Infectious Greed (67 page)

Before 2002, investors had simply trusted chairman Jack Welch. But now that Welch had resigned—and had been tarnished not only by the plunge in the stock, but by negative publicity surrounding a high-profile affair he had with the former editor of the
Harvard Business Review
—investors were less trusting of General Electric and, especially, its financial businesses. When investors learned from documents filed in Welch's divorce proceedings that GE was giving him tens of millions of dollars in retirement benefits—including a wine budget of more than many investors' salaries—they wondered if Welch had been truthful about GE's performance.

General Electric was really two companies: GE Industrial and GE Capital.
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GE Industrial made lightbulbs, airplane engines, and gas turbines, and “brought good things to life”—as the company advertised on television. GE Capital borrowed and loaned money, and was an active player in derivatives. GE Industrial was the General Electric most people knew. But GE Capital was the engine that drove the firm's profits.

GE Capital was created during the Great Depression, with the modest
aim of helping consumers finance their appliance purchases. But by 2002, GE Capital essentially had become a bank. It had more assets than all but two U.S. banking conglomerates, six times more than its assets in 1990.
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In its 2001 annual report—issued in 2002—General Electric comforted its investors by stating, “As a matter of policy, neither GE nor GECS [GE Capital] engages in derivatives trading, derivatives market-making, or other speculative activities.” But in a footnote, General Electric noted that, because of changes in the way it accounted for its derivatives operations, it had reduced its earnings by $502 million, and reduced shareholder equity by $1.3 billion.
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These numbers were roughly the same as the restatement Enron had made in 2001, yet investors didn't seem to care. General Electric noted, “This accounting change did not involve cash, and management expects that it will have no more than a modest effect on future results.” The rating agencies continued to give General Electric a rating of AAA, and Bill Gross remained one of the few investors to express a loss of faith in General Electric. Fortunately for the credit-derivatives market, General Electric did not appear to be in any danger of default.

 

 

S
ome commentators argued that if insurance companies and industrial corporations were taking on credit risk from banks, that was a sign that these companies must be in a better position than banks to hold and monitor such risks. If markets were efficient, the hot potato, by definition, would be passed to the party best able to handle it. As the argument went, Enron, General Electric, and Prudential were in a better position to monitor and bear the risk of corporate loans than the major Wall Street banks.

There were two flaws in this argument. First, because credit default swaps reduced the regulatory costs of banks and insurance companies, both types of firm benefited from swapping positions, regardless of which was in a better position to evaluate and examine the loans underlying the credit default swaps. From a regulatory perspective, both banks and insurance companies lowered their costs by doing credit default swaps with each other. Because credit default swaps were off balance sheet, industrial corporations also achieved regulatory benefits. Second, and more fundamental, banks were in by far the best position to monitor corporate loans. They were the firms that had made the loans, they
had relationships with the borrowers, and they uniquely had access to the data and personnel necessary to keep tabs on the company's prospects.

In other words, banks were passing much of their credit risk to insurance companies and industrial corporations, even though banks were in a better position to monitor that risk. Just as interest-rate risk had flowed from Wall Street to Main Street during the early 1990s, now credit risk was being passed to parties less able to bear it. And, once again, the culprit was financial innovation designed to take advantage of legal rules.

According to Martin Mayer, a leading banking expert, credit default swaps sacrificed the greatest strength of banks as lenders: their ability to police the status of a loan.
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An insurance company—especially one outside the United States—couldn't do much more than look at a borrower's public financial statements. Nor would it have an incentive to monitor the borrower, because each credit default swap represented only a small portion of the borrower's overall debt. Moreover, an insurance company that bought credit risk from a bank might pass it along to another institution, which might pass it on to another, and so on. Because there were no disclosure requirements for credit default swaps, it was impossible to know who ultimately held the risk associated with a particular company's loans. But it required a fantastic leap of faith to assume that the holder of the hot potato was in the best position to keep tabs on the borrower.

Thus, credit default swaps distorted global investment by leading parties to misprice credit risk. Borrowers who were not being monitored tended to take on greater risks, which meant that the banks making new loans to these borrowers would charge higher interest rates. As the cost of capital in the economy increased, companies would take on fewer projects at higher cost, and economic growth would suffer. Moreover, because banks didn't bear the risks associated with loans, they had an incentive to lend more money than they otherwise would. The International Monetary Fund concluded, “To the extent that regulatory arbitrage drives the growth of the market, banks may be encouraged to originate more credit business than they would have done otherwise and then to transfer the risk to non- or less-well-regulated entities . . . such as insurance companies and, to a lesser degree, hedge funds.”
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Regulators in the United Kingdom expressed concern that, with credit default swaps, “There is a risk of mispricing by less sophisticated market participants.”
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And a top credit derivatives expert, Satyajit Das, worried that investors did not understand the risks associated with these instruments: “Unlike
other financial products that have remained largely in the professional markets, one of the most alarming things about credit derivatives is the way they have been packaged into numerous deals that have been sold to relatively small institutions and even occasionally to high-net-worth individuals, which I think has the potential to cause problems.”
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One final problem with credit default swaps was that, as with any insurance policy, payment hinged on the language describing what was covered—the definition of a default. A loan agreement was a lengthy document that typically specified numerous standard events of default. Loan agreements had evolved over decades, based on the experience of parties, under various market conditions. In contrast, credit-swap agreements were slim documents that allowed parties to use any definition of “default”—ranging from the borrower's failure to make payment to the appearance of a newspaper article suggesting the borrower
might
default. Over time, credit default swaps had become more standardized, and bankers tightened contract terms after Russia's “default” in 1998; but, parties to credit default swaps still could, and did, change the terms for particular deals. In their effort to develop highly customized credit default swaps, banks had created unforeseen difficulties. Having done hundreds of billions of dollars of credit default swaps based on simple documentation, the banks finally understood why the underlying loan agreements had been so lengthy.

The consequence was that parties to credit default swaps bore
legal risk
associated with whether obligations had been triggered. A party that believed it was hedged might be whipsawed if the language in one credit default swap required payment while the language in an offsetting swap did not. J. P. Morgan Chase faced this precise problem when Argentina announced a rescheduling of some debts, and ultimately defaulted on some debts but not others. J. P. Morgan Chase had entered into credit default swaps related to Argentina with different clients using different language.
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The bank recorded $351 million in losses on Argentina in 2002, and the disputes about how much was owed on which swap remained tied up in court as of early 2003.
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The use of credit default swaps revolutionized the bankruptcy process. The defaults by Enron, Global Crossing, and WorldCom created enormous uncertainty about which creditors would be paid, and when. Essentially, market participants had tried, by private contract, to opt out of bankruptcy proceedings that were mandated by federal law, leaping ahead of the line of creditors awaiting payment from these defaulted companies. It remains uncertain whether those efforts will be successful.

In his 2003 letter to Berkshire Hathaway shareholders, Warren Buffett warned of the dangers of credit default swaps, calling derivatives “time bombs” and “financial weapons of mass destruction.” (Buffett had been burned by credit derivatives buried in portfolios held by General Re, a reinsurance company he had purchased.) While some market participants objected to Buffett's warning, calling it a “serious slur” and “bad judgment,” Federal Reserve chairman Alan Greenspan took note.

Greenspan had been resolutely pro-derivatives and anti-regulation. But on May 8, he appeared by satellite at a banking conference in Chicago and gave a very un-Greenspan-like speech. His remarks were lucid and peppered with colorful metaphor, references to wildcat banking, and hard-hitting criticism. He concluded that he was no longer “entirely sanguine with respect to the risks associated with derivatives.” Reporters apparently had no idea what to do. Most newspapers ignored the speech; others covered it, but directly contradicted each other.

Greenspan delivered two ripostes to the derivatives industry. First, he cautioned dealers about market concentration, citing “the decline in the number of major derivatives dealers and its potential implications for market liquidity and for concentration of counterparty credit risks.” He specifically mentioned concerns about credit default swaps, because some players were exiting the market. As the number of dealers declined, he said, it became even more important that each one remaining stay in the game. Credit derivatives trading, like poker, is not fun with only a few players.

Greenspan cited a single dealer with a one-third market share, and a handful of dealers with two-thirds of the market. If one of those dealers failed, derivatives markets might become illiquid, just as they did during the Long-Term Capital Management fiasco. Even worse, that dealer might be the first of many dominos to fall. Imagine a poker game where everyone at the table is borrowing from everyone else. Now suppose the biggest loser goes bust after losing a big bet with someone not at the table. Suddenly, all of the poker players at the table are insolvent.

The one dealer of greatest concern to Greenspan was JP Morgan Chase (as its new logo). (Greenspan didn't mention the bank by name, but most experts agreed he was referring to JP Morgan.) That bank's 123-page annual report for 2002 listed $25.8 trillion of derivatives, including $366 billion of credit derivatives, in terms of notional value, the value of the underlying loans the derivatives are based on. Even the fair value of JP Morgan's credit derivatives—just a fraction of their
notional value—was greater than the bank's combined investment banking fees and trading revenues for 2002, and more than that for any other dealer.

By comparison, Long-Term Capital Management had $1.25 trillion of derivatives, less than five percent of JP Morgan's, yet the Federal Reserve was forced to engineer a bank-led bailout in 1998 because of concerns about such systemic risks. Banking regulators obviously didn't want to do this again. Greenspan's implicit message was that derivatives dealers should be extra careful not to become too exposed to any one of their competitors. He especially seemed to direct this message to anyone dealing with JP Morgan.

Second, Greenspan warned that dealers needed to disclose more information about their derivatives. Financial institutions have lengthy footnotes chock-full of tables setting forth various financial data, including details about derivatives. But their hundred-plus-page annual reports are opaque, even to research analysts covering the industry. Here, Greenspan's language was unusually pointed: “Transparency challenges market participants to present information in ways that accurately reflect risks. Much disclosure currently falls short of these more demanding goals.”

For Alan Greenspan, those were fighting words. He and his regulators apparently had been reading the latest round of impenetrable annual reports from financial institutions. If they couldn't understand what was happening at the big banks, who could?

In this case, JP Morgan's disclosures actually were better than those of its peers. The bank reported various risk measures, including “Value-At-Risk,” which captured in a single number the firm's highest expected loss under certain assumptions. The bank also said it analyzed worst case scenarios using a more sophisicated system called “Risk Identification for Large Exposures,” better known by the not-so-reassuring acronym “RIFLE.” Unfortunately, shareholders didn't get a lot of information about RIFLE.

Similarly, the bank reported that 94 percent of its derivatives assets and liabilities were valued based on “internal models with significant observable market parameters.” Investors should have been nervous about the use of internal models to value derivatives—recall that when Askin Capital Management discovered its internal models were in error its fund collapsed instantaneously. It would have been better if banks used only quoted market prices, but those weren't available in many derivatives
markets, and would have been less available if markets become less liquid. Moreover, “internal models with significant observable market parameters” were better than “internal models with unobservable market parameters.” Unfortunately, JP Morgan (like many derivatives dealers) also reported many of those not-so-comforting “unobservable” valuations.