As credit default swaps have come in and out of focus over the last year, I have been struck by the assumption that this product would of course continue to exist. I have trouble seeing their legitimate uses. In theory, they could allow banks to diversify and hedge credit risks better, but once risks rise beyond a modest level, CDS pricing looks to equity markets rather than debt for reference points, which begs the question of the validity of the risk methodology. And there were periods last year when high rated credits (and I mean decent ones, not ones suspected of being rating agency fictions) had their fundraising costs pushed to bizarrely high levels due to the arbitrage between cash bonds and CDS. In addition, the use of CDS had lead to a hollowing of credit risk assessment skills and a ballooning of speculation.
Last week, Chris Whalen of Institutional Risk Analytics argued forcefully against the continued existence of CDS, and said that European regulators might force a wind-down of the product:
We hear….that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter.
The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market, who were accustomed to receiving loans from one large French institution, which then stupidly converted the loans into equity. That’s right. This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure. Sound familiar? Yup, just like AIG.
Unlike the approach taken by Paulson and Geithner to bailout AIG and JPM (via the Bear Stearns rescue), however, the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments. The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments……if this unconfirmed report turns out the be true, then the beginning of the end of the CDS market as we have known it will be at hand….
In the event, as other governments around the world follow the very reasonable example of the EU, the OTC derivatives market will implode and these unfunded liabilities may very well force the nationalization/liquidation of C, JPM and AIG, among others. And in the event, Hank Paulson, Tim Geithner, Alan Greenspan, Ben Bernanke and other senior officials at the Fed in Washington are going to have a lot of explaining to do to the Congress, to a new President and the global financial community.
Tell us again, Chairman Greenspan and Chairman Bernanke, just why do you believe dealing in OTC derivatives and particularly CDS contracts are activities that are safe and sound for global banking institutions?
The Financial Times’ John Dizard examines the raison d’etre of CDS, finds it wanting, and calls for the market to be wound down.
From the Financial Times:
David Goldman, an old friend and credit strategist turned private investor, still goes through the credit run sheets from the dealers. “The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors. What are reported as trades are really ways to establish prices to satisfy the auditors.”
For several years, I have been among those calling for thoughtful, prudent, moderate steps for the reform of the credit default swaps market…
I was wrong. The global credit default swaps market should just be liquidated, the contracts allowed to expire and the booby traps defused….
Essentially, while the back office messes of the CDS market are being cleaned up, that leaves the question of why we need these things. We don’t. The outstanding credit default swaps should be offset against each other, where possible, and the rest allowed to run off or be paid out as defaults occur.
Some of the counterparties will default; those losses should be accepted as the price of another huge pile of wasted effort, along with cold war bomb shelters and media studies doctorates.
There are three possible defences for treating the CDS market as a going concern: its support for capital raising, its utility for price discovery and its role as a risk-management tool. All have melted like so many Lehman deal cubes in waste incinerators.
Consider capital raising. Writers of protection in the CDS market must now hold increasing amounts of cash as margin against the probability of default for the “reference entities” or borrowers they bet on. This has led to the sale of tens of billions, if not hundreds of billions, of dollars, euros and pounds worth of securities to raise that cash.
Or, in the case of banks, capital that could support new sound lending is tied up, waiting to fund payouts to the buyers of protection on a long line of prospective defaults.
Some of those buyers hold actual exposure in the form of bonds or supplier contracts; many more have just made side bets.
In the meantime, those forced sales and frozen balance sheets have helped ensure that the issuance of new shares and bonds trails off to a trickle.
That leads to the value of such swaps for price discovery. Bad joke. Price discovery is a useful economic function; that is the rationale for commodities markets. But CDS are derivative instruments, whose price is “discovered” these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books.
So CDS dealer sales of Citigroup equity through derivatives means higher equity volatility, then higher CDS spreads, leading to more margin calls, leading to more sales of bank stocks . . . This has become a system-wide tail-swallowing exercise in lunacy.
If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.
So, CDS as a risk-management tool. Let’s ignore the smoking Krakatoa of AIG Financial Products’ value at risk, and look at one facet of risk modelling in the market as a whole.
A credit default swap is a very different creature than the traded equity of a “reference entity”. CDS cover only one on-off risk, that is, default on reference obligations. So in the airless world of ideal models, CDS values are better considered as binomial probability distributions, rather than as the continuous probability distributions that are closer approximations of equity values.
Yes, there are problems with formalistic dependency on either family of distributions, but not as many as with using equity volatilities to price CDS.
When implied probability of default, and equity volatility, are relatively low, you can do some seemingly plausible regression analyses to fit the series. But at high levels of default risk and equity volatility, if you hedge the one with the other you get frantic, self-defeating activity.
Risk management with CDS was largely about what the bankers called “reg cap arb” (regulatory capital arbitrage), or making big spreads and bonuses by scamming the regulators whose employers, the taxpayers, now have the bill.
Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. “The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn’t work my whole life so some investment bank can take all our capital. Do I look like Hank Paulson?”
Let’s rebuild real capital markets.
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Regulating CDSs by making them illegitimate strikes me as a symptomatic remedy that does not address the root cause of the sickness. It could actually make things worse. Wipe off CDSs, introduce one more inefficiency and sure enough there will be another gig in town everyone will be excited about but hell bent to run amok.
The problem is that CDSs were mispriced. Not that they existed in the first place.
CDSs were mispriced because of badly designed and unstable banking regulations. Not because the CDS market was unregulated.
Capital adequacy regulations based on internal ratings were written precisely in such a way to allow to write off credit risk synthetically. Rating methodologies were precisely tuned so that a bank could buy CDS protection from a hedge fund by having them post 5% collateral
and still achieve substantial benefits in terms of capital charges.
How can more regulation about CDSs succeed to undo the damage done by the existing banking regulations? Let’s focus instead on restructuring capital adequacy rules.
Capital adequacy rules are designed in such a way to favour debt over equity. They make it much cheaper for banks to issue loans than to take equity position. They skew the natural risk profile and induce mispricings. They temper with the pricing balance between credit and equity. Why?
In addition to regulations, tax laws compound the very same unbalances manifold. They skew the credit-equity balance by making interest payments tax deductible while double taxing dividends. Tax laws are inducing grave inefficiencies. The need to be rewritten from the bottom up.
Having eliminated the distorting effect of bank regulation and of tax laws, CDSs will find their natural use and be highly beneficial as market completing instruments.
We don’t need more regulation. On the contrary, we need less, much less of it. It’s distorting regulation which brought us here in the first place. We need non-intrusive regulations that limit risk taking without messing up with delicate price balances.
Why is nobody talking up the obvious benefits of being able to short senior debt with spectacular inherent leverage?
Capital adequacy rules are designed in such a way to favour debt over equity. They make it much cheaper for banks to issue loans than to take equity position. They skew the natural risk profile and induce mispricings. They temper with the pricing balance between credit and equity. Why?
It’s a good question, irene, but I think there are good answers. Besides the relative volatility of earnings streams vs. debt repayment streams, I also suspect we’d generally prefer banks involve themselves in lending rather than ownership.
I agree that the tax laws are borked.
We don’t need more regulation. On the contrary, we need less, much less of it. It’s distorting regulation which brought us here in the first place. We need non-intrusive regulations that limit risk taking without messing up with delicate price balances.
Disagree. I don’t want excessive writing of insurance by anyone, whether a hedge fund, a bank, or the FDIC, that they can’t cover.
Quote:
” It’s a good question, irene, but I think there are good answers. Besides the relative volatility of earnings streams vs. debt repayment streams, I also suspect we’d generally prefer banks involve themselves in lending rather than ownership.”
Irene here.
That is indeed the standard argument. And look where it took us. Years of risk suppression and great moderation followed by a magnificent explosion. Why? Because of debt accumulation. The system as it is designed is inherently unstable.
Quote:
“Disagree. I don’t want excessive writing of insurance by anyone, whether a hedge fund, a bank, or the FDIC, that they can’t cover.”
Irene here.
I actually agree with this comment you are making. Regulation should limit risk taking in order to avoid insolvency and the associated systemic risks. But regulations should do so without perturbing prices across asset classes. This induces major macroeconomic effects on the capital allocation front that are by definition inefficiencies. And this is not just free market idealism. I think we see with this crisis that the greatest portion of erroneous capital allocations in the past were linked to the excessive use of debt and leverage.
That is indeed the standard argument. And look where it took us. Years of risk suppression and great moderation followed by a magnificent explosion. Why? Because of debt accumulation. The system as it is designed is inherently unstable.
Yep, I think you’re right. This is the fruit of repeated, forcible tweaking of aggregate demand and supply through use of government policy. Monetary and fiscal policy definitely work once, twice, or even three times. But every time it’s used in succession leaves a bigger pile of debt and brings us closer to the zero bound. My biggest worry in this environment is that we successfully foster one more disinflationary debt creation cycle, but I currently think too much damage has already been done for that to occur.
But regulations should do so without perturbing prices across asset classes.
I quoted too much of you on the disagree, and contemplated going back to fix that, but I’ve spammed the blog too much tonight already. We’re pretty close here. :D
The only point of contention I have is whether banks should be actively discouraged from equity stakes. I think they should, because we want banks to be involved primarily in lending of funds, as both their raison d’etre and core competency(yeah). We don’t want them to become real estate tycoons, nor do we want them to become stupid cowboys. Fractional reserve lending/borrowing is a much more grave necessary evil than it’s commonly seen to be.
This is why I like the bank-as-public-utility model. These are special entities for a reason, and don’t get me started on the bank charter pixie dust we’re spreading over insolvent companies. I just don’t believe such a model’s just not tenable in the real world, so we’ve got to come up with something else. Capital ratio weighting seems to me a reasonable way to do that.
Quote:
“We don’t want them to become real estate tycoons, nor do we want them to become stupid cowboys.”
Yes, but let’s talk about the unintended consequences. All the repossessions happening are indeed turning banks into real estate tycoons!
Equity based mortgages would have prevented that from happening. Think at a mortgage where the mortgagee buys shares in a real estate asset and the mortgageor buys the remaining shares. Then the mortgagee pays rent to the mortageor in proportion to the value of the collateral. The collateral is regularly marked to market. If the collateral appreciates the rent goes up. If it depreciates the rent comes down and ultimately less is owned. Bubbles would not form, negative equity would be impossible.
But you are right about the monetary implications of all this.
Monetary policies are the elephant in the room. By privileging debt over equity, central banks are also at the root of the problem.
Instead, they should have the credit-equity pricing balance as a leading policy criterion alongside with the control of the money supply and inflation metrics. They should do so by making equity investments along with banks, co-participating and risk sharing with banks. This way, along with a revision of banking regulations and tax laws, the credit equity balance would be fully restored.
I don’t think this is too far fetched. Actually, again talking about unintended consequences, the Fed balance sheet is now filling up in a rush with a glut of risky assets. Might have been wiser to do this in a more orderly manner over time.
All in the monies game are hunters and seek a kill to feed their gullet. All that is done to fix this bump in the road, will only incress the next bump.
Skippy
“Wipe off CDSs, introduce one more inefficiency and sure enough there will be another gig in town everyone will be excited about but hell bent to run amok.”
A purely speculative assumption with no examples (of the “efficiency” of CDS’s), so the rest of your hypothesis is meaningless. Meanwhile, we do have tangible evidence of the disaster of CDS’s without regulation; you are very, very wrong, Irene.
Nice point-counterpoint between Irene and NDK.
I don’t have nearly the financial acumen, but it strikes me that the fact that someone can invent a product (CDS) and that someone buys it, does not necessary mean that the product is safe, sound, or useful. And the problem isn’t the frauds so much as it is the people who sincerely believe.
The CDS is a risk generating machine by design. The only possible value is that parties can hedge their exposure by selling risk to a counterparty who is better able to accomodate that risk. The risk exposure by all parties must be transparent, reflected in the financial statements, so that investors and regulators can judge, and limit, how much risk any given party has taken on.
The problem is that is not how the CDS market is structured. The CDS market is a criminal enterprise in which both parties knowingly subverted the underlying principle of “fudiciary responsibility” and transparency, with the approval of regulators across the world. Both parties accepted far more risk than they could ever possibly cover and deliberately hid it to defraud investors for personal gain.
If some mutt holds up a 7-11 with a squirt gun for $25, there are 25 cops on the scene. If an investment bank steals $1 Trillion, there are no cops to be found.
The US is taking the wrong approach to the whole situation. There should be seizures and forced liquidations of these criminal enterprises, not kid glove bail outs. The problem is that the Fed, Treasury, SEC, and all other Bush administration regulators are accomplices.
Was at a dinner last night in Washington with David Wessel (WSJ, NPR), and asked him about what he sees in the CDS market. He is very well connected and does very good market reporting. However, his response was simply to define what the market was, and potential issues of what any market could be. So there seem to be deficits in the reporting on the CDS markets thus far. Considering he is the editor of the economy section of the WSJ, this is a bit disconcerting. He was lost on the name of Christopher Whalen, so his blog exposure seems relatively small, but he did bring up Brad DeLong. Thank you blogosphere.
Aren’t banks (C, AIG, JPMorgan) more CDS writers than buyers?
What’s the link between EU and other countries’ move to CDS moratorium and nationalization/liquidation of C, AIG, and JPM?
Others declare moratorium, so, they won’t pay when default event occurs, but it doesn’t increase bankruptcy risk of reference assets. No?
Wrote this back in September: Solution: Declare All Credit Default Swaps Null And Void
/quote/
At the same time:
* all financial exchanges and markets of the world close for a week
* CDS are declared null and void and new CDS creation is forbidden until new regulation is in place
* the publicly dealt financial entities have seven days to figure out and publicly restate the value of their liabilities and assets excluding all CDS
* a onetime windfall tax will be created that socializes overt advantages some entities will have from this
* the proceed of that tax shall be used to prop up the capital of the big losers in a program comparable to the Reconstruction Finance Corporation of 1932.
/endquote/
Allowing CDS is allowing your neighbors to take out fire insurance on your house. When ten neighbors each can make a million by burning down your house, how well would you sleep?
CDSs were mispriced because of badly designed and unstable banking regulations. Not because the CDS market was unregulated.
Or conversely: The players in the CDS market were too stupid to realize that their CDS were mispriced with respect to badly designed and unstable banking regulations.
“The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments…..”
I don’t believe it.
In the same article (no longer serviced by the link provided), IRA breathlessly tells us he tried (unsuccessfully!) to contact “EU officials” over the “weekend” to corroborate his story. Are we supposed to believe the IRA has a direct line to Trichet? If there are really large secret positions of French banks, which apparently are not marked to market, contrary to French banking regulations, then those in the know would number Very Few. And I doubt the IRA knows them.
YS:
I have advocated prohibiting the creation of new CDSs for a year. All trading for liquidation only.
Irene – very interesting thoughts. I’ve always fashioned myself as a libertarian (small “l” mostly), but have had a hard time finding or understanding a deregulation or laissez faire angle on the CDS problem. Have you written, or do you have links to things that you have read, that support the case you are making here.
I agree we don’t need more regulation. The only insurance policy that’s working is life insurance, because of the ultimate collateral I guess. So lets just regulate bankers who deal in the CDS market to put up their life as collateral. Problem solved.
b is right, just cxl all the CDS’s that are not genuine hedges and put the perps in jail and seize their assets.They knew damn well what they were doing and it wasn’t creating dynamic new products, for all to benefit from, it was lineing their pockets, as fast as they could and to hell with the consequences.
It’s either that or the whole system goes down.
As to all this guff about the “Net” being relatively small, from the DTCC, it may be, but the other problem is paying the margin calls. The margin calls have sent the dollar through the roof, killed the stock mkts and because the cash raised for margins is put into the safest place, sent treasury rates through the floor.
Commodity mkts have cxl’d deals many times, when the whole mkt was threatened, this time the whole financial world is threatened.
Just cancel all CDS. That way we don’t have to figure out which are “genuine hedges”. That will get rid of an estimated $50 trillion overhang.
Then when the volatility from that surprise dies down, figure out what to cancel next if necessary. CDO’s perhaps, we’ll see.
The important thing is: no more government support for existing contracts. They’ll turn us all into slaves for years. These FT articles and such are a distraction, wanting us to think about what to do going forward, rather than incisively fixing our current condition in a way the bankers might find quite uncomfortable.
The longer we delay fixing the problems with these crazed financial instruments the worse the pain and suffering throughout the world.
Unilateral canceling of CDS contracts would have severe effects on all swaps markets. Anything that trades under an ISDA agreement, mainly FX and Interest rate swaps, becomes very difficult to price and if you think we have credit problems now wait until the currency and rate markets shut down. May be a novel idea but how about no government intervention and let those that overextended themselves go down.
CDS as a product has functioned exactly as planned, that is as a risk transfer. It was mispriced but so was every other asset class. However, CDS has been a much better indicator of risk than the equity markets. CDS is as valid a product as any other derivative such as equity options, the only difference is CDS does not require adequate upfront margin (maintenance margin is required). Adequate margin and central clearing are all that is needed.
I agree they should nullify these contracts.When the value of the CDS settled on default is larger than the underlying pool of debt AND the CDS insurance was essentially unbacked with capital reserves it is not a stretch to call the CDS market fraudulent.
These ridiculous and reckless derivative insurance policies written without any capital reserves should be declared illegal if they were written without any honest attempt at reserves for potential losses.
if my neighbors in this building wrote 1000 insurance policies on my refrigerator breaking down the payout would be many times the value of the fridge when it eventually broke, causing some distortions in the building's finances.
furthermore, if the policies were payable in cookies I bake in my kitchen the demand for my cookies would shoot through the roof when the fridge dies since every contract would have to be settled in my cookies (money).
So far, payouts on lehman default protection insurance policies are nearly ten times it's recent market cap. Here are the links:
“Lehman's collapse wipes out a company that had a market value of $45.5 billion in February 2007 “
http://www.bloomberg.com/apps/news?pid=20601170&refer=home&sid=abVpg8xJDMWk
“The pay-outs on around $400bn of defaulted credit derivatives linked to Lehman Brothers are likely to be higher than anticipated”
http://www.ft.com/cms/s/0/25137702-972d-11dd-8cc4-000077b07658.html?nclick_check=1
the refrigerator example is exactly what is going on globally. the dollar has risen solely due to the short squeeze from the settling the fraudulent, unbacked insurance derivatives. Collapsing banks caused a liquidity black hole lets the fed print as it pleases with no immediate ramifications. the printed money is being used to take over corporate america at fire sale prices. this is how ben's helicopter works.
CDS were used as part of a package when offloading MBS….”In case of default on your deal, for a couple extra bucks you can insure against it with this CDS.”……Car salespersons are more honest. CDS is not technically insurance so it flies underneath the radar.
10 years to clear? If true, Euroland is not as bad off as I thought. See, they are trying to isolate the debt. Hope that’s all of it.
Here, use the Federal Reserve to sort out and pay down the outstanding debt while the Treasury starts a new bank with new currency. Congress redefines regulations (again). It’s going to come to that anyway, what the hell are they waiting for?
Allowing CDS is allowing your neighbors to take out fire insurance on your house. When ten neighbors each can make a million by burning down your house, how well would you sleep?
Does that mean we should ban put options as well?
Anonymous said
“Unilateral canceling of CDS contracts would have severe effects on all swaps markets. Anything that trades under an ISDA agreement, mainly FX and Interest rate swaps, becomes very difficult to price and if you think we have credit problems now wait until the currency and rate markets shut down.”
That’s bunkum both mkts worked before CDS’ were invented and would carry on just fine, if they didn’t exist.
CDS’ were purely a means to make massive upfront bonus’ and leave all the risk out there in the future and if it went wrong, so what, by then they’d be long gone, money in hand.
It was just the same as 10 yr naked option writeing and calling the premium yr profit and getting it put in yr bonus, dressed up under a different name. That everyone from the Board down was in on the scam, doesn’t make it any better.
They all also knew that if it went wrong, the problem would be so big, that the Taxpayer, via the Government would have to step in.
It was and is the biggest heist in History.
the most substantial reason for a cds intervention is the rise in Sovereign CDS. The US gov’t has moved on the gold market and they will eventually move on this.
Not sure I understand bunkum but you are right, fx & rate swaps can exist without CDS. I was talking about govt canceling standardized legally binding CDS contracts under ISDA because they dont like the outcome. Whether its CDS, Rates, or Fx they all trade under an ISDA swap agreement, if you cancel for one product it calls into question whether the others are binding. For example, FNA/FRE are the biggest counterparty in the rate swaps market, if a treasury auction fails and rates spike massively there could be large losses so does the govt not like that and cancel those contracts? How do you price for that, and how do you enter into new contracts with that uncertainty…essentially a shut down of the rates & fx swaps market.
As far as CDS being a large scam. The vast marjority of contracts have a five yr tenor with a duration little over 3yrs meaning most of CDS traded between '98 and '06 have fully or mostly realized actual PnL not fake accrual as you suggest. The financial system is not in the predicament it is in because of CDS. The fear and dire warnings of ruin by CDS are vastly overstated. Yes, some firms went to excess and the mistake is not allowing them to fail.
a,
I have mere hedge fund buddies who speak to Trichet on a regular basis. Whalen has made it his business to cultivate a lot of regulatory contacts. And he did not say he was trying to reach Trichet. If the problem his source said was afoot, there would probably be a lot of mid-level bureaucrats who are aware of it. “Official” is a bit pompous, but it does cover a multitude of sins.
i think whalen is really onto something in recognizing many CDS are not being brought to DTCC cash settlement because some euro banks who sold them cannot afford to pay, a la AIG. and further that the attempt to fund these instruments is becoming a bottomless liquidity sink as credit spreads skyrocket. a moratorium may be the only way out.
but i would like someone to address the effect of a moratorium on synthetic CDOs. it seems to me that a fiat cancellation would unilaterally destroy an asset class that is on the books of every pension fund, insurance company and bank — and in size sufficient to force the financial system nationalization that whalen is also predicting.
In other posts I wondered about the involvement of European banks in this financial crisis. Too much silence and little disclosure from highly leveraged banks on this continent. It could well be that primary banking institutions are working on that…
Leave the CDO’s alone, it’s the CDS’ that are the problem, as the worse they trade the more strain they put into the system, which then feeds on itself and as most are just punts, only some punters would lose potential profits.
Take out the CDS’ and the system would have a massive boost and CDO’s and the like would recover, as would so many other values.
kridkrid writes:
Irene – very interesting thoughts. I’ve always fashioned myself as a libertarian (small “l” mostly), but have had a hard time finding or understanding a deregulation or laissez faire angle on the CDS problem. Have you written, or do you have links to things that you have read, that support the case you are making here.
Irene here.
kridkrid, I didn’t write this down, it’s more like a stream of consciousness I am venting here at this point. I frankly find the press coverage of CDS markets rather shortsighted.
The case of principle I am making is that government intervention [be it through regulation, taxation or monetary policy] so far has not been market neutral and it has caused massive shifts in prices. Price shifts give rise to misallocation of resources almost by definition. In particular, favoring debt over equity assets is one of the root causes of our current predicament.
I don’t see anything wrong in trading any derivative payoff at all. Market completion as a rule is beneficial. What is wrong is price manipulation.
Regarding CDSs, one of their natural functions is to be lightweight vehicles for price discovery. Notwithstanding the mispricings, they have been and still are a much better indicators of credit worthiness than credit ratings themselves.
There is also a good reason why it makes a lot of sense to trade CDSs while insurance without vested interest is forbidden and rightly so. The reason is that the materiality condition in the case of CDSs is directly linked to asset prices, while this is not the case for insurance.
Hurricane insurance without vested interest amounts to proliferation of risk through betting. If such insurance policies were traded, they would not in any way lessen the damage that hurricanes causes to those who actually carry a vested interest. On the contrary, it would make insurance companies less credit worthy.
Credit insurance between parties who do not owe the reference name instead does lessen the effect of credit losses to the holders of cash assets. In fact, in case a default occurs, in order to claim a payment the protection buyer needs to procure a defaulted bond to deliver. This creates demand for defaulted bonds and raises recovery rates. As a consequence, in the presence of a synthetic CDS market, credit risk distributes better across the system, recovery rates are higher, yields on cash bonds are lower.
If a government had to unilaterally nullify CDS protection contracts, the biggest loosers would be the holders of the underlying cash assets which would find themselves in a situation of having to bear the full impact of much lower recovery rates and no demand for their defaulted assets.
Nullifying all CDS contracts would have atrocious consequences for many reasons.
(i) this action would establish a precedent and would have to be priced in for all contracts across all other asset classes;
(ii) because of the indirect effects of the CDS market, it would amount to a major and unquantifiable transfer of wealth for which no compensation plan can be devised;
(iii) it would severely suppress recovery rates;
(iv) because of the effect on recovery rates, it would lead to immediate repricing of all cash assets that would depreciate severely, leading to concentration of risk among the subset of investors that tend to be cash bond holders.
Freezing CDS markets for one year would also make it harder to unwind CDS positions by entering into offsetting swaps. And what about hedging of synthetics CDOs? That’s a big market which depends on dynamic hedging strategies based on CDSs. Also cash CDO managers find CDSs very convenient for hedging purposes, allowing them to write off credit risk upon credit degradation if they cannot afford to take the full hit of default losses.
Now, I realize someone may argue that intervention in debt markets is needed at this point. But I disagree with the idea of intervening only on the synthetic side without touching cash assets.
The intervention that at this point is needed cannot be perfectly market neutral as it should be meant to rebalance decades of mispricings of debt assets versus equity assets. So I am willing in this occasion to make an exception to my natural liberarian bent. But at the very least, intervention should be gauged to have a uniform impact across all debt assets. Government interventions [if they really need to be carried out] must be systemic and broad based. Governments cannot cherry pick, give at this and take from that.
So let’s ask, what is the main issue at this point? The problem is that the greatest majority of market participants has a balance sheet which is way heavier on the liabilities side than on the asset side. So let’s knock down the nominal of all debt assets, bonds, CDSs, swaps, treasury bonds, by a uniform 25% across the board. If 25% is not a good number, let’s look at 10%, 40%, but let’s be even handed across the board and get over it. Let’s call it Uncle Sam global credit restructuring and get through it. After that, let’s reform regulations, tax laws and monetary policies to set in stone that all of them need to be market neutral across the debt-equity asset spectrum. And hopefully we should have a more balanced system.
Irene wrote: ” because of the indirect effects of the CDS market, it would amount to a major and unquantifiable transfer of wealth for which no compensation plan can be devised;”
A little late to start worrying about major, unquantifiable wealth transfers.
And if we’re going to worry about it, why worry about CDS market participants, rather than, say, taxpayers?
“It was just the same as 10 yr naked option writeing and calling the premium yr profit and getting it put in yr bonus, dressed up under a different name. That everyone from the Board down was in on the scam, doesn’t make it any better.”
Except there’s a limit to exposure on writing puts that go ITM… the strike price X the numbers of shares. The downside risk on a CDS contract is unbounded. To think that these things can ever be “priced correctly” is an epistemic farse. At what level can you possibily price a derivitive contract that has an unbounded loss potential?
It’s an issue of the rule of law. These are not legitimate contracts. If there exists a scenario where you cannot possibly hold true to a contract, the contract is invalid. Very simple. It’s not in the best interest of the US to enforce invalid contracts between private individuals.
Irene,
the finances were functioning very well without the current-size CDS market for decades, and with far more regulations. Your argument does not stand scrutiny.
The explosion of the number of derivative contracts written coincided exactly with the rounds of deregulation that started in the 80s.
I think I have a couple kindred Anonymous spirits here but I’ll say it again in the spirit of the argument.
It doesn’t matter what we do going forward, not much anyway. Not nearly as much as what we do about the $50 trillion (estimated) existing overhang of CDS. Divided by the number of US citizens, that is over $160,000 for every man woman, child and baby. $500,000 for a family of three.
I will not pay it. It is a matter of principle. I will not pay it.
Now then the choices are to declare the contracts void (Obama announces an Executive Order on Day 1 in office, for example), or to let the longs collect $50 trillion from the shorts.
Needless to say there is not $50 trillion available to pay. Lots of banks will implode. That’s a reasonable outcome.
Or cancel the contracts. That’s another reasonable outcome to this situation.
The third option that governments and banks are probably trying to bring about, making me pay “my share” of it, is not a reasonable outcome. And one way or another, it won’t happen.
I recommend that the policymakers understand that we are onto the situation, and they should find an approach that does not involve taxpayers bailing out participants in the CDS market.
I read the Whalen article on CDS. My takeaway was this: if we terminate the CDS market, we stand a real chance of rebuilding some confidence in the financial markets.
That confidence will be further bolstered once home prices stop deflating. All this will take some time, the latter I can be patient with, but the CDS mkt should go now.
Someone earlier in the thread asked if we should ban put options as well.
The basic idea behind options is that they are a zero sum game. The seller of options has margin requirements; he must back any potential losses with cash (in the case of puts) or the underlying assets (in the case of calls). This isn’t the same as the writing of naked CDS’s with unlimited losses.
As long as margin requirements are adhered to, there can’t be a situation where option buyers purchase ‘insurance’ that is worth more money and/or assets than are available in the world.
‘Bin Laden puts’ aren’t a problem as long as they can be traced back to a specific buyer. That’s the real issue, people being allowed to dart in from the shadows, steal money from the public markets, and dash back before anyone can identify them. I always figured the buyers of the puts on airlines days before the 9/11 attacks were politically connected and that’s why nothing came of it. The #1 terrorists and criminals are always on a government payroll, don’t forget that.
Anon @ 10:01
“the real issue… people being allowed to dart in from the shadows … and steal money before anyone can identify them…”
Let me improve on that statement by saying that another real issue is the thieves who steal in broad daylight with full accountability, and then argue that they weren’t stealing, they were “hedging” or “innovating”.
And again, this type of thief operates with the full knowledge that the government has his back.
“An 18th century speculator buys insurance on a British cargo ship in which he has no interest. The
speculator then sends a message to his cousin in Paris, asking the cousin to inform the French fleet of the ship’s schedule. A French frigate uses the information to sink the British vessel. The speculator collects on his
insurance contract.”
http://rolfe.winkler.googlepages.com/Kimball-Stanley.pdf
"The real question is, Are there appropriate firewalls between trading desks and captive servicing businesses," said Josh Rosner, a managing director at Graham Fisher & Co., an investment research firm in New York."
http://www.bloomberg.com/apps/news?pid=20601087&sid=aKNiPlPCy_g&refer=home
Given frenzy of acquiring mortgage servicing companies and concurrent epidemic mortgage servicing fraud, above quote certainly gives pause. How convenient to have subsidiary servicers busily manufacturing bogus defaults while CDS profits soar.
Remember Poindexter’s brilliant idea for terrorism futures? You could buy Dirty Nuke In Downtown NYC May ’09 contracts and regulators, monitoring the prices of various terrorist events, would use the market information to plan counterterrorist measures.
That was a little too hard for even the Bush admin to swallow… if only Poindexter had a background in finance we’d be getting daily updates from MSNBC on why it’s so critically important that AIG be able to make good on its Terrorism Mass Casualty Swaps.
Government has only blunt tools, and regulating CDS’ out of existence seems plausable. A nuanced view is possible, but these are not nuanced times.
If the primary use of CDS is for leverage and dissemble data, then they are goners. If they have greater value as a form of risk management a justification will be made for keeping them.
Unfortunately for them, they were a primary transmission method for the crisis, and are largely seem as an amplifier of systemic risk.
We need a simple transparent system, and this is why they are on the chopping block.
http://www.ftc.gov/bcp/cases/fairbanks/index.shtm
http://www.ftc.gov/opa/2008/09/emc.shtm
Wasn’t lucrative subprime shorting just insider trading taken to previously unknown and egregious extremes? I-banks know what their servicers are doing. These bets were rigged, fraudulently disenfranchising homeowners for their own self enrichment.
Alarms should have been going off everywhere when a normal risk management tool became such a speculative, no skin in the game sure pathway to riches.
Kudos to Brooksley Born ! At least some of these sad examples of humanity hear you NOW !
Anon @ 11:31
Read Portfolio’s recent article, The End of Wall Street. I had always wondered how the super smart guys in Wall Street who timed the collapse of the subprime market pulled it off, and the article makes it clear: they felt, just like everyone else with a lick of common sense in 2005, certain that there was a housing bubble.
And then investment banks like Goldman Sachs that were selling MBS’s approached them directly and begged them to short their product.
So they weren’t that smart after all. They got in on the short-MBS market before anyone else because they were in Wall Street, running hedge funds, and they had enough common sense to run with a huge opportunity even if they didn’t understand what they were really doing.
Once they began to understand what was going on (read the article, it’s shocking), some of them began to ring the alarm bells but by then everyone was completely swept up in the mania. You always get punished for pointing out that people are being foolish, might as well not even bother, instead try to profit from them instead.
No insider trading involved. The guys who created the MBS’s and CDO’s and CDS’s… well, that’s a different story.
Don’t close the cds casino down immediately – tax any winnings heavily.
Have the government capture most of the speculative revenue generated in the credit default swap (CDS) market through a sort of gambling tax charged on the winnings when transactions are settled.
The beauty of taxing away most of the winnings is that it only hits capital employed in speculation (rather than supporting genuine economic activity) and provided by players who are too often able to avoid paying taxes anyway.
This mechanism would move the government into the role of the ‘house’ in the derivatives casino, instead of being the punter, as it has been to date.
The key point is that this gain or loss is purely speculative, and the gain equivalent to gambling revenue.
Moreover, purchasers of speculative credit default insurance rig the game – they may see a shift in the odds in their favor – as more insurance is purchased, it becomes harder for companies to raise capital or borrow fresh money, and more likely to default.
Credit default swaps are a zero sum game, but the failure of a single counterparty could set off an unholy chain reaction of enormous consequence.
Very basically, the government could impose a very high tax rate on the speculative gains made by the purchasers of credit default swaps when companies actually default.
There would be several advantages:
1. The government would have a new if sporadic source of revenue which would not come from the “real” economy. This is capital that is tied up in speculative instruments, so taxing it would be unlikely to affect the ‘real’ economy, except positively.
In itself, this tax might help stabilize the system because of the general knowledge that if companies are to fail the drain on societal resources won’t be so high.
2. The people who bought (or buy) credit default swaps to insure their actual risks would not be taxed, as they would exchange $100 of (say) Lehman exposure for $100 in cash. This would preserve the product for its legitimate purpose and eliminate the casino.
• This would also take some pressure off companies because the number of players who would be willing to bet against a company (buy credit insurance against default) for only a small net gain would not be very many, allowing the companies’ creditworthiness to be determined by more normal market forces, such as suppliers and banks rather than financial speculators.
• Corporate bond yields might narrow as people try to buy the outstanding paper for less than the cost of the tax. There must be an optimum tax rate for this.
3. If a seller of credit default insurance was “too big to fail’ (AIG) or, as in the case of Bear Stearns, too interconnected to fail because of its credit default swap obligations, the government would obtain a vast amount of the resources for the rescue from the tax on the winners – rescues based on such payments would be a lot cheaper for the taxpayer.
4. If the losing institution was not ‘too big to fail’ the taxes would be simply net revenue for the government to use for stimulus or to reduce its own deficit.
5. It would essentially cut back the unknown taxpayer exposure to the rest of AIG’s credit default swap book, as well as those in the as yet un-rescued monoline insurance companies and some of the banks.
on “support for capital raising”
1. I go long some really crappy debt
2. I buy a CDS on it
If the cost of the CDS is lower than the spread on the crappy debt, I get a risk-free premium to treasuries. Therefore I can go out an buy loads more crappy debt i.e. raise capital for causes that really don’t deserve it, and take zero risk for the extra income.
In actual fact, I do have counterparty risk on the CDS, but I probably ignored that. Also, if I’m being pedantic, it seems that Treasuries aren’t risk-free any more either.
Thomas
The basic idea behind options is that they are a zero sum game. The seller of options has margin requirements; he must back any potential losses with cash (in the case of puts) or the underlying assets (in the case of calls). This isn’t the same as the writing of naked CDS’s with unlimited losses. As long as margin requirements are adhered to, there can’t be a situation where option buyers purchase ‘insurance’ that is worth more money and/or assets than are available in the world.
How is CDS unlimited losses? Seems to me, the max loss is the face value of the reference bond. Once a bond has a “credit event”, the seller has to pay face value for bond. You can simulate the purchase of CDS protection by buying a expiring put option every month.
But I do agree that CDS sellers should post more collateral. That’s the root of this problem. Higher collateral will detract the sellers from taking too much risk, which I think is at the root of the CDS problem.
“Don’t hate the player, hate the game.”
From what I understand “credit default swaps” otherwise known as CDS contracts have been widely used by hedge funds and others to speculate on the viability of banks, other financial institutions such as brokerage houses, and auto manufactures.
These bets on various companies were not made on any regulated exchange and no one knows the exact size of the problem; I’ve heard it said that “Credit default swaps” are similar to homeowners insurance, because the buyer pays a premium and, in return, receives a sum of money if a specified event occurs. However, unlike homeowners insurance the buyer of a CDS contract does not need to own the underlying security, in fact the buyer does not even have to suffer a loss from the default event.
So I was wondering why just nullify the value of CDS contract held by a bank or hedge fund that does not own the underlying security? I’d think a well crafted tax rule would remove much of the uncertainty in the market and not penalize owners of of CDS contracts who own the underlying security much like a laser guided bomb can destroy a bunker without much collateral damage.
I suspect CDS were the root cause of the AGI take over by the federal
government and its seems there will be other big companies that might
soon fail like Glencore “A Swiss giant on the edge”
http://www.creditwritedowns.com/2008/11/glencore-swiss-giant-on-edge….
I’m not a trained lawyer or a formally educated economist so I’m just thinking out loud what obstacles and downsides do ya all think would there be to using tax laws to help out the auto and banking industries and indirectly regulate an unregulated market in “Credit default swaps?”