Greenspan wrong; credit-default traders disinfect market

Wall Street_Henr
Specialist Arthur Andrews, foreground, works at his post on the floor of the New York Stock Exchange. (AP Photo/Richard Drew)

  Here's Alan Greenspan, in a 2002 speech he gave to at least two different national audiences, on the alleged self-balancing properties of credit-default swaps, the privately-traded bond insurance contracts that brought down American International Group and threaten to stall the financial markets:

  "As the market for credit default swaps expands and deepens, the collective knowledge held by market participants is exactly reflected in the prices of these derivative instruments. They offer significant supplementary information about credit risk to a bank's loan officer, for example, who heretofore had to rely mainly on in-house credit analysis. To be sure, loan officers have always looked to the market prices of the stocks and bonds of a potential borrower for guidance, but none directly answered the key question for any prospective loan: What is the probable net loss in a given time frame? Credit default swaps, of course, do just that, and presumably in the process embody all relevant market prices of the financial instruments issued by potential borrowers."

  Credit-default swaps were made possible, private, and common by financial deregulation under Greenspan, the Democratic Clinton administration, and the Republican-led U.S. Senate in the late 1990s. The business grew into a $50 trillion monster market, much more valuable on paper than the bond market it's supposed to ensure.

  But the swaps market was only as good as the information traders had on the value of the bonds and related assets. As debt markets ground to a halt this year, the swaps' private nature, their off-the-market opacity, came to be seen, no longer as an example of unfettered free markets, but as a hazard to free markets, which depend on accurate information, as PhillyDeals has noted here (last item, from SEC chairman Christopher Cox) and here (last item). 

  New Development: Investors and traders, prodded by the post-Greenspan Federal Reserve and other government agencies, are belatedly organizing a credit-default swap clearinghouse that will make plain what Greenspan and his allies left concealed: the value, ownership and risk profiles of credit default swaps and the securities they're tied to. Bloomberg story here.