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“When Even Good News Worsens a Panic”

From the start of the credit crisis, panic has been caused by what we didn’t know. What happens if a Lehman Brothers is allowed to fail? What happens if toxic mortgage-backed securities are bought through a government bailout? Then, what happens if the U.S. treasury decides not to bail the banks out of these bad debts?

So it should have been reassuring that one of the most nerve-racking of the unknowns turned out to be benign.

We now know that we should not have feared huge loses in the multitrillion-dollar unregulated market for esoteric instruments called credit default swaps. Transactions in this market have been orderly, and the losses have been modest.

Instead of cheering this happy news and reassuring investors, Washington last week pilloried these swaps and set out to regulate or even ban them. Bankers know this puts at risk one of the few remaining smoothly functioning parts of the credit market. Markets reacted to this new unknown unknown: How much damage will be caused by regulators creating new problems and distracting attention from the real ones?

To be fair, credit default swaps are complex and poorly understood. These swaps let investors buy insurance against a company or a country defaulting on its debt payments. If a bank decides it has too much exposure to, say, the oil industry, it can insure against the risk of companies in this industry defaulting.

Last week, banking expert Peter Wallison of the American Enterprise Institute walked the sophisticated audience of the Exchequer Club through how these swaps work. He offered the example of bank A making a $10 million loan to company B. Bank A can eliminate most of the risk of B from its books by going to C, a dealer in these swaps, who agrees to pay the $10 million to A if B defaults, in exchange for A paying an annual premium to C for the protection. A will want collateral from C to be sure it’s good for the debt. As a dealer, C will hedge its exposure, entering into a swap with D, which also hedges through E.

Dealer E feels palpitations and chest pressure. A panic attack or a heart attack? This could be a matter of life and death, unless Dealer E makes the right judgment.

Read the full article here.