The Shadow Economy

If it seems like the U.S. government has no idea how to solve the current economic crisis, there's a reason: they don't. But there's an important reason for this.

I've written about the massive market in Credit Default Swaps (see Financial Weapons of Mass Destruction) and the total lack of regulation as a result of the Commodity Futures Modernization Act of 2000 . This was the disastrous piece of legislation that McCain's economic advisor and (former) campaign co-chair, Sen. Phil Gramm, tacked on to an appropriations bill at the last minute (see Financial Weapons of Mass Destruction - Part 2).

Think of Credit Default Swaps (CDSs) as "insurance" for bonds issued by corporations, municipalities, and others. Bond owners buy swaps to protect themselves in case a company defaults on its debt or bond. The seller of these swaps takes on the risk of default. But unlike traditional "insurance," financial institutions can insure a bond even if the company issuing the bond doesn't know it.

The result of this lack of regulation has been speculation, market manipulation, and highly leveraged growth in the CDS market. It's been called a "Shadow Economy," and it's now a $58 trillion market that no one (including the U.S government) truly understands.

For example, one credit analyst estimates that there are about $400 billion in CDSs associated with the bankruptcy of investment bank, Lehman Brothers. These CDSs will be auctioned later today at about 10 cents on the dollar, but won't be settled for a couple of weeks.

The resulting $360 billion loss will be spread out among sellers of the CDSs, including banks, insurance companies, and other companies. Eventually the loss to sellers of CDSs will be out in the open, at least for the Lehman bankruptcy. This may cause other firms who sold Lehman CDS's to go into default, and if it does, those who sold CDSs on these companies will suffer losses, and so on.

The problem is that no one (including the U.S. government) knows exactly who has sold CDSs and on which companies. The result is a "credit freeze." Banks won't loan to each other or to businesses that need funds to continue operations, resulting in severe damage to the world economy. Since financial losses due to CDS exposure is not included in the $700+ bailout plan, recent actions by the government have had little effect.

Would Treasury Secretary Hank Paulson have made the decision to not bail out Lehman Brothers had he known the extent of CDS exposure other companies have? We may never know, and that's the problem with the lack of regulation and transparency in financial markets.

We will eventually work our way through this, but the next time a presidential candidate boasts that they are a "deregulator," remind them that sometimes regulation isn't such a bad thing.