New York to Regulate Some Credit Default Swaps

I’m glad someone is trying to keep his eye on the ball. With serial bailouts artists Paulson and Bernanke working full bore on their showstopper, they’ve somehow managed to overlook the most obvious culprit for a systemic crisis, namely, the credit default swaps market (yes, rescuing AIG was an effort to keep that market from imploding, but that one-off did nothing to address its inherent wobbliness). While creating an exchange for CDS will enable new contracts to be handled with procedures that will help promote greater safety (the biggie being posting of collateral), existing contracts cannot be migrated to an exchange, so that threat will hang over our collective heads until the maturation of existing contracts brings their value down in magnitude.

We’ve written repeatedly about the risks that CDS pose, and other bloggers who have been attuned to the risks are repeating and updating their warnings. From Overhedged:

The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market….

The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.

It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB [Mother of All Bailouts] may be just the beginning.

From Accrued Interest:

Now, I’ve got no problem with enforcing some basic short-selling rules, but it won’t make a difference until something changes in the credit-default swap (CDS) market.

Let’s stipulate that speculation and manipulation is part of the problem here. Let’s stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.

To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan’s falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.

In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn’t help either. Media reports suggesting that a particular “expected” default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.

So New York State’s move to step into this regulatory vacuum is understandable, but given all the concerns about this market, one wonders why the Federal Reserve, which has been engaged in a regulatory land-grab, hasn’t tried to get this market under its jurisdiction (to at least the extent it could). The problem, as a Bloomberg article outlines, is that the New York effort will be limited to cases in which the contracts are insurance, that is, they hedge a position or exposure. Many investors use CDS to punt or create synthetic bonds, and those uses presumably would not be covered. But the New York move may push the Feds to step to the plate.

The usual suspects, such as the International Swaps Dealers Association, issued predictably dire warnings. It isn’t clear how much of this is well founded and how much is self-serving (the ISDA, like the Securiites Industry Association and the American Securitization Forum, is as much a lobbying group as a standards-setter). But partial regulation is likely not to be effective, as much as progress in this arena is badly needed.

From Bloomberg:

New York State will start regulating a part of the $62 trillion market for credit-default swaps, calling it a culprit in the global financial crisis.

Credit-default swap protection sold to investors who also own the security they’re protecting will be treated as insurance, Governor David Paterson said in a statement today. State insurance regulators would require entities selling credit- default swaps in those cases to show they can actually pay the claims if there is a default.

“The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,” Paterson said in the statement. “I urge the federal government to follow New York’s lead once again by regulating the rest of the credit-default swap market.”…..

The state’s actions wouldn’t apply to contracts where an investor buying credit-default swap protection doesn’t own the underlying security….

The state action “threatens to disrupt global derivatives markets,” said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, an industry group that represents dealers and investors in the market and sets standards for trading.

“The state of New York should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good,” Pickel said in a statement…..

Insurance companies, which are prohibited from entering into derivative transactions directly, created special purpose vehicles to sell protection using the swap market. These SPVs were minimally capitalized because their obligations in the event of a security defaulting were guaranteed by the insurance company.

Yet, credit-default swap contracts sometimes require protection writers to make payments unrelated to defaults, such as providing collateral against a contract in the event an insurer is downgraded or is taken over by regulators….

“We are concerned that this plan has not been well thought through,” Tim Backshall, chief strategist at Credit Derivatives Research LLC, said in a note to clients today. “These ad hoc actions are more likely to cause further dislocation than help any realignment and normalcy.”

The new guidelines will become effective in January, Patterson said.

“Theoretically, it could decrease liquidity and increase protection costs for people who are looking to use it as a hedge,” said Brian Yelvington, a strategist at independent bond- research firm CreditSights Inc. in New York. “It doesn’t seem to be the solution to the problem at hand. A nationally regulated exchange would seem to be a better fit for the market.”

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  1. Matthew Dubuque

    Matthew Dubuque

    This critical CDS market does not need a state regulator. It does not need a Federal regulator.

    It needs a vicious and nasty GLOBAL regulator.

    Perhaps a complete breakdown of Bretton Woods is required to bring this point home.

    So be it.

    Matthew Dubuque

  2. JC

    “New York State will start regulating a part of the $62 trillion market for credit-default swaps, calling it a culprit in the global financial crisis.”

    Forgive my ignorance, but I would REALLY like to know how this works.

    How can a 62 TRILLION market exist, in just this one segment of the financial world?

    62 Trillion is HUGE! Huger than huge!

    Is that real money, or is it all fake paper, that we make believe is money?

    According to Wikipedia, the Gross Domestic Product for the WHOLE WORLD – yes, the whole world – was 54 trillion.

    So how can one market be, even theoretically, 62 trillion???

  3. Anonymous

    Well JC you finally figured out the problem: more debt than there is money and they are trying to stop the dominoes from falling or the debt will come due worldwide and defaulting causes financial Armageddon.

  4. Abbott_Of_Iona

    “Matthew Dubuque said…

    Matthew Dubuque

    This critical CDS market does not need a state regulator. It does not need a Federal regulator.

    It needs a vicious and nasty GLOBAL regulator.

    Perhaps a complete breakdown of Bretton Woods is required to bring this point home.

    So be it.”

    I agree with you Matthew Dubuque the CDS market does not need a state regulator. It does not need a Federal regulator.

    It also does not need a Global Regulator.

    The CDS market needs to liquidate in the absence of ANY FACIST IDIOLOGY, including the contrived grab for power by Paulson and a gun to the head of Congress with only minutes left on the clock before a NEW PRESIDENT,

    under what Mathew

    “a vicious and nasty GLOBAL regulator”

    is elected.

    I think it might be best if the CDS market liquidated.

    The Communist Party of The Peoples Republic of China can start a war if they wish.

    It’s fairly certain they won’t be collecting on properties in California or Florida if they do.

    But perhaps you prefer “a vicious and nasty GLOBAL regulator” to price discovery.

  5. mxq

    “Federal Reserve, which has been engaged in a regulatory land-grab”

    Nicely put.

    Given that there are no more independant IB’s in the US, i wonder how much longer the SEC is going to stay relevant?

  6. Dean

    The unregulated CDS market is the problem. BTW I have seen figures exceeding $200 Trillion (vs. the $63 Trillion figure indicated in the post).

    However, trying to regulate at this point isn’t similar to closing the barn door after the cows have left?

  7. Steve

    Bretton Woods ended under Nixon.

    In 1999, the Congress explicitly exempted over-the-counter derivatives, including CDS, from Federal oversight.

    If New York State outlaws CDS, traders will use London as the legal domicile for the contracts and trade through foreign subs.

    Federal legislation is needed, in conjunction with a G-8 agreement or equivalent individual sovereign regulatory actions.

  8. Been there

    “The state’s actions wouldn’t apply to contracts where an investor buying credit-default swap protection doesn’t own the underlying security….”

    Just like insurance, the policy holder has to own the underlying asset- OK. I think regulatory oversight is a necessity for his market. I’m just not sure what (if any?) additional backstopping is created with regards to pre-existing CDS arrangements by New York’s new regulatory position. I assume this new oversight will create an environment that begets stronger protection sellers for new CDS contracts.

    Does this somehow provide additional protection for existing protection buyers –or- is this just another case of closing the door after the horse has left the barn in full gallop down the road(and subsequently getting squashed by a Mack Truck).

  9. Abbott_Of_Iona


    Money is classically defined as

    A medium of exchange

    A unit of Account

    A store of value

    The things that you talk about are NOT MONEY


    They are bets on two flies walking up a window pane.


    Ask yourself JC,

    Do you own a CDS?

    I know I don’t.

    Why should one cent of my money (€ in my case) be spent on a bunch of gamblers who cannot stop gambling.

    Paulson IS A FASCIST.

    He overtly threatens the elected representatives (Congress) of the Citizens of the USA with ARMAGEDDON.


    Can you hear the breaking glass? Crystalnacht?

    So, tell me JC, now that were such good friends, exactly what would happen if neither of the flies made it to the top of the window pane.

    I’ll save you the trouble. Gamblers will always gamble.


    IF THE Communist Party of China want war. Left them have it.

    If any Republican or Democrat is not prepared to stand up to the Communist Party of China then you will know what they are TRAITORS.




  10. Anonymous

    If the Democratic Congress gets sucked into this bailout garbage by the right wing mafia. Let’s just sell wall street a neg-am loan package with a 1 percent teaser and a five year balloon. Oh, we allready have.

    Ok, let’s foreclose and nationalize the banking industry.

  11. JC

    Thanks for the responses.

    What I don’t understand, is that these “bets” really seem to take place in their own universe, with its own set of rules. (Still don’t really understand “credit default swaps, actually.)

    And it reminds me, really, of other markets ABOUT markets, that aren’t real:

    1. Fantasy football.
    2. World of Warcraft (there is a market, as you can buy advanced characters).
    3. Things like InTrade – where you bet on the outcome of various elections.
    4. Bets on sports itself.

    What I don’t understand, is that in each of those markets, the cost of that market is noticeably SMALLER than the “real” thing that market is based on.

    So – if “credit default swaps”, are simply a form of betting, and insuring against those bets – how in the WORLD was this false market nothing more than a novely item, like the other markets I list above?

    What is the PURPOSE, of a CDS? Can someone tell me that? They must havea purpose, right, other than a bet on when mortgages will be paid or not.

  12. Matthew Dubuque

    Matthew Dubuque

    What this fiasco about CDS swaps being regulated in New York (which is completely unequipped to manage this; recall the catastrophe that was AIG) seems to be is an attempt by certain swaps dealers to avoid punitive federal or global regulation by consenting to trivial regulation by New York State.

    Yet another back room deal in pursuit of their free market jihad.

    Matthew Dubuque

  13. JC

    Tried to answer my own question, by going to Wikipeda.

    Wow, that’s a crazy definition right there – here’s a taste:

    A CDS contract is typically documented under a confirmation referencing the 2003 Credit Derivatives Definitions as published by the International Swaps and Derivatives Association. The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.

    The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations, and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.

    CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment grade corporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco’s restructuring in 2000 led to the credit event’s removal from North American high yield trades.[2]

    Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.

    Now, doesn't this seem, with all the pro forma definitions, that this is like an RPG – D&D, if you will – with it's own arcane rules?

    Seriously – substitute "orc", "golem", "strength", "magic user level", etc – for some of the definitions – and it seems to flow right along.

    And I STILL don't know what these CDS things are useful for!!

  14. Abbott_Of_Iona


    You are correct ~ Even if you do not know it.

    “"bets" really seem to take place in their own universe, with its own set of rules”

    Your understanding requires one more input.

    The Universe you refer to is not yours it is theirs.

    The rules you refer to are not yours. They make the rules.

    And in case you are unaware they can change the rules ANY TIME THEY WANT (personally I call that FACISIM)

    They say, the rules just changed. Short selling (PRICE DISCOVERY) is no longer allowed.



    And the Masters Of The Universe sat down at a poker table with the Communist Party Of China with your money.

    Tell me JC, who has a bigger bazooka now.

    It’s not Fantasy Football JC

    Greenspan, & Bernanke, were (are) playing for real (with your money).

    JC, forget about maybe having to pay 1c or 2c extra Income Tax.

    Your children, grandchildren & great grandchildren will pay for this poker game ~ UNLESS ALL CDS ARE LIQUIDATED.





    You say,

    “that market is noticeably SMALLER than the "real" thing”

    JC, look you have to understand that a gambler doesn’t know the “REAL THING”

    JC, Paulson is gambling with your children.


    He is out of control

  15. Anonymous

    Credit Default Swap proposal:

    1) Declare them illegal for regulated enterprises (insurance, utilities, finance, health care)

    2) Declare them as legally without validity, cannot be counted as assets, cannot be enforced in court.

  16. Anonymous


    The communist party of China does not want war nor US real estate. They want Tiawan…

    ‘The Chinese president also praised the good momentum of the development of the Sino-U.S. ties in recent years in various areas.

    He said China is ready to work with the U.S. side to intensify dialogue, exchanges and cooperation, and properly handle issues concerning mutual interests and of major concern, particularly the Taiwan question, in a bid to push forward the sustained and steady development of the Sino-U.S. constructive and cooperative ties.’

    Translated from diplo-speech: “Give us Taiwan and you’ll get the loan.”

    Does anyone find this development at all surprising? Why should China risk a war with the US when they are beating our brains out economically? This is typically what happens to nations that have a strong military, weak economy and poor strategic thinkers. The military is not the solution to every problem.


  17. Abbott_Of_Iona

    “Anonymous said…

    SEPTEMBER 22, 2008 9:36 PM

    “Credit Default Swap proposal:

    1) Declare them illegal for regulated enterprises (insurance, utilities, finance, health care)

    2) Declare them as legally without validity, cannot be counted as assets, cannot be enforced in court.”

    I say,

    1) Correct ~ Enron, Worldcom, Any Com your having with your breakfast

    2) They are (and have) gambled the lives of you unborn children into slavery because they always believe the next pony will win.

    3) If Paulson wants to bet the $500,000,000 he got (tax free) from Goldman Sachs on two flies on a window pane. Let him.


  18. Abbott_Of_Iona



    The Communist Party Of the Peoples Republic Of Chain want Taiwan.

    They also want Tibet, Africa, South America, Iraq, Iran and Saudi Arabia

    That doesn’t change what they are.

    A bunch of MURDEROUS F**KS who will be happy to murder your children.

    So you have two options,

    1. Tell the Communist Party Of the Peoples Republic of China to F**K OFF AND DIE (Including not paying THE FACIST PAULSON)

    2. Accept the Credit Default Swap Market amounts to nothing more or less that a bunch of drunken gamblers who were using your money AND YOU LOST

    Let me see, River,

    Do you want the Communist Party Of The Peoples Republic Of China to


    Or do you want the Monkey Bush Paulson Fascist Government to


    I didn’t think so.


    You better hope that the CDS market dies.

    If it doesn’t your children will.

  19. LeeAnne

    These people hate the public, have nothing but contempt for them with absolutely no cred in public service. Here’s a guy, the personification of Goldman, Sachs’ culture: ‘create a sense of urgency, look your client in the eye, and lie.’

    These people don’t work for the public. That was the last generation. This generation began with “don’t trust anybody over 30, and when they took charge, fired everyone approaching 50, not because the technology was over their heads and they were untrainable, but because the ethics of that generation were about to be turned upside down and they wouldn’t be able to adjust to the new non-ethics.

    The boomers needed, ‘leave your brains at the door,’ young things who would lockstep and push company product.

    These people cannot be put in charge of this. This is a trillion dollar boondoggle. The world is already laughing at us when they’re not terrified. Beginning with using a President for pornographic ravings -demonstrating a willingness to bring down the very office of the Presidency itself.

    This is a country gone nuts!

    For an excellent CDS paper see:

    International Financial Conglomerates:
    Implications for Bank Insolvency Regimes
    Richard Herring*
    Wharton School
    University of Pennsylvania
    Current draft: July 2002–intl_finan_conglom-doc.pdf+The+state+action+%60%60threatens+to+disrupt+global+derivatives+markets,%27%27+said+Robert+Pickel,+chief+executive+officer+of+the+International+Swaps+and+Derivatives+Association,&hl=en&ct=clnk&cd=3&gl=us&client=firefox-a

    IV. Concluding comment
    The international patchwork of bankruptcy laws and procedures is unlikely to lead to an
    efficient resolution of a bankrupt international financial conglomerate. It seems doubtful that
    going concern value could be protected adequately and, worse still, the unwind is likely to spillover
    to damage other institutions and market participants if counter parties attempt to liquidate
    positions at once, driving down prices and causing problems for other investors with similar
    positions. Since we lack workable procedures to unwind the affairs of a failing international
    financial conglomerate in an orderly manner, the result is likely to be a chaotic scramble for
    assets that could infect other markets and institutions, with potential disruption of the real

    Despite ex ante protestations to the contrary, the authorities are unlikely to risk such an
    outcome and so the result is likely to be a bailout that will prop up the failing institution. The
    continuation of recent trends toward globalization, conglomeration, consolidation and increasing
    reliance on trading of OTC derivatives implies that we may be confronted with a growing
    category of firms that are too complex to fail. This, of course, has ominous implications for
    moral hazard. A market perception that such firms will benefit from official support in times of stress gives them a competitive advantage completely unrelated to their ability to add value to
    the financial system.
    It dulls the incentives for creditors to demand disclosure of risky positions
    and monitor such exposures. Weakened market discipline will enable such institutions to take
    larger, riskier positions without paying appropriately higher risk premiums to their creditors.
    The result may be larger potential insolvencies that require still larger bailouts to forestall
    systemic risk.

    For market discipline to operate effectively in constraining risk taking by financial
    conglomerates, the regulatory authorities need a credible procedure to unwind the affairs of an
    international financial conglomerate in an orderly manner, without systemic spillovers. This will
    require ways of dealing with the various aspects of complexity highlighted in the preceding
    analysis. This means finding answers to a series of difficult questions. Within financial
    conglomerates, how can the various lines of business be mapped into the various legal entities to
    which the bankruptcy process must be applied? Within countries, how should the actions of
    various functional regulators be coordinated in the event of failure? Across countries, how
    should the various national approaches to insolvency resolution be harmonized to ensure a
    cooperative process? Across OTC derivatives markets and clearing and settlement systems, how
    should the needs of the bankruptcy administrator for time to achieve an optimal resolution be
    accommodated without impeding the ability of market participants to continue trading?
    Development of improved processes and procedures for dealing with an insolvent financial
    conglomerate deserves an urgent place on the international regulatory agenda.

  20. Dave Raithel

    RE JC’s inquiry as to what Is a CDS: I got this from another finance blogger (I linked to from here) who emailed me a CDS primer prepared by Nomura Fixed Income Research. Sorry, I have no link but maybe Google could dig it up. Here’s a definition for you:

    “A credit default swap (CDS) is a kind of insurance against credit risk. It is a privately negotiated
    bilateral contract. The buyer of protection pays a fixed fee or premium to the seller of protection for a
    period of time and if a certain pre-specified “credit event” occurs, the protection seller pays
    compensation to the protection buyer. A “credit event” can be a bankruptcy of a company, called the
    “reference entity,” or a default of a bond or other debt issued by the reference entity. If no credit event
    occurs during the term of the swap, the protection buyer continues to pay the premium until maturity.
    In contrast, should a credit event occur at some point before the contract’s maturity, the protection
    seller owes a payment to the buyer of protection, thus insulating the buyer from a financial loss.”

    That’s the essence of it (though I gather that convolutions make them more complicated); a straightforward CDS could be, for example, Me selling You coverage should the Fed Gov fail to make good on the T-Bill You now hold. You’d pay me 25 basis points per year (as I gather from the Telegraph yesterday) and if they don’t pay at maturity, I pay You instead, take the T-Bill, and then go try to seize assets, (I want Yuca Mountain) etc.

    None of that sounds too odd, really. The perverse quality of CDS’s is hidden in Yves’ post where it reads: “Credit-default swap protection sold to investors who also own the security they’re protecting will be treated as insurance…..The state’s actions wouldn’t apply to contracts where an investor buying credit-default swap protection doesn’t own the underlying security….” So its as if I could buy home owner’s insurance in case MY house burned down; but furthermore, I could buy some kind of insurance in case YOUR house burned down – hell, I could buy some “risk protection” for fear that You will paint Your house a color I found aesthetically displeasing, IF somebody wanted to sell me some. I’ve read that such nonsense does go on, though I don’t know this – I’m just a literate layperson who tries to follow this catastrophe. But I’ve heard that odd things can be taken as the triggering condition for payment on the theory that those events do have “economic” repercussions – e.g, the death of a board member known to be for or against some business strategy; ministers of foreign agencies falling out of favor (oil), things like that.

    Now in a world of clever people, where wit is mistaken for wisdom…it’s a wonder things haven imploded already….

  21. AnoninCA


    What do CDS do? CDS = synthetic asset. I take your money put it in a Treasury money market account and sell a CDS in your name. I pay you the Treasury money market account interest + the premium on the CDS contract (less a tidy fee of course). Assuming there is no insurance payoff on the CDS, you’ll get your money back after a few years. You are now the owner of a synthetic asset.

    How did CDS grow so big? Accrued Interest explains: nobody could be bothered to write the constracts so that they were resellable. Instead of selling off contracts you don’t want, it’s much easier to just buy an offsetting contract.

  22. AnoninCA

    Jc, by the way I forgot to note that every “investor” in synthetic assets puts up far less money than the total amount that could be due on the CDS, so just about every synthetic asset deal is undercapitalized.

  23. vlade

    I said it before, and I will say it again. Exchange traded CDS will solve part of the problem, but not by any means large part of the problem. Margining will not help. Parties collateralise even now (most of the serious ones, anyways), but your problem is when you have a CDS on AIG written by LEH.
    Yep, you had the collateral up to a certain value, but all of sudden a) the cpty is not there b) the reference entity is in default c) ergo, the value of the CDS (as in general contract in potentia) is likely much higher than the collateral and you’ve just lost heaps of money – and the heaps of money is just the first order of the losses, because even with Basel I and more so with Basel II treatment you could have been getting lower reg cap with the CDS contract, so you need to find the capital to spruce that as well.

    So, in a situation like that, you will a) get some collateral that the defaulted cpty was posting to you b) post probably large MTM loss on the CDS contract itself
    c) if you had the contract offset by another contract, loose a lot of money on the other contract or;
    d) have to find some extra capital for your reg cap if you were using the CDS for offsetting a real bond and claiming reg capital relief (as well as realising the loss on the bond, but that’s covered in b))

    You cannot effectively margin (or collateralise) for jump events (especially where there could be a correlation between the contract underlying and the writer of the contract – and in panic all correlations go to 1), as is the market learning now the hard way.

    The problem with CDSes is that there’s a jump event under which the value of the contract (ergo loss for someone) jumps drastically, in a non-continuous way. With a normal IR swap, if the value of a 10M notional contract jumps from 500k to 10M in a day, it’s probably because the world has ended (and the interest rates jumped by tenfold). With a CDS, it’s a real possibility on just about any contract.

  24. jck

    “I’m glad someone is trying to keep his eye on the ball.”
    Yves, I appreciate your sense of humor, NY State has been regulating CDS since the early 90s, remember the monolines? AIG ? their CDS positions were all regulated by the NY State Insurance Commissioner. Feeling better now ?
    The only change is that the monos and AIG can no longer write insurance on CDOs and other exotica, but then the market for CDOs being dead and buried….

  25. Dave Raithel

    Re Vlade and AnoninCA: How do I avoid drawing the conclusion that CDS’s shouldn’t be as regulated as … my bank? In fact, might the greater lesson be that no newly invented financial instrument can be offered or traded without some regulatory oversight and without an exchange? All my thinking about these financial doings takes me back to what got me reading this blog – I’d stumbled across a link elswhere referencing Hyman Minsky, from whom I’d taken an econ class back in the Dark Ages of Reagan’s first year in office. The fundamental point from Minksy, that stability breeds instability, can be applied to just about any kind of financial practice, or so it would seem. Once a particular kind of instrument (CDS’s) prove remunerative, other parties adopt the practice. Success encourages complacency and the relaxing of standards. Then comes interconnectedness. Then on day, a precipitating event requires that the CDS’s be disentangled.

    There’s an amusing diagram at under the heading “Notional vs net: complexity is our enemy”, of what might need disentangling. (Stephen Hsu is a professor of physics at U of Oregon.)

    I don’t know how such entanglements can be prevented without regulation. Sure, the counter arguments will be that people will just take their business elsewhere, that innovation will be stymied, etc. (Someone above observed that the regulation needs to be global.)

    But now we’re talking about a $700 billion cost of innovation, which is designed, at least in part, to prevent the unravelling of the CDSs, which is to come (but nobody knows exactly when) if capital remains frozen in place.

  26. Dave Raithel

    This is from the link to the John Hussman letter (in Yves Smith’s links page for 9/23). After proposing that bond holders take the hit to fix what ails us, he writes:

    “Among the obstacles to the efficient management of this crisis has been the growth in recent years of the credit default swap (CDS) market. These swaps are essentially insurance policies that pay the holder in the event that an institution’s bonds fail. The large CDS market makes it more likely that the failure of one institution will infect another. In many cases the notional value covered by such swaps exceeds the value of the debt of the underlying companies, suggesting that the CDS market is being used for speculation in the same way that one might attempt to purchase life insurance on an unrelated individual. Both credit default swaps and short sales should be allowed for bona-fide hedging purposes when an investor has a related asset that is at risk. However, it is appropriate for regulators to curtail the speculative use of credit default swaps and short sales relating to financial institutions.”

    But this would also have to mean that existing contracts held by a party that does not have “a related asset that is at risk” would be declared null and void?

  27. Anonymous

    September 23, 2008

    Right on Yves and blogers!

    At the risk of repeating myself, please dear hearts, do yourself a favor and hit, and have a copy of Satyajit Das’s “Traders, Guns, & Money” shipped to you overnight. It is mostly easy reading, humorous, entertaining, and informative all in one package regarding CDS’s, and derivatives in general. And most chapters do end with a four, or five, spin off of the original trade that will have your head spinning, and then splitting in complexity. Never mind. Just go out and kick the dog, or have another martini, and go at it again.

    I read one of two reader reviews before buying the book about four months ago. It said in general, “I learned a lot about the derivative market but I still don’t understand it.” I remember saying to myself at the time, “Well…we’ll see about that.” Read something I wind up not understanding? Not a chance. The guy was right! Thing is, nobody “understands” it because it’s simply not understandable in any historical financial market securities knowledge beyond the first purchase.

    It’s like the old joke about the guy shipping a rail car of onions from Arizona that gets traded six times, or so, before it reaches the East Coast. The East Coast buyer then calls the farmer in Arizona and complains that the onions are rotten and can’t be eaten. The farmer then says “eaten?” those onions weren’t meant for eating they were meant for trading. You get the picture.

    So…as said before in this blog sheet, and by the New York regulators, set up a resolution desk for holders of the original securities being insured, and write off the whole umpty ump $trillions of non-eatable derivatives.

    Earl L. Crockett
    Santa Cruz, CA

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