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.