Like It or Not, the Credit Default Swaps Market is Too Big to Fail

A piece by John Dizard in the Financial Times, “Get used to underwriting big lenders,” made me realize a bit of cognitive blindness. Central banks are committed to backstopping the credit default swaps market.

Of course, that should be obvious. The Bank of England, ECB, Fed, and other central banks have intervened in various ways to shore up the financial system. The CDS market is a subset of that, ergo it is included. And the most compelling reason for the Bear Stearns salvage operation was to prevent the nightmare scenario of cascading counterparty failures from becoming a reality.

Somehow, the idea that major monetary authorities are now underwriting the opaque, ill-understood, never-been-through-a-real-downturn CDS market seemed ludicrous. But as another FT writer, Lucy Kellaway noted apropos management fads, “No idea is too ridiculous to be put into practice.”

Recently, plans to have a central clearinghouse and even put CDS on exchanges have been moving forward, and that’s progress of a sort. The ideas of getting these contracts cleared centrally, and better yet, traded on exchanges, is one of the best and conceptually most straightforward reform ideas around (yes, clearinghouses can fail too, but historically they have done so far less frequently than individual institutions). But don’t kid yourself that that will have much impact on the outstanding contracts. New ones can be done under the new regime; current ones are just about certain to stay where they are.

For instance, this Bloomberg story makes it sound as if changes can be implemented quickly:

Regulators and banks agreed to changes aimed at easing the risk of a collapse in the $62 trillion market for credit-default swaps.

Morgan Stanley, Deutsche Bank AG and Goldman Sachs Group Inc. are among the 17 banks creating a system to move trades through a clearinghouse that would absorb a failure by one of the market-makers, the Federal Reserve Bank of New York said yesterday in a statement following a meeting with the firms. A guarantee may encourage more trading of default swaps, said NanaOtsuki of UBS AG, one of the banks involved in the agreement….

The group will reduce the volume of outstanding contracts through multilateral trade terminations. They also agreed to extend the changes in credit-default swaps to other derivatives contracts backed by equities, interest rates, currencies and commodities.

Clearing and settlement is a detail-oriented process, yet at the same time, procedures need to be standardized to allow for efficient processing of large volumes of transactions. Agreeing on documentation and procedures will take time, implementing it will take additional time. The article cited New York Fed president Timothy Geithner saying he planned to make “meaningful progress” in the next six months. That’s about as ambiguous a commitment that one can make.

I have a good deal of trouble understanding the notion that existing bi-lateral contracts can be replaced with ones with a clearinghouse, If you are the CDS protection writer, you’ll want to move it over, and arguably the protection buyer wouldn’t mind, since the clearinghouse’s credit would be presumably be better than that of the protection writer. But these contracts are customized, so the new ones would have to corresponding terms (otherwise, you have to renegotiate, which is time consuming and costly). Similarly, it would be difficult to design a computer system and back office procedures to handle heterogeneous instruments. Finally, there is great variation in how much margin has to be posted on current contracts; those with favorable arrangements will refuse to transfer to the clearinghouse.

Despite the central banks’ belief that they can contain and contend with the risk of CDS counterparty failures, I keep thinking of a story I heard in business school. One of the professors, who came from a family active in government service and had had some posts himself, said he could distinctly remember the day in 1968 when he first realized that there were limits to what America could do, that it could not simultaneously combat poverty, fight a ground war in Asia, and send a man to the moon. Central banks would benefit from thinking through what their version of triage would be if their powers were tested.

From the Financial Times:

For at least another couple of years, if not considerably longer, counterparty risk in the credit derivatives market, and its associated trades, will be effectively underwritten by the central banks of the US, Europe, the UK, Japan, and, towed like a dinghy, Switzerland. Never mind the legislative or regulatory rule writing; the logistics and technology are not here yet for credit derivatives to substantially shift over to a clearing house-cleared, efficiently margined, mode. Yes, before the PR people send me the e-mails, I know the exchanges have put some software and facilities in place, but what is available does not have the scale or articulation necessary to replace the bilateral bank-and-dealer system.

So the central bankers, and, by extension, taxpayers, will be underwriting the present system for some time.

Not that they are happy about it, and their unhappiness will be expressed through harsher capital ratios and the forcing of common equity issuance on ever-worse terms. You can expect more contradictory public policies, such as calls for re-stimulation of the economy accompanied by regulatory insistence on putting more securitisations on the balance sheet, reducing lending capacity.

The process will be harder on the banks and dealers, and therefore on those who depend on them, thanks to the central banks’ hesitancy in forcing recapitalisations last year and earlier this year. Back then, I thought it would make sense for central banks such as the Fed or the European Central Bank to push for big, co-sponsored roadshows to raise capital for the institutions under their umbrellas. The capital raises should have been larger, less piecemeal, and been done quickly.

Instead, the central banks were, it seems, hoping that the relief rally in financial stocks that followed the Bear Stearns takeover would go on long enough, and be strong enough, for sufficient capital to be raised on favourable terms. We are now seeing that relief rally peter out.

There was also a fantasy on the part of some regulators that it was possible to return in short order to a world where credit was priced and extended by committees within banks. This on-balance-sheet world, though, presupposed that the people, or, as they call them now, “skill sets” existed within banks. I remember the floors of company credit analysts at Chase and Citi in the 1970s and early 1980s. They aren’t there now.

So until the misfiring, jerry-built structure of securitised, market-priced, semi-automated credit is repaired in a systematic way by people who know what they are doing, there really is no choice but to effectively guarantee the big institutions’ debt.

When markets such as those for credit default swaps are transparent, one-price- for-one-credit systems, with reliable information from trusted sources (ie, not legacy rating agencies), then we can allow individual institutions to fail. Not now.

But regulators, taxpayers, and speculators can take out their frustrations with the lack of competence at the top of governments and financial institutions by relentlessly pounding down the institutions’ stock prices, and voting the governments out of office.

That process will take a while. So the short-bank-and-dealer-equity-long-their-debt trade won’t get “arbed away” any time soon.

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  1. Melancholy Korean

    As a former equity derivs trader, my two cents here is worth less than usual, but the new clearinghouse agreement makes me hopeful for the first time during this credit crisis.

    Agree it will take some time and lots of pain (your comments about clearing and settlement bring back horrid memories of how difficult settling even simple trades could be) but the message from Geithner’s speech at the Economic Club was loud and clear: the Fed will force the banks to get this discreditable mess cleaned up. I notice he mentioned they started the process in 2005, but there’s nothing like a crisis to get people moving.

    R. Sandor at the Milken Global Conference said the CDS situation was the one thing that caused him real worry. I agree. But it looks like this weapon of financial mass destruction will finally be identified, tagged, warehoused, and secured.

  2. Yves Smith

    melancholy korean,

    Thanks for your comment. I went and looked at the post again, and realized I had not stated anywhere that CDS need to be not only cleared centrally, but better yet exchange traded (I’ve written before that getting as many instruments as possible moved onto exchanges is one of the simplest, cleanest reform ideas around),

    So that’s a long winded way of saying I agree with you completely. I’m tweaking the post to more clearly make the point that the plan is a good one, but giving the impression (perhaps unintentionally) that it will solve the problem of the CDS currently outstanding is misleading.

    I’m cranky about Lehman and Bernanke this evening and am letting it bleed into unrelated topics.

  3. James

    Im reminded of the Taleb article from last week when he mentions that if someone is going to destroy the world its going to be the BOE trying to bailout northern rock.

  4. etc

    If the short credit side of a CDS is assigned to a central clearinghouse or an exchange, there’s potential for a windfall to the counterparties. If the protection writer doesn’t pay a FMV fee for the clearinghouse/exchange to assume the short position, the protection writer gets a windfall. If the protection recipient doesn’t pay a FMV fee for the clearinhouse/exchange’s lower counterparty risk under the CDS, the protection recipient gets a windfall. Hopefully, the people funding the clearinghouse / exchange have enough skin in the game to negotiate hard and prevent counterparties from getting big windfalls from centralization.

  5. Anonymous

    Of course, the dealers aren’t going to clear anything except indexes. And, of course, the local newstand has more capital than the Clearing Corp.

    Hey it makes for great copy and might send the Dow up 20 points.

  6. Danny

    The CDS market will crumble unless the Fed turns on the printing machines full speed. A $62T dollar notional amount with $1-2T in real losses? Oil is going to go through the moon if the Fed starts bailing out hedge funds who are ‘systemically important’, or the Fed is going to have to take these swaps on their books to save the banks who made these bets. Pick your poison.

    The collapse of the CDS market is a question of when, not if.

  7. Richard Kline

    Dizard has it exactly right, to me, that the Fed’s plan for the capital wipeout of much of top tier bank reserves was simply to hold the banks together while equities cheered up and in consequence ‘the markets refunded them.’ Um, no. That was a wish, not even a hope, and as a plan has flopped. The banks aren’t recapitalized to their stated losses, with many more losses in the pipeline.

    —And that’s what worries me about the CDS situation. Again, the ‘hold on and pray’ program is a non-starter, as it were. In both areas, what is lacking is a real, near-term plan for recapitalization. This is no one’s brief at the government level, really, and that’s part of the problem. Not going looking for trouble doesn’t play because trouble is assuredly coming looking for us.

  8. Danny

    Independent Accountant,

    I will probably switch into gold when things get significantly worse. Right now I’m heavily weighted in undervalued mining shares, ag stocks and natural gas.


    I think if you really want to get ahead of the newsflow curve you could title a post ‘When Central Banks Fail: Cleaning up the Wreckage of the CDS Blow Up.’

    I’m more interested in thinking about what the consequences of this are.

  9. Danny

    And by switching into gold, I mean real bullion, most probably in countries outside the US, as the UK has already started raiding safety deposit boxes, and if my memory is correct, isolated instances in the US.

  10. Fledermaus

    So basically they wrote a bunch of junk securities that do not add any value, paid themselves hefty fees and bonuses for selling the junk to suckers, and because of all this they now have what amounts to a gold plated insurance policy against losses they they’ve never paid a single primium on.

    Man I went into the wrong line of work

  11. mack

    Speaking extemporaneously about exchange formation (w/o specific market experience in CDS’s), I can’t imagine how anyone w/ existing contracts would desire for same to be traded publicly (on either side).

    If for no other reason than the contracts can be valued based on any metric the holder feels appropriate through the perverse incentive afforded via recent FASB adoptions, i.e., if there is a market, you’ve gotta mark to it, etc. (No market?, Well…)

    More simply put: If you don’t know what you’ve written is worth and I can’t or am unwilling to divulge, why rock the boat?

    Agreements all around that this segment should be standardized and moved to an exchange. But, age and experience knocking, I’d have a hard time seeing the existing holders desirous of seeing a market price on their holdings w/o some substantial caveats.

    I think it’s notable that illiquid instruments are only truly “marked” when there is a crisis, but, that’s probably only topical if this market does, indeed, implode.

    PS- Best wishes and thanks for all your reporting, analysis and commentary.

  12. Anonymous

    Could be asking indirectly for a throttled market place which slows down economies where the fast buck projects are no more. Rules and regulations will cause the cost of money to rise. Better to close the barn door now even if all the pigs are already eating up the garden.

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