EchoBlog

... Explain to me how corporations were using these funds and these derivatives. How is it helping? ...

When the credit default swap market started to take off, it became very much a fashionable thing to do, and there were several groups involved. One, there were the banks, and the banks were basically able to make millions.

And they were able to make loans to people who did not necessarily qualify for loans in the first place with the bank, because the banks then said, "Well, I'll admit this loan, but because I can sell off this risk to somebody else, ... I can basically take the risk, which I normally wouldn't do." ...

For corporations there were two benefits. One, people who would normally not have received funding were receiving funding, and the people who would have received funding were able to raise more money. So the volume of credit available expanded quite substantially. That was the first benefit.

But the other thing was, smaller banks around the world could actually now get access to clients, because if you're a small bank in the world wanting to lend to, say, an Exxon or somebody like that, you may not have the direct relationships. But you could now acquire these loans quite easily through these credit insurance contracts in the secondary market.

So what happens is we saw this risk gradually permeate through the financial system, and that has two effects. The first is the pool of money available for a corporate borrower vastly expanded. But the second thing that happened, which was less probably impressive and far more risky, was we were gradually tying people in very different parts of the world, who you may not necessarily know, into this web of finance.

So you might have a loan to Exxon, which everybody thinks JPMorgan has made, but then JPMorgan has distributed the risk to, say, 30 banks in different parts of the world, like in Japan, China, in the United Kingdom, in Germany, in Australia. Then they may in turn have hedged their risk with somebody else.

So you get this almost web out there, and the regulators all loved this because they thought risk was being distributed, reducing the risk and the chance of a crash. But in reality, it was introducing a new risk into the system.

And that risk was not very well understood, because remember, an insurance contract -- what was actually happening is the contract is only as good as the credit quality of the insurer. They have to pay you, and if they can't pay you for whatever reason, then this whole process of risk transfer breaks down. And people didn't really understand that the insurance market wasn't getting rid of the risk; it was just moving the risk around in a very interesting way. ...

The other thing it did ... was kind of an interesting psychological process. People changed the way they looked at credit risk. ... Once you get into a world where you think you can at a moment's notice go and insure the loan with somebody else, there are a couple of psychological changes which occur. One, you're less concerned about the repayment risk, because you think your risk is only from the moment you make the loan to when you hedge it with these instruments.

Second, you're assuming that the market for these instruments is always going to be good, and it's going to be liquid, and it's going to be functioning. And one of the strange things about financial markets is they're liquid generally when you don't need them to be liquid, and when you need liquidity, unfortunately, they tend to be illiquid.

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