Dinallo on Credit Default Swaps: “There Was No ‘There’ There”

[WSJ Law Blog]

Last night’s 60 Minutes feature on the credit derivatives market was plastered with lawyers: Frank Partnoy, a law prof at the University of San Diego; Harvey Goldschmid, a Columbia law prof and the former commissioner of the SEC; and Law Blog regular Eric Dinallo, the insurance superintendent for New York.

As expected, these three bright legal minds helped shine some light on the confusing CDS market and how it contributed to Wall Street’s meltdown. Here are some highlights from the show:

They’re essentially side bets:



“A derivative is a financial instrument whose value is based on something else,” explained Partnoy. “It’s basically a side bet.” Partnoy said you can liken a derivative to a sports bet. “We don’t own the teams,” he said. “But we have a bet based on the outcome. And a lot of derivatives are bets based on the outcome of games of a sort. Not football games, but games in the markets,” such as the performance of the mortgage market or whether interest rates were going to go up or down.

No ‘there’ there:



Dinallo said that credit default swaps — essentially private insurance contracts that paid off if the underlying investment went bad — were totally unregulated, meaning that the banks and investment houses that sold them didn’t have to set aside any money to cover potential losses. “As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps,” he said. “And there was no ‘there’ there. There was no money behind the commitments.”

It was legalized gambling: 100 years ago it was illegal gambling, explained Dinallo. And then Congress made it legal gambling with the Commodity Futures Modernization Act of 2000, which removed derivatives and credit default swaps from federal oversight and preempted the states from enforcing existing gambling and bucket shop laws against Wall Street.



A vague understanding: When 60 Minutes’ Steve Kroft asked Goldschmid whether Wall Street honchos understood the risks, he said: “No. My impression is to the contrary, that even at senior levels they only vaguely understood the risks . . .And when it tumbled, there was some genuine surprise not only at the board level where there wasn’t enough oversight but at senior management level.”

[amoureux]

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