Will more transparency fix credit default swaps?

Quick: Give me a definition of credit default swaps, and do it in a way that an idiot like me can understand.

Can't do it, can you?

Don't worry -- you're not alone. The notoriously complex investment vehicles remain a mystery to many folks in the financial world, but regulators are trying change that.

The SEC wants to make credit default swaps more transparent by running the previously unregulated investments through a centralized clearinghouse. That role will be played by the British firm LCH.Clearnet Ltd. SEC Chairman Christopher Cox called the move "an important step in our efforts to add transparency and structure to the opaque and unregulated multi-trillion-dollar credit default swaps market."

The swaps are being blamed by many for causing financial havok throughout the world. But how?

The Associated Press describes credit default swaps as "commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults. ... They played a prominent role in the credit crisis that brought the downfall of Lehman Brothers Holdings Inc., a government rescue plan for giant insurer (AIG), and Merrill Lynch & Co. selling itself to Bank of America Corp."

OK, that's clear as mud.

Let's try this National Public Radio podcast instead. Alex Blumberg offers this explanation:

"Let's say there's a guy named Frank and he has a life insurance policy. When he dies, the beneficiary gets a million dollars. Now imagine a whole bunch of other people saying, 'I want a million dollars if he dies, too.' And so they take out life insurance policies on Frank. Now imagine Frank dies, and all those people bought their policies from the same company. That company, more or less, was AIG."

So the swaps were intended to act as insurance against the default of financial instruments. Somewhere along the way, though, they morphed into a form of speculation. That, says Blumberg, is where the trouble began.

The podcast casts suspicion directly on the lack of transparency surrounding the swaps. One expert told Blumberg that everything would have been fine "if everyone in the chain knew the financial stability of everyone else in the chain. The problem, however, is that every deal is private, so they don't know. ... This lack of information is what has been causing huge problems."

Enter the SEC and its centralized clearinghouse. And with Cox admitting that "more needs to be done in this area legislatively," there likely will be even more regulation down the road.

It's just one more lesson that we've learned too late.

Comments

[Adrienne]

Here's an easy way to understand credit swaps: SCAM

Actually you did a great job on this, putting an intentionally complicated instrument into layman's terms, or at least breaking it down to a point anyone could sort of understand.

Great post and thanks for the heads up on the NPR podcast!

Adrienne

[Bill Sheridan]

Thanks, Adrienne! "Planet Money" is quickly becoming my new favorite podcast. You know this stuff is confusing when even the layman's explanations leave you scratching your head.