CHICAGO (Reuters) – On Main Street, insurance protects people from the effects of catastrophes.
But on Wall Street, specialized insurance known as a credit default swaps are turning a bad situation into a catastrophe.
When historians write about the current crisis, much of the blamewill go to the slump in the housing and mortgage markets, whichtriggered the losses, layoffs and liquidations sweeping the financialindustry.
But credit default swaps — complex derivatives originally designedto protect banks from deadbeat borrowers — are adding to the turmoil.
"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book "Web of Debt."
"I’m sure their predictive models were right as far as the risk ofthe things they were insuring against. But what they didn’t factor inwas the risk that the sellers of this protection wouldn’t pay …That’s what we’re seeing now."
Brown is hardly alone in her criticism of the derivatives. Fiveyears ago, billionaire investor Warren Buffett called them a "timebomb" and "financial weapons of mass destruction" and directed theinsurance arm of his Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research, Stock Buzz) to exit the business.
LINKED TO MORTGAGES
Recent events suggest Buffett was right. The collapse of Bear Stearns. The fire sale of Merrill Lynch & Co Inc (MER.N: Quote, Profile, Research, Stock Buzz). The meltdown at American International Group Inc (AIG.N: Quote, Profile, Research, Stock Buzz). In each case, credit default swaps played a role in the fall of these financial giants.
The latest victim is insurer AIG, which received an emergency $85billion loan from the U.S. Federal Reserve late on Tuesday to stave offa bankruptcy.
Over the last three quarters, AIG suffered $18 billion of losses tied to guarantees it wrote on mortgage-linked derivatives.
Its struggles intensified in recent weeks as losses in its owninvestments led to cuts in its credit ratings. Those cuts triggeredclauses in the policies AIG had written that forced it to put upbillions of dollars in extra collateral — billions it did not have andcould not raise.
EASY MONEY
When the credit default market began back in the mid-1990s, thetransactions were simpler, more transparent affairs. Not all thesellers were insurance companies like AIG — most were not. But theprotection buyer usually knew the protection seller.
As it grew — according to the industry’s trade group, the creditdefault market grew to $46 trillion by the first half of 2007 from $631billion in 2000 — all that changed.
An over-the-counter market grew up and some of the most activeplayers became asset managers, including hedge fund managers, whobought and sold the policies like any other investment.
And in those deals, they sold protection as often as they bought it– although they rarely set aside the reserves they would need if theobligation ever had to be paid.
In one notorious case, a small hedge fund agreed to insure UBS AG (UBSN.VX: Quote, Profile, Research, Stock Buzz),the Swiss banking giant, from losses related to defaults on $1.3billion of subprime mortgages for an annual premium of about $2 million.
The trouble was, the hedge fund set up a subsidiary to stand behindthe guarantee — and capitalized it with just $4.6 million. As long asthe loans performed, the fund made a killing, raking in an annualizedreturn of nearly 44 percent.
But in the summer of 2007, as home owners began to default, thingsgot ugly. UBS demanded the hedge fund put up additional collateral. Thefund balked. UBS sued.
The dispute is hardly unique. Both Wachovia Corp (WB.N: Quote, Profile, Research, Stock Buzz) and Citigroup Inc (C.N: Quote, Profile, Research, Stock Buzz)are involved in similar litigation with firms that promised to step upand act like insurers — but were not actually insurers.
"Insurance companies have armies of actuaries and deep pools ofpolicyholders and the financial wherewithal to pay claims," says MikeBarry, a spokesman at the Insurance Information Institute.
"SLOPPY"
Another problem: As hedge funds and others bought and sold theseprotection policies, they did not always get prior written consent fromthe people they were supposed to be insuring. Patrick Parkinson, thedeputy director of the Fed’s research and statistic arm, calls thepractice "sloppy."
As a result, some protection buyers had trouble figuring out who wasstanding behind the insurance they bought. And it put investors intowebs of relationships they did not understand.
"This is the derivative nightmare that everyone has been warningabout," says Peter Schiff, the president of Euro Pacific Capital at theauthor of "Crash Proof: How to Profit From the Coming EconomicCollapse."
"They booked all these derivatives assuming bad things would neverhappen. It was like writing fire insurance, assuming no one is evergoing to have a fire, only now they’re turning around and watching asthe whole town burns down."
(Editing by Andre Grenon)
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