Being blamed for such things as the 2008 financial crisis, exacerbating the Greek credit crisis, and the culprit behind the recently reported $2 billion JPMorgan Chase & Co. (NYSE:JPM) loss hasn’t helped credit default swaps (CDS) in gaining good respect (my guess is that there’s a lot of respect out of fear). Although, at times, it may be true that CDS can be viewed – probably incorrectly – as weapons of mass destruction, this article addresses the question: Besides the obvious benefit to risk, money, and speculative mangers, are CDS beneficial to Main Street and the economy?
The question matters in that there appears to be growing interest in greater regulation of these products, and, as almost everyone knows, regulation disrupts markets and in almost all cases, distorts and slows economic activity. A full cost and benefit analysis of potential regulations on CDS is for another day – this article simply shows the correlation of CDS growth with overall economic activity and discusses two potential negative effects of regulation.
In theory it’s a simple question of economic science – we measure the correlation of CDS with overall economic activity and adjust for compounding factors that influence economic growth – and viola, the remainder is the benefit (or cost) of CDS. Although the methodology (“correlation is not necessarily causation”) has its limitations, this article addresses two adverse effects that regulation (or elimination of certain aspects of CDS) could have on the overall economy: first, the negative employment effect on the financial industry and the multiplier effects on connected industries; and second, the effect on bond markets.
Credit default swaps were invented in the late 1990s and grew in popularity relatively quickly, from about $900 billion in value in 2001 to about $62 trillion in 2007 and now stands at about $30 trillion. Over the same horizon, employment in the credit intermediation and investments grew by around 7%. Doing some simple econometrics, the numbers come out that about 1 additional employee is associated with about $340 million in CDS; thus, about 90,000 people have jobs because of the invention of CDS, down from about 186,000 at its peak.
How does this employment flow through the economy? It depends, of course, on the nature and form of any potential controlling regulation. Let’s assume a regulation was imposed to outlaw synthetic CDS. Additionally, let’s assume the outlawing of synthetic CDS would directly decrease employment by 20,000 (about $1.3 billion in wages). The indirect and induced effects from the decrease in employment and wages indicates a total of 185,000 jobs would be lost (an entire month’s BLS employment figure), or a total of about $10 billion in labor income. It’s not made up – CDS trading matters.
The second effect is on bond market trading. Overall, CDS trading continues to lower the cost of issuing bonds, as well as increases liquidity in the bond market. The positive effects of CDS are greater for smaller, less established firms in terms of savings from borrowing costs. Assume that CDS regulation increased borrowing costs on the small firms by enough to reduce capital expenditures by small businesses by say $10 billion. This direct regulatory tax of $10 billion equates to an estimated decrease of 440,000 in employment (indirect and induced).
Overall, control freak types that want regulators to sooth their anxieties over any potential CDS-induced economic cycle should consider these two factors, and many others, before they really decide that they want regulators rubbing their back and telling them that everything is going to be ok.