The Credit Default Swap Mess: Did U.S. GAAP Play a Role?

A member of the AECM listserv reported that today's episode of "60 Minutes" explained that a credit default swap (CDS) "was actually an insurance instrument, and perhaps fraudulently sold as [a] financial instrument to avoid insurance regulations and insurance regulators." It is hard for me to challenge that assertion, as I am certainly no expert on insurance regulation, I do know that many financial contracts that meet the definition of a "derivative financial instrument" contains elements of insurance. 

But, even though one can easily point to instances where our financial markets lacked adequate regulation in recent years there is some danger in blaming the lack of regulatory oversight for the entire mess. The regulatory pendulum invariably swings too far back when pushed by politicians seeking a quick fix to the financial malaise of the moment. Therefore, I want to propose yet another accounting fix that might obviate some of the more extreme actions being contemplated—like broadening insurance regulation beyond its historical boundaries, or even scapegoating Wall Street executives (there is already just cause for much abuse of that crowd).

At the outset, I should also state that as is often the case lately, my thoughts in this area were catalyzed by – you guessed it – Jim Noel. He really needs to have a website that I can link to.

Thou Shalt Mark (Some) Derivatives to Market

Statement of Financial Accounting Standards No. 133 requires derivative financial instruments within its scope to be measured at fair value. No exceptions. It sounds like a principled-based standard so long as everyone understands what a "derivative financial instrument" is. In fact, so many things can be seen to be derivatives (insurance contracts not excepted) that FAS 133 could have altered the entire landscape of accounting if the phrase "within its scope" were omitted from the previous sentence.

For example, ordering pizza for delivery has all the economic earmarks of a forward contract. I realize that I'm being a little bit silly here, but I hope you get my point: one of the FASB's objectives in promulgating FAS 133 was to curb abuses from reporting really important zero-value-at-inception financial contracts, like interest rate swaps with notional amounts in the billions of dollars, the same as a pizza delivery order. If the price of pizza changes before delivery takes place, that's not such a big deal unless you're a poor college student (not bad grades, no money … get it?). But if LIBOR declines by 10 basis points, you went from neutral to a big transfer of wealth on a $10 billion swap contract.

CDS's and FAS 133

Among other things, a derivative within the scope of FAS 133 has to have an "underlying" (para. 5a), which is defined in the glossary of the standard as:

"A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself." [bolded italics supplied]

Can you see that some of these "other variable[s]" may overlap with events that might otherwise be dealt with via insurance? The FASB certainly realized this when they specifically excluded certain types of insurance contracts from FAS 133 (para. 10c). With specific exceptions, however, financial guarantees (think CDS's) are within the scope of FAS 133 if they also meet derivative criteria set forth in paragraphs 5 – 9 of the Standard. I certainly don't want to criticize the FASB on this point, because I think that whether or not you call CDS's insurance or a derivative financial instrument, these are contracts that need to be marked to market. The FASB's intentions were, I believe, well-reasoned, but there is no avoiding rules-based accounting when you have a multi-attribute accounting model.  There is only one way to distinguish between which assets will be marked to market, and which will be valued otherwise: rules.   

Put This in Your Capital Adequacy Pipe and Smoke It!

The point is that even well-intentioned and well-crafted rules can come back to bite you.  One problem is an arcane practice in accounting dubbed "offsetting" by the cognoscenti. It happens all the time, not just involving financial instruments, and it's stealthy: gains and losses on disposals of long-lived assets (offsetting the cost and revenue components); operating lease accounting; pensions. There are all kinds of pronouncements, major and minor, that either explicitly or implicitly bless offsetting, but with derivatives it has come back to bite us real hard. So hard, that I think the practice of offsetting any asset with any liability should be declared streng verboten.

To see why it can be so problematic with derivatives, take a financial institution with $9 billion of liabilities covered by $10 billion of assets. Next, assume that said financial institution enters into a CDS (or any sort of derivative – I don't care) with a notional amount of $10 billion.

FAS 133 would yield a value of zero for this derivative investment at inception because the receivable leg of the 'insurance coverage' (or interest receivable in an interest rate swap) on the $10 billion would be exactly offset by the liability leg: i.e., the 'insurance premium' (or interest payable). Even though we have an accurate report of fair value, we have no idea of the exposure to risk of changes in fair value.  

For purpose of illustration, let's say the present values of those asset and liability legs are both $7 billion.  The balance sheet picture would be altered by reporting $16 billion in liabilities ($9 + $7) covered by only $17 billion in assets ($10 + $7), as opposed to offsetting the two and ending up with zero. You don't need Basel II to figure out what's going on here: FAS 133 does a good job of measuring the value of derivatives, but disclosures notwithstanding, provides nada to help understand the risk of future changes in value. 

Simple Would be Nice for Once

Congress just passed a bailout bill that went from three pages to over four hundred in about of week of deliberations. Requiring the asset and liability sides of derivatives to be separately measured and reported seems like an amazingly simple fix that could simplify regulation of the financial and insurance industries, reduce the need for the disclosures in financial statements written so as to discourage one from reading them, and help investors more easily assess risk.

What I am proposing is certainly not a panacea, because there is still much that is wrong with financial reporting—but do see my earlier post on wiping out securitization accounting (FAS 140). Nevertheless, I'm willing to bet that much of the accounting-driven financial engineering, excess investment and speculation with derivatives that has brought our economy to its current sorry state could be derailed: if we take the simple steps of eliminating offsetting in derivatives reporting, and wiping FAS 140 off the face of the earth.

Comments

[David Merkel]

If a credit derivative is insurance, then so is every event-driven contract. Yes, they are like insurance, but many contracts have insurance-like features to them. That doesn't make them insurance.

All of the insurance regulators deemed CDS to not be insurance. There is revisionist history going on now in the face of failure.

[Been there]

Hi. I’m a relatively new reader to your blog. Thanks, I enjoy reading your thoughts and ideas.

I’m a partner in a CPA firm and have been active in my state society in various ways, including as member of the Ethics Committee for the past few years- and- soon to be serving in a similar capacity at the AICPA level. I generally agree with most of what’s been written here, but unfortunately, I’m not in agreement with parts of this post.

FYI- you can find the 60 Minutes clip in question at the following website:

http://calculatedrisk.blogspot.com/

I watched the clip and thought it explained the environment and evolution of “credit default swaps” (CDS’s) in a straight forward fashion. While our small business clients haven’t utilized CDS’s, I’ve read a great deal about them. We also have various individual clients who hold senior level positions at large financial institutions- so I’m not completely clueless on this topic.

IMHO the problem with CDS’s, the problem was not poorly written financial reporting standards, but rather, it was due to legal and regulatory shortcomings. Credit default swaps are insurance (or should have been treated as such). There is a protection seller, a protection buyer and an underlying asset, just like with regular insurance. Also similar to insurance, the buyer pays the seller for protection against a future event that would negatively impact the value of the underlying asset.

Unfortunately, since the market for CDS’s was not regulated (and that seems to be the only significant difference it has with insurance products), protection sellers were not being monitored to verify that they had the financial wherewithal to pay potential future claims (as we’re now finding out the hard way). Nor were protection buyers (sans regulation) precluded from buying protection on underlying assets in which they had no direct financial interest (speculation). Some knowledgeable folks have noted how funny things would start to happen if people, in general, were allowed to buy insurance against the possibility of their neighbor’s house burning down.

To conclude, I don’t disagree with your comments about offsetting, they seem to make a great deal of since. Rather, the problem with writing financial reporting standards for CDS’s was flawed because the CDS market was a flawed unsustainable (non-viable) system, and even the most well written standards could not make up for that deficiency.

I continue to look forward to your comments.

[Jason]

Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and selling them as a credit default swaps (CDS). They do this in order to protect themselves by large payment to mortgage providers such as insurers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com

[Chris]

I'm not sure CDS are really a posterchild for this approach, which works rather better with conventional, non-contingent fixed-floating swaps (essentially returning them to their 1970s origins as "exchanges of borrowings").

A protection seller on the asset side has a fixed-term annuity under which payments are contingent on the reference credit not defaulting and on the liability side has a payment whose occurrence is contingent on default of the reference credit and whose amount is contingent on trading levels of reference credit debt at the time of default. (Given recent trends in the CDS market, I'm assuming cash settlement.)

How is it clearer to decouple those two payments rather than showing the MTM value of the package? Assuming the goal is to inform, rather than terrify and confuse, investors, how is showing a gross notional exposure without reference to the likelihood that payment will be made (or will cease) going to help? Or worse, would the liabilities be accounted for as for normal contingent liabilities so that investors would see no liability until some remoteness threshhold was crossed at which point they'd magically appear on the balance sheet?

I have my differences with mark-to-market (not least selectively booking one's credit spread blowing out as "gain"), but in this context I feel about MTM as Churchill felt about democracy.

[David]

>All of the insurance regulators deemed CDS to not be insurance. There is revisionist history going on now in the face of failure.

I disagree with the contention of revisionism - in fact, the CDS was designed to avoid regulation by the very way it was worded in its design, (by a team from JP Morgan).

http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking?gusrc=rss&feed=business