(Yves should be back – and so the site should return to normal – tomorrow. If all goes according to plan, you’ll be hearing a lot less from me for a week or so. Yves’ book – Econned – will be quite valuable, and so well worth the wait. )
By George Washington of Washington’s Blog.
I have repeatedly argued that over-the-counter credit default swaps (CDS) – or at least at least “naked” CDS – should be banned (“naked CDS” is the term I coined to describe the situation where the buyer is not the referenced entity. I will not comment on whether or not there is a real economic benefit when the referenced company buys CDS concerning itself or its suppliers as an insurance policy; I will leave that analysis to the CDS experts).
Says Who?
I’m in good company, of course, as many economists and financial advisors have warned of the dangers of CDS:
- A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown
- Warren Buffett called them “weapons of mass destruction” in 2003
- Warren Buffett’s sidekick Charles T. Munger, has called the CDS prohibition the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it”
- Former Federal Reserve Chairman Alan Greenspan – after being one of their biggest cheerleaders – now says CDS are dangerous
- Former SEC chairman Christopher Cox said “The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis”
- Newsweek called CDS “The Monster that Ate Wall Street”
- President Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives “have threatened the entire financial system”
- George Soros says the market is still unsafe, and that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so-called short sales.
- U.S. Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.
- Nobel prize-winning economist Myron Scholes – who developed much of the pricing structure used in CDS – said that existing over-the-counter CDS were so dangerous that they should be “blown up or burned”, and we should start fresh
- In perhaps the most anti-derivatives statement of all, Nassim Nicholas Taleb said this month, “To curb volatility in financial markets some financial products ‘should not trade,’ including complex derivatives.”
But CDS seller are now saying everything is fine, that they are making changes which reduce risk, and that the danger has passed.
As an article in Bloomberg noted this week:
A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster.
So are CDS really safe now?
Not So Safe
Well, initially, before we can even begin to have an intelligent discussion about this issue, it is important to note that – according to Satyajit Das, a leading credit default swap expert – the commonly-accepted figures for the CDS losses suffered due to Lehman’s bankruptcy have been understated.
And it is also important to acknowledge that the government’s proposed regulations of CDS (if they ever pass) won’t really fix the problem. Indeed, Das says that the new credit default swap regulations not only won’t help stabilize the economy, they might actually help to destabilize it.
And it should be remembered that the overwhelming majority of derivatives are held by just 5 banks. So the people behind the effort to reassure everyone that CDS are safe again are the too big to fail banks, desperate to restart the toxic asset and exotic instrument gravy train.
And the big financial firms and the government are both desperate to increase leverage, rather than allowing the deleveraging play out. See this, this, this, this and this.
As Nouriel Roubini said last month:
This is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest…
The releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending.
CDS are an important way of creating leverage (for example, last year, the market for credit default swaps was larger than the entire world economy). So there is a huge (although wrong-headed, in my opinion) incentive to underplay the risks of CDS.
It is also possible to argue (although I haven’t seen this argument validated by any experts) that CDS are inherently destabilizing for the financial system since they increase interconnectivity.
And don’t forget that credit default swap counterparties drive company after company into bankruptcy, and that – once a company the counterparties aare betting against goes bankrupt – the counterparties cut in line in front of all of the bankruptcy creditors to get paid (and see this). In other words, there are other problems caused by CDS other than destabilizing the economy as a whole.
Interesting Alternatives
Two of the most interesting proposals in dealing with CDS come from Paul Volcker and Yves Smith.
Volcker argues that banks which receive taxpayer bailouts should not be heavily exposed to derivatives trading.
Yves Smith says that the best approach would be to significantly tax credit default swaps. She argues that that would shrink the CDS market – and the associated risks – faster than anything else. The more I think about it, the more Smith’s approach makes sense.
The Bigger Problem
Perhaps most importantly, CDS sellers – like the big sellers of other financial products – know that the government will bail them out if CDS crash again. So they have strong incentives to sell them and to recreate huge levels of leverage.
Indeed, the same dynamic that led to the S&L crisis also led to last year’s CDS crisis, and will lead to the next crisis as well. So – while CDS might be a particularly dangerous type of “weapon of mass destruction” (in Buffet’s words) – the financial looters will probably find some way to loot on the public’s dime, no matter what happens to CDS, unless they are they are meaningfully reigned in (or broken up).
In other words, the bottom line is that – yes – CDS are still dangerous. But – just as a killer, unless restrained, could use a paper weight to kill – the too-big-to-fails would just use some other instrument even if naked over-the-counter CDS are banned or tamed. Taking away a convicted murderer’s gun might be a good first step. But if he is still free to cause harm, he may very well kill again.
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“naked CDS is the term I coined to describe the situation where the buyer is not the referenced entity. There is at least some economic usefulness for the referenced company itself buying CDS as an insurance policy; so this essay will not comment on that situation”
what is this nonsense? a company should buy effectively life insurance on its bonds? this is absolutely non-feasible situation. personal life insurance protects against moral hazard: insured’s life is more valuable than the potential payout.
for a company, this situation does not apply: the bondholder will be made whole by the insurer, the insurer (a big bank most likely) will be bailed out by the gov’t, the gov’t will be stuffed with the unemployment benefits and some tax arrears.
what is the social benefit, who is to benefit besides the bondholder?
George, go back to the drawing board with your ideas.
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George,
Many thanks.
The EC Commisson has just closed a public consultation on “Possible initiatives to enhance the resilience of OTC Derivatives Markets”: http://ec.europa.eu/internal_market/consultations/docs/2009/derivatives/derivatives_consultation.pdf
Is the Commission, in your view, asking the right/wrong questions? My impression is that the Commission intentionally has sought to limit the scope of the consultation, thusly avoiding the big picture king you questions that you ask in your post. If you are interested, you can also find the the submissions of stakeholders. Here is the positio of the ECB: http://circa.europa.eu/Public/irc/markt/markt_consultations/library?l=/financial_services/derivatives_derivatives/public_authorities/ecb_enpdf/_EN_1.0_&a=d
Since I am not knowledgeable enough on the issue itself, I can neither support your criticism or not. However, the EC Commission knows of course that the EU has limited competence in the area of taxation and that where competence to legislate exists, unanimity among the Member States is required (unlike e.g. market regulation) which is almost impossible to achieve. That may be an explanation why the issue of taxation is not even touched upon in the consultation.
If the Lisbon Treaty is approved, the EU’s competence in the area of taxation would be extended. We will have to see how the Irish vote on Friday.
The European Commission could always propose something on taxation
http://ec.europa.eu/taxation_customs/taxation/gen_info/tax_policy/index_en.htm and we do not need the Lisbon Treaty. Of course to decide is a different story.
It’s a pity that both EU institutions do not even consider taxation of derivatives and CDS. Nobody has really explained why they do not want to do it. http://mgiannini.blogspot.com/2009/09/g20-summit-2009-odyssey-dawn-of-man.html. It’s quite typical for the EU Commission to ask wrong or biased questions to get biased consultations. First they decide what to do then they consult…
No surprise that Trichet, ECB’s chairman, has just come out at European Parliament hearing against taxation of financial transactions without explaining us why…Aren’t there/they good economists?
M.G.,
we will tax everything! sarkozy now plans to expand the french carbon tax to cover every breathing creature, wild animals included. we will tax everything! there will be tolls on pedestrian walks as well. taxation is the most creative power on earth!
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After the destruction of wealth of this financial crisis and the clear misallocation of resources of previous years, as one of the main cause of the crisis itself, I wonder if there is still somebody who can honestly and reasonably contend that “the new classes of derivatives can only be welfare increasing”. Try to explain that to some taxpayers…and also to some intellectually honest economists.
Ban ’em! Why do we continue to forumulate public policy based on faith-based economics?
The best I’ve seen on this is a link Yves provided a couple of weeks ago:
This approach is mingled with insights from Walrasian general equilibrium theory, in particular the finding of the Arrrow-Debreu two-period model that all uncertainty can be eliminated if only there are enough contingent claims (i.e., appropriate derivative instruments). This theoretical result (a theorem in an extremely stylized model) underlies the common belief that the introduction of new classes of derivatives can only be welfare increasing (a view obviously originally shared by former Fed Chairman Greenspan). It is worth emphasizing that this view is not an empirically grounded belief but an opinion derived from a benchmark model that is much too abstract to be confronted with data.
http://democrats.science.house.gov/Media/file/Commdocs/hearings/2009/Oversight/10sep/Colander_Testimony.pdf
Credit derivatives are not dangerous just because they can cause huge losses, but above all because of the financial mechanics involved. Cash settlement is the biggest problem with derivatives markets. Ordinary financial instruments just lose their value. Derivatives are able to create additional liabilities from thin air.
When a bond defaults, no money changes hand. The bond simply becomes worthless. When a CDS is triggered, there are huge cash transfers involved.
Even if the net exposure to a CDS is small, the sheer volume of simultaneous cash transfers involved in the settling of CDS for a widely traded reference entity can present enormous liquidity problems for the whole financial system. The simultaneous cash transfers create a sudden outburst of demand for short term credit that can overwhelm the financial system.
There are solvency issues as well. A single default can bring down a whole chain of CDS counterparties if the ultimate risk taker fails, even if the intermediate counterparties’ net exposure is zero.
Shall we tax every single cash transfer and trade? It does not do any harm…
I don’t know what you are referring to. I didn’t refer to any taxes as far as I know. I simply mentioned that derivatives are a source of unpredictable and sudden surges in demand for liquidity in the financial system.
In “ordinary” financial transactions, cash demand is at least somewhat known in advance, or made with cash that is already available. In certain derivatives transactions, sudden large demands for payment may appear at almost any moment. This is a special challenge to liquidity planning.
Taxing financial transactions (ever so slightly) is not a bad idea, though. It could act as a damping effect on the system. And damping is exactly what is needed for an unstable oscillator such as the modern financial system. A little damping is a small price to pay for much needed stability.
Unfortunately such taxes are very hard to make tight enough so that they are not circumvented.
The real CDS problem is it changes the behavior of debt owners (forget about cds owners who hold no underlying debt; I wish i could buy insurance on my neighbors house….) As a debt owner without “protection” you a good negotiating partner in a bankruptcy, and tend to care more about the firms you ivest in. The CDS makes all of this moot-good lending and active partnership in your investments changes everything…
The CDS contract is a lethal speculative tool. Its cost is low and its contingent payout is enormous. In its most generic form it is a contingent interest difference contract. This speculative nature of the contract demands that it be a regulated transaction.
We might do well to consider controlling their use by insisting that the seller (and buyer) of the contract be able to honor the contract, thru either or both of central clearing and legislated collateral requirements.
AIG sold something like 40,000 CDS contracts. AIG could not honor the contingent liability they assumed. For AIG to assert that it did not know that it could not honor the contracts is the rankest form of dissembly.
In the context of current contract law, it seems to me that AIG has perpetrated a massive fraud. That allegation might not stand in court; nonetheless, the public will bear the cost of what was/is a failed speculation. What infuriates the public is the fact that it did not benefit from the episode in any way.
Again the CDS debate is an old one. There is no reason for them to exist. If companies want to take out an insurance policy, then let them take out an insurance policy through a regulated insurance underwriter. Yes, they will have to pay considerably more for one, but that’s because CDS do not reflect a reasonable assessment of risk.
CDS are an integral part of the current rigged, gamed system of crony, casino capitalism. Not only do the 5 big banks hold most derivatives but they control the supposed clearinghouses like the ICE. It is like saying you are no longer gambling because you moved from the craps table to the slots.
Naked CDS multiply risk, not reduce it.
The prospect of collecting on CDS encourages raids on companies to undermine them.
CDS are used to mask a simple fact. Any deal that needs CDS to hedge it is a deal that should never have been made in the first place.
Here Here!
Thank you Hugh for pointing out the very core of the problem and a root cause of this systemic failure.
“CDS are an integral part of the current rigged, gamed system of crony, casino capitalism.” Yes, the major players do own or control every aspect of the game, Markit Indices, clearing houses like ICE and now DTCC. http://www.risk.net/risk-magazine/news/1533894/markit-teams-dtcc
Beyond being the securitizers, makers of CDOs, REITs and mortgage bond entities comprising synthetic tradeable ABX Index,there is another integral element they owned and controlled in this vast arena of market manipulation, the mortgage servicers.
These would be the same mortgage servicers who, to date have received $22,282,160,000 in incentive payments for mortgage modifications as part of the administration’s Making Home Affordable program aka HAMP but have failed to be proactive in effective mortgage modifications because despite hefty 22+ billion incentive, mortgage defaults are frankly more profitable for all involved.
“A recent AP analysis of the 38 servicers the government is paying found that:
•At least 30 face lawsuits from homeowners and advocates claiming they charged illegally high fees, prematurely foreclosed on homes and engaged in illegal collection practices. Most of the lawsuits allege violations of laws that protect homeowners in foreclosure and prevent debt-collection abuse. Treasury’s program requires servicers to comply with these laws.
•At least 14 have been accused of misleading customers before the program began about whether they would qualify for loan modifications or how low their new payments might be. In many cases, servicers are accused of telling borrowers not to make payments because their applications for modifications were pending — and moving to foreclose anyway.
•At least three of the companies settled federal predatory collection allegations by pledging to correct their behavior. They have since been sued hundreds of times by homeowners who allege the same illegal practices.
The AP analysis focused on the 38 servicers participating in Making Home Affordable, the federal plan giving servicers financial incentives to approve loan modifications. Most the servicers had been sued for charging illegal fees; forcing homeowners to buy unnecessary insurance; illegal collection practices; misleading customers about the federal program; and foreclosing on homeowners with pending loan modification applications. Some servicers have promised in legal settlements to stop unfair practices, then were sued again multiple times for the same practices.”
http://www.usatoday.com/money/economy/housing/2009-08-05-mortgage-foreclosure-help_N.htm
For more stimulating reading on mortgage servicing fraud:
EMC Mortgage Corp. – http://www.ftc.gov/opa/2008/09/emc.shtm
Select Portfolio Servicing – http://www.ftc.gov/fairbanks
Ocwen Federal Bank – http://files.ots.treas.gov/93606.pdf
Why am I going off on mortgage servicers who openly and actively engage in mortgage servicing fraud in a discussion on credit default swaps?, you might well ask with good reason. It would be an appropriate analogy to consider mortgage servicers akin to feeder funds that supplied Madoff with billions. Servicers manufacture defaults that feed the CDS casinos, fabricating “credit events” for grossly levered up players to cash in their CDS bets on. “Manufactured mortgage defaults” became profitable with ABX Index and other CDS venues, particularly when these owners that Hugh mentions in his post utilize their insider knowledge of servicers’ fraudulent activities to rig those CDS bets targeting specific tranches. An innocent homeowner whose mortgage payments are current, paid up to date or even over paid [and believe me that has been precisely the case with many victims] who has been dragged into this casino has a snowball’s chance in hell of ever emerging whole again. Fortunately, of late many judges are seeing the criminality of this scheme and taking appropriate action.
You can talk about corrective regulatory action or even CDS taxation all the live long day but the only serious shot we have now at genuine sustainable recovery is to bring down this scheming house of cards and prosecute those who not only brought our financial system to its knees but who are destroying American homeownership and in so doing, destroying our country.
I just gave $25 bucks to Alan Grayson to help him get re-elected next year so he can continue his fight to get the Fed audited.
I’m not a big shot or (God Forbid) a bankster. Ha ha.
I’m just a “little guy”.
But if 5 million little guys each gave Alan Grayson $25, then we might have a chance at getting the Fed audited and putting the Financial Industrial Complex out of business.
I know a little about Fed history and I don’t buy all the conspiracy theories about the Fed. I know there were bubbles and busts long before the Fed was created, and there were currency debasements when gold was a currency. I don’t go for that nutjob stuff about the Fed.
Still, it’s not good to have an insider cabal with so little oversight tied to the hip of a financial industry full of millionaire apparatchiks sucking the nation’s blood.
Let a little light in to this, and lets see if we can make our democracy work better for everyone, not just the select few with access to capital and the political clout to get bailed out at our expense when they lose it. It might get messy, but that’s when a great nation is supposed to rise to the occassion.
Go Alan Grayson. But don’t get too hot headed. Keep your cool and stay in the light of logic and truth.