for credit default swaps that can provide this information. Essentially the credit default market as a whole behaved irrationally in that it acted as if the possibility of a large scale default was non-existent, and thus the necessary market mechanisms to cope with a large scale default never emerged. This was a direct result of a lack of regulation of the derivative markets.

Risk Management Failure

The New York Times has a good article outlining the opposition to derivative regulation during the last couple of decades.  It's particularly damning to Alan Greenspan, and Robert Rubin, two avid proponents of not regulating derivatives.  For them and other free marketeers  derivatives had  dispersed risk among investors to a level that made the risk negligible.  Greenspan believed that derivatives were the ultimate hedge and used his stature to prevent derivative regulation on the grounds that doing so would damage the markets.  On the Oracle Greenspan's bidding, the Republican Congress legislatively blocked derivative regulation, and a lame duck President Clinton signed derivative deregulation into law.  High finance had solved the vexing problem of capitalism's cyclical credit crises.  

Events have revealed the extent of this hubris.  Irony has turned into tragedy.  The ultimate hedge spawned into viral risk spreading swiftly as the plague through the entwined parties and counterparties.  Now the best we can do is try to stanch the mortality rate while madly searching for a cure.  Take up the bodies.