Credit Default Swap
Portfolio manager’s Letter May 2009
Learning Things The Hard Way III – Credit Default Swap
Regulation of credit default swap should be easy; after all, they are just a form of insurance. Insurance companies have been highly and more or less successfully regulated for more than a century. While we certainly do not want state by state regulation of credit default swap some form of federal rules similar to those that require sellers to be licensed, disclose the amount of business that they write for credit default swap; and require the companies that are assuming risk maintain capital reserves sufficient to cover the losses that result from the contracts they write. Some people have even suggested a rule that would require a buyer of a credit default swap to show a legitimate insurable interest.
These rules are not just of interest to the public but are essential protection for investors in the common stock companies doing this business. It is important to note that AIG’s disclosure of the size of their credit default swap business and the risks the company had assumed was such that there was no way for an investor to understand the risks of owning the stock.
With something like $50 or $60 trillion of credit default swap estimated to have been in existence last year, the need for regulation would seem obvious. Presently there are plans to set up an exchange to clear these credit default swap transactions, and this would help to create transparency and could set rules for posting collateral. While this might reduce some of the confusion (estimates of the notational amount of credit default swap outstanding have been more than cut in half since the first of the year by just eliminating duplicate and offsetting contracts), it is not clear that this would be enough to prevent the kind of abuse that was AIG.
Logic would suggest that with the proper disclosure, and regulation this would be an interesting business for Berkshire Hathaway; with their large Insurance business and expertise in assessing financial risks, it would, in a sense, be just an extension of their existing business. But for this business to be attractive to Buffett, there would have to be substantial capital requirements for anyone wanting to write this credit default swap insurance. Otherwise, we have the situation we just escaped were there was no relationship between the premiums paid by the purchaser of credit default swap insurance, and the risks born by the insurance company.
It appears that anyone that could sign his name to a contract was able to collect a premium. It did not matter whether or not they had any idea as to the size of the risks they were insuring or whether there was any chance that they could pay for the losses that they were supposed to be covering.
Buffett has written credit default swap business in the past and has indicated that he might in the future, but he has said he will not sign any contract that requires him to post collateral. The reason is no mystery; what makes the insurance business attractive is the float (the premium money that Berkshire Hathaway gets to hold until they have to pay claims). If there is an exchange holding collateral, they would be holding the float, not Berkshire Hathaway.
So we can assume that Buffett would prefer regulation similar to the insurance business, as opposed to regulation built around a clearing house or exchange. The capital requirements would have to be high enough to limit the number of parties that could write this business, otherwise competition would drive premiums too low to provide a profit. In fact it would seem that as far as Berkshire Hathaway is concerned the higher the capital requirements the better.
From the investors’ standpoint, there must be protection for situations like AIG. By the time that the shareholders discovered the extent of risks AIG was taking with their credit default swap business, the shareholders were already broke, and the company was in hock to the taxpayers for $180 billion. AIG did not have enough capital to cover the risks they were accepting with these contracts, and the premiums they were charging were imbecilic.
It isn’t easy to understand how this situation got so far out of control. But the solution would appear to be simple enough. No company should be allowed to write credit default swap insurance unless they have the capital to cover the risks that they are assuming, and shareholders should have an absolute right to enough information to understand the risks their company is taking. Under these circumstances, this would likely be a very profitable business for Berkshire Hathaway.
Credit crisis
There has been a lot of talk in the media about how our current credit crisis has damaged our economic system, together with the usual muttering from the left about the nasty nature of Capitalism. While these attitudes are normal and to be expected, it seems to me they are be based on a fundamental misconception about economics and human behavior. I admit that mine will never be a popular view, but I think it likely that the reason why capitalism works and that socialism does not, is that capitalism with its free markets, is able to correct its mistakes.
The problem is that this has not been, and never will be a painless process. Until there is pain, there is no will to correct. Or, as I have said before when it comes to economic systems, pain is the mother of wisdom, as we learn to this new weapon the credit default swap. The good news is that as opportunities for accumulating wisdom, this one is going to be a beat.
I wish it were not so. I wish that I could believe that the introduction some liberal political system could magically eliminate the pain from the human condition, but the older I get the more I find that my mind rebels from this suggestion. Mistakes are part of the human condition, and since politicians are human there is no reason to believe they are exempt. The biggest problem with our corrective process is that instead of searching for causes and corrections we waste most of our time looking for something or someone to blame.
Economic crashes are nothing new. In the United States there were six in the Nineteenth Century and three in the Twentieth Century, while the causes of these crashes were not always the same, in each case the damage tended to be short term while the long term result has always been a stronger economy, and growth of living standards. In a recession the strong well managed companies survive and gain market share, while the profligate, dishonest and inefficient perish.
This is the reason that Buffett has worked so hard to build a hurricane proof ship, and his reward for this effort is likely to be beyond anything that we predict at this time. This element of natural selection in the free market economy is what makes it work, but is something that politicians are reluctant to accept.
The great inflation of the seventies caused seventeen years of discomfort but eventually gave us two decades of prosperity and unprecedented international growth. What our current turmoil will produce we cannot imagine now, anymore than we could have predicted the future in 1940 or 1980, but we should keep in mind that the crashes in the past did not led to long term collapse.