ISDA and Credit Default Swaps

Back in February 2008 I asked: "Have the world's major banks fallen into the very trap that sank Enron?" I was referring to Enron's use of super-complicated financial transactions. Sunday CBS' Sixty Minutes broadcast an interesting investigation into the roots of the financial crisis. Referring to the means by which high-risk home mortgages became popularly traded, one expert interviewed remarked:

"The instruments themselves are at the heart of this mess."

However, today the explosive problem lies down the transaction chain from those overly-complicated instruments. It is Credit Default Swaps -- which banks bought as an unregulated and under-financed form of insurance contract against purchases of dodgy mortgage-backed securities -- that have brought the international financial system to the brink of catastrophic. So Credit Default Swaps served both as investments and as a means to insure purchases of mortgages. These are not backed up as insurance policies are by large reserves of cash.

And their popularity has skyrocketed recently. A table provided by the Bank for International Settlements shows that the Credit Default Swaps grew from only $13 trillion in December 2005 to $58 trillion in December 2008 (to put this figure in perspective, estimated world GDP for 2007 was $65 trillion). CDS were sold by all the firms that have collapsed or been bought out: Lehman, Bear Stearns, etc. This "shadow market" is unregulated.


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What is ISDA?

According to the website of ISDA (International Swaps and Derivatives Organization) the value of these ranged over the past year from $62-56 trillion dollars. According to the ISDA website:

ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 850 member institutions from 56 countries on six continents.

It's mission includes "efforts to identify and reduce the sources of risk in the derivatives and risk management business," "developing the ISDA Master Agreement," and "promoting sound risk management practices." It looks as if they should have tried harder.

But it would not have helped. ISDA itself had been a source of the problem. This 1999 ISDA press release statement which I dug up is particularly revealing:

"We applaud the unanimous recommendation of the President's Working Group on Financial Markets that Congress enact legislation to provide legal certainty for swaps, hybrid instruments, Treasury amendment products and other over-the-counter products, and that Congress act to remove barriers to financial innovation."

ISDA got what it wanted.
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* ISDA news release of Wednesday, September 24, 2008