Bush and The Credit Bubble

By David Ignatius
Thursday, January 15, 2009; 4:03 PM

Editor's note: We bring you this column as part of our RePosted feature, where we dig through our archives to find opinion pieces that shed light on current events. This column was originally published on November 15, 2002.

LONDON -- -- What's the chance that credit markets could suffer the kind of bubble-bursting collapse that has afflicted stock markets around the world over the past two years?

Even if the likelihood of such a financial crisis is relatively small, that's the kind of question George W. Bush and his economic advisers should ponder as they think of how to use the mandate the president won in last week's midterm elections. For Bush now has the political power to fix important things that are wrong -- not just in Iraq but in the global economy.

Bush should start by finding a serious financial expert to succeed Harvey Pitt as chairman of the Securities and Exchange Commission. This administration has been shamefully weak in financial expertise, fielding what many analysts say is the weakest team at Treasury and the White House in decades. Now is the time to bolster the group with a heavyweight who would make clear to Wall Street and the world that there is a new financial sheriff in town.

Bush would be wise to send a born worrier to the SEC, as opposed to a cheerleader like Pitt or the sadly miscast William Webster, who this week withdrew under fire from his post as the administration's accounting watchdog. Ideally, Bush will replace Pitt with someone of the stature of former Treasury secretary Robert Rubin or former SEC chairman Arthur Levitt. Both were constant worriers while in office; they saw the clouds behind the silver lining of the 1990s boom, even if they didn't always act on their foreboding.

There's plenty for financial regulators to worry about these days, according to some new figures, prepared by the investment bank Morgan Stanley, that were presented here last week at the Oil & Money 2002 Conference sponsored by the Energy Intelligence Group and the International Herald Tribune.

The Morgan Stanley numbers suggest that there's far more weakness in credit markets than most policymakers recognize. Morgan Stanley Managing Director J. Robert Maguire noted that bond defaults in 2001 and 2002 have totaled over $180 billion, and that defaults in investment-grade bonds over the past two years have exceeded the cumulative total of the past 20 years. Credit quality has been dropping since 1995, as measured by Moody's ratio of credit downgrades to upgrades, Maguire said.

Overhanging the credit market, meanwhile, are severe weaknesses in the banking sectors of other key countries. "Japan, China and Germany -- that's the whole world," said another top executive with one of the globe's largest commercial and investment banks.

The scariest numbers involve those exotic financial instruments known as "credit derivatives," which have exploded in volume over the past several years, largely in response to the weakness in credit markets. According to Morgan Stanley, the value of these credit derivatives has grown from just $50 billion in December 1998 to an estimated $2.4 trillion in December 2002. The dot-com run-up was modest by comparison.

Because "derivatives" aren't well understood even by the people who buy and sell them, here's a brief explanation. They get their name from the fact that they are "derived" from an underlying financial asset. An example are "futures" options that allow investors to bet on whether the underlying common stocks will go up or down in price.

Today, investment banks can create derivatives that allow you to trade almost any slice of the global economy you want -- from the risk that a particular company will default on its bonds to the risk that interest rates will go up, down or sideways.

Credit swaps offer the appearance of stability, through a kind of ad-hoc insurance pool. They allow a company holding WorldCom debt to hedge some of its exposure by swapping its default risk with another company holding bonds from, say, France Telecom. The cost of the insurance is a tiny percentage of the nominal value of the losses that would be suffered if the bond or loan actually defaulted -- which sounds reassuring until you realize that sometimes many things go bad at once.

Interestingly, a major market for these credit-default swaps is financial institutions that hold bonds of clients that have become shaky. Rather than risk offending the client by selling the bonds, the financial institution will quietly buy a credit derivative.

It's a big, unregulated circus, and sensible analysts have been scared about the derivatives market for years. Investment guru Warren Buffett sounded the alarm in a long interview in Fortune during the mid '90s. And while he was Treasury secretary, Rubin often complained privately about the danger of a cascading failure in the derivatives market that could take down the rest of the financial system.

And yet, despite all this high-level worry, Washington has done little to address the problem. Wall Street banks headed off regulation by imposing new internal standards for risk management after the August 1998 financial crash. And politicians have had no stomach for challenging the financial institutions whose lobbyists effectively control the key congressional committees. Finally, regulating derivatives would be a bureaucratic nightmare, with the Fed, the Treasury, the SEC, the Commodity Futures Trading Commission and several other agencies all claiming pieces of the action.

So the derivatives bubble keeps growing. It's like Enron before the Enron scandal -- too complicated for anyone to understand, except the people who are profiting from it.

After this month's electoral triumphs, President Bush has the clout to impose real regulation on Wall Street and thereby restore confidence in the global financial system. But does he have the will?

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