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Guarantees Are the Real Derivatives Crisis

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It won't be long before the marketplace begins to undertake a full accounting of public sector guarantees and commitments.

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"Guarantees Encouraged Excessive Risk Taking."

This statement was a throwaway line in a story I read the other day in the Wall Street Journal. But it is a sentence that I keep coming back to.

You see, to listen to the financial pundits, derivatives (particularly credit derivatives) and securitization were the key toxins that triggered the banking crisis. And while in some respects this is true, I would offer that in many ways both are really derivatives of something far more troubling, and that is financial guarantees.

Going way back in time, financial guarantees originated to support trade. Bank letters of credit, the earliest form of financial guarantee, enabled unknown buyers to journey well beyond their local markets and successfully return with goods because a foreign seller was sufficiently comfortable with the credit risk of the buyer's bank. (And mechanically, the bank paid the seller and the buyer reimbursed the bank. I like to think of it as The Silk Route American Express Card. And to be clear, the underlying principle of today's ubiquitous global credit card industry is rooted in these now "Jurassic" letters of credit).

But as simple as these early transactions were, they highlight four key elements that have relevance today:

First, in many respects, the sellers really didn't care who the buyer was or what the buyer's credit risk was. The sellers had a guarantee from someone they thought was sufficiently creditworthy to execute a transaction.

Second, and a consequence of the first, the guarantor's reputation mattered most. And over time savvy sellers demanded letters of credit of only the "best" banks.

Third, the only person truly familiar with the credit risk of the buyer was the buyer's bank. And in this regard, there was enormous asymmetry of information. The bank knew everything. The marketplace knew nothing.

Finally, the banks were entwined in the real economy and arguably, the financial stability of the banks determined the financial stability of the economy. No banks. No trade.

Put differently: Guarantees encouraged excessive risk taking, but the economic benefits were well worth it. Trade flourished.

Needless to say, when you fast forward to today's economies, guarantees are everywhere. FDIC insurance supports American bank deposits. EXIM guarantees support the sale of airplanes to developing nations. Visa (V), Mastercard (MA), American Express (AXP), and Discover (DFS) guarantee millions of consumer payments to merchants every day. Fannie Mae (FNM) and Freddie Mac (FRE) guarantee trillions of dollars of mortgage-backed securities. And rumor has it that very soon a German-owned development bank (KfW) (whose debt is guaranteed by the German government) will guarantee bonds issued by Greek banks to German banks whose deposits are guaranteed by Germany's private FDIC-like deposit insurance plan.
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Position in SPY options, SH, SRS and JPM
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