Einhorn: First, Let’s Kill All the Credit Default Swaps

David Einhorn, who enjoys his considerable reputation for hard-fought battles against firms with shaky finances and dubious accounting (Allied Capital and Lehman), has taken aim at a new and equally deserving target: credit default swaps.

In an interesting bit of synchronicity, Einhorn’s comments in a letter to investors overlap to a considerable degree with a post we wrote yesterday on why a clearinghouse for derivatives wasn’t a solution to the dangers posed by credit default swaps (and note the Orwellian branding, the reforms are about “derivatives” which include benign ones, names simple interest rate and currency swaps, yet the bill has loopholes that will let many, indeed probably most, credit default swaps escape).

Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant. And I don’t mean the failure of AIG, either.

Even though Einhorn gave a stinging, wide-ranging indictment, he missed one of the issues I find troubling, which is that credit default swaps result in information loss, which in turn lowers the quality of credit decisions. In other words, the product is inherently destructive.

In the world of old-fashioned fixed income investing, creditors would evaluate a borrower to make sure it had good odds of meeting its obligations. The lender could and usually did make inquiries about the borrower’s income, and its other commitments. If it was a business, the bank might also want to assess information that would help it evaluate the stability of the borrowers income (for instance, learning who its main customers were to determine how diverse and solid they were).

Just as with securitiztion, credit default swaps lower the incentive to do borrower due diligence. Why bother, when the CDS spreads on the reference entity tells you what the market thinks and you can use CDS to reduce or lay off the credit risk? But the original lender is in a privileged position; he is able to gather data from the borrower that it non-public and thus will not be incorporated in a market price. Thus giving creditors an incentive not to do that work systematically lower the quality of credit decisions.

But that reason is a bit abstract, although the costs are real. Einhorn focused on more tangible types of damage wrought by CDS, as summarized by the Financial Times. First, CDS are a means of extortion:

“I think that trying to make safer credit default swaps is like trying to make safer asbestos,” he writes in a recent letter to investors, adding that CDSs create “large, correlated and asymmetrical risks” having “scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay”.

Second, CDS speculators win if companies die. Given that the volume of CDS outstanding is a significant multiple of the amount of bonds outstanding, they are not used primarily for hedging, but for creating “synthetic” exposures. And those on the short side have compelling reasons to influence outcomes. When a company gets in trouble, the best outcome is often an out-of-court restructuring of debt before it gets even further in trouble. As much as the Chapter 11 process has certain advantages, it is also costly and risky. A CDS holder (one with a significant short position) can buy some bonds (now at a cheap price) of a struggling company to assure it has a seat at the table in negotiations so it can block a renegotiation of the debt and force a bankruptcy filing so it can assure its payoff on the CDS. From the Financial Times:

CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called “basis packages” buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors “have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors”

Einhorn also agrees with our contention, that a credit default swaps clearinghouse is not a viable solution. As we said yesterday in comments:

CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis. The way around that pre-crisis was making AIG and the monolines the bagholders. That game is over, but the Street is hooked on the revenues…..

….in invoking AIG, I am saying that an undercapitalized clearinghouse is a concentrated point of failure and a very big one too, a systemic risk all of its own.

Einhorn’s views:

“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity,” he notes.

That’s because it is almost impossible to adequately capitalise against such developments. “There is no way a clearing house could demand enough collateral,” he says. “The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral.”

I think you need more people recognizing that CDS serve the interests of the financial sector at the expense of the real economy, and calling for the product to be banned. Only then might you see radical enough action taken.

However, as much as I hate CDS, I have reluctantly concluded that they cannot be taken out overnight. They have become sufficiently enmeshed in our financial infrastructure that eliminating them is like disarming a web of nuclear weapons. If you make a mistake on any one, they all go boom. One (and this is far from the only) problem is that the big banks not only have large CDS exposures, but they have other hedges related to them (such as interest rate swaps). So simply putting CDS into runoff mode could lead to dislocations in other markets.

I prefer regulating them very intrusively (like insurance, to make sure the counterparties are adequately capitalized), limiting new CDS writing to hedging existing positions (that would need to be tightly defined and monitored) and limiting CDS writing to end users (which would include proprietary trading desks) to where the investor had an insurable interest, as in owned the bonds, and only up to his exposure. That plus increasing capital requirement over, say, a three year period, to reflect the true default risk of the product should shrink the market enough to allow regulators to then ascertain whether it could then be put in runoff mode. But the intent of policy should be loud and clear: to strangle CDS, with the hope of killing them.

And for those who hope netting might do the trick, reader Richard Smith disabuses us of that notion:

Another point is about the struggle to keep up with ‘financial innovation’ in the OTC market. A problem for clients and regulators alike. CDS are probably the nastiest of these. They are so polymorphous – part of a basis trade, or a directional bet, or a sort-of-legit hedge, or a synthetic, depending on context; and no cap on speculation a la Gambling Act; and then vaguely like derivatives, or insurance, or short bond positions, or a prediction market.

But you couldn’t rule out the possibility that equally nasty new products could be developed by some smart aleck. Maybe there should be a charge on the inventors to cover the cost of regulatory catch up. Or something equivalent to airworthiness regulations, which even libertarians accept without demur, as far as I understand. That would slow the innovators down a bit – proving the ‘wings’ aren’t going to come off their new financial products and kill all the passengers.

Another observation I’d been meaning to make on ‘CDS trade compression’: the 20-40% that some commentators are so pleased about. I worked on an app like this for a large IB (recently unpopular in the guise of an mollusc) at the turn of the millennium. They had half a million daily NASDAQ trades at that time and their settlement IT guy in NY was freaking out as his mighty mainframe began to wilt under the volumes. Even with quite a conservative approach to compression (there are choices about how aggressively you net the trades – we thought we could get it down to 25,000 trades per day if we really went for it) we got 80% compression straight away, so, 100,000 netted trades per day. Of course those are highly standardized trades. The aggregation was something like stock, side, settlement date, counterparty, trade flags. NASDAQ is often characterized as an OTC market so it is really the product standardization that matters, rather than the nature of the venue perhaps. I think it went to 90% within a month or two as we got bolder but I may be confabulating; it’s a while ago.

If they can only get 40% trade compression out of CDS, after a year, there must be an awful lot of detritus left over (especially when IIRC most of the counterparties are TBTFs). So things like contract clauses, reference entity, duration of cover must be all over the place in what remains. Difficult to hedge or lay off I should think. And some unconfirmed trades too no doubt. A total mess.

Ignoring all the other shortcomings of CDS the natural thing would be to standardize the product:: that’s happened so many times before, but IBs hate standardization of course for the margin erosion it brings, and anyway now we get this cartel-like protection of the margins, under the guise of support for ‘finanical innovation’.

The implication is that what is on the banks’ books now is a bit hairier to manage than they are ‘fessing up. As other experts who similarly hate the product, like Satyajit Das have observed, simply banning new protection writing would probably lead to hugely disfunctional behavior prior to the date and also lead to problems (as in big time losses, which in a worst case scenario could result in another bailout) as positions that were in runoff mode would be essentially frozen and could not be managed.

But if we can get agreement on aims, which is the product should be killed, then it becomes possible to debate the best (least painful and costly) means.

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  1. ben

    One other regulatory provision to limit their use to true insurance situations – they should not pay off until the original due date of the underlying debt.

    The basic argument here is very simple – you can’t buy fire insurance on a house you don’t own.

      1. RueTheDay

        Because in the absence of an insurable interest, perverse incentives are created. If I can take out a fire insurance policy on your home, I now have an incentive to burn it down. This is not merely a theoretical proposition – insurable interest laws were passed throughout Europe and America in the 17th and 18th centuries specifically because people were taking out life insurance policies on strangers and then killing them.

        1. Kid Dynamite

          should we ban short selling of stocks too? i certainly don’t think so… how about put options?

          the “you can’t buy fire insurance on a house you don’t own” argument is a red herring designed to confuse the populace. Here’s one key difference: if i buy fire insurance on a house I don’t own, i could burn that house down, right? Well, if you buy CDS on a company whose bond you don’t own, you CANNOT destroy that company… in fact, you can ONLY destroy the company if you actually DO own the underlying bond, and have overhedged with CDS.

          so actually, we can quickly see what the proper analogy is:
          you should not be able to (And cannot) over-insure the value of your own home: if it’s worth $500k, you cannot buy $5mm of insurance on it.. CDS should be the same way.


          1. RueTheDay

            Your analogy is logically incoherent.

            If you buy fire insurance on a house you own and then proceed to burn it down, the insurance claim offsets your financial loss in the house and you come out even. If you buy a policy on your neighbor’s house and then burn it down, you suffer no financial loss on the house and come out ahead by an amount equal to the insurance claim.


          2. RueTheDay

            My above post is a bit of a starwman, I’ll admit.

            I do take issue with your comment that “if you buy CDS on a company whose bond you don’t own, you CANNOT destroy that company” however.

            Traders would buy CDS on a company’s bonds, they would then begin aggressive naked short selling of the company’s stock, the rapidly falling stock price would cause ratings agencies to lower their credit rating, and the firm’s creditors often had clauses that required additional collateral be posted if their credit ratings dropped, the additional collateral required caused a deterioration in their financials which increased the likelihood of default thus increasing the value of the CDS.

            So one did not have to actually own the bond in order to “destroy the company” and profit from a CDS trade.

          3. Yves Smith Post author

            Rue is absolutely correct here, and Kid Dynamite, this again this points to a lack of knowledge on your behalf of how this product has been used. A lot of commentators have pointed out that CDS are a far better mechanism for putting a company into a death spiral than selling stocks short, and there is some pretty strong evidence that CDS have in fact been used this way.

          4. Kid Dynamite

            come on Yves, Rue, you guys are talking like members of the Ignorati. The problem with CDS comes when you OVERinsure an interest – THAT is where the perverse incentives come in, because you actually CAN influence what happens when the company runs into trouble, because you are a debtholder (on debt that you don’t care about, because you’ve OVERINSURED it via CDS) and get to make those decisions.

            I’m not going to debate with you the fact that short sellers cannot drive companies into the ground. It does not happen. And ratings agencies, to my knowledge, have NEVER lowered the rating of a company because its stock price decreased – ratings get lowered because the company’s financial situation sucks, which is frequently reflected by a falling stock price – evil short sellers or spurious CDS buyers do NOT cause ratings changes.

            Buyers of CDS, just like short sellers of stock, have no rights in terms of voting or say in restructuring matters, and thus CANNOT force a company into bankruptcy.

            These are not my theories, Yves, they are facts.

          5. Yves Smith Post author


            I have a policy against ad hominem attacks. Name calling is a fast way to getting your IP blocked. I have stated that clearly and repeatedly, but I infer you are a new reader here.

            As for not knowing the terrain, you again and again are commenting and demonstrating lack of knowledge as to how CDS work. As I said in the post, and you ignored, there are known cases of CDS holders and have a large short position picking up the cash bonds in a distressed company so they could take a blocking position on a renegotiation (which usually requires a high % approval of bondholders, much lower than under Ch.11).

            And for a CDS, you can either cash settle (as in you get the difference between what the bonds are believe to be worth and 100%), or present the bonds and get 100% payout. So buying the bonds does not reduce their return by much, maybe not at all.

            Again, I suggest you do your homework. You are demonstrating that you know very little about CDS.

          6. Kid Dynamite

            ***First of all, it was not my intention to make any ad hominem attacks.

            oh my goodness Yves – every time you post you are proving my point.

            Yves – read what you just wrote, and observe that it’s EXACTLY what i’m talking about with OVERINSURED INTERESTS. The problem does NOT come from people buying CDS. it comes from them buying CDS and then buying a smaller interest in bonds near the endgame, or buying bonds and then buying a large interest in CDS. it’s over-insurance that creates perverse incentive.

            you continue to tell me that i don’t understand, and at the same time you prove the exact point i’m trying to make. believe me – i understand.

            let me try to simplify this one more time:
            1) IF JoeHedgeFund (JHF for short) owns bonds in company XYZ, he should be able to purchase protection (CDS) for no more than the notional that he owns.
            2) if JHF does not own bonds in XYZ, it doesn’t matter how much CDS he purchases – but at no point when he owns the underlying bonds, or eventually purchases the underlying bonds, should he be allowed to own CDS greater than the notional of his bond position.

            This removes the perverse incentive caused by overinsurance.

          7. Yves Smith Post author


            The term of art is “insurable interest” which others HAVE used and I used in the original post, and you chose to ignore. We have been talking about this all along and you have been acting as if we were saying something different.

            Go read the post again, you will see that idea is stated and also explained in the text.

          8. RueTheDay

            KD – It is NOT simply about OVERinsuring. It is about insuring without an insurable interest. In fact, one could view overinsurance as a SUBSET of insuring without an insurable interest, rather than vice versa. In the case of taking out too much insurance on an asset you possess, one does not have an insurable interest in the portion that represents the overage. To prove my point, let’s say your house is worth $500k but for some reason you have chosen NOT to insure it. I then take out an insurance policy on it for $500k and proceed to burn it down. In this case, the house was NOT overinsured, yet the problem remained. That is because the real problem is, as Yves and I have stated, the lack of an insurable interest NOT overinsurance.

          9. anon

            KD is quite right in this debate.

            The absence of an insured interest is simply a special case of overinsurance.

            That’s the logic.

            BTW, RuetheDay has it backwards in that regard.

          10. Yves Smith Post author


            I am afraid not.

            If you allow people with a bona fide interest to insure, and you limit insurance to the amount of the underlying, you have to allow only for insurable interests only. I see no socially valid reason to allow bona fide longs not to be able to insure, and this “overinsurance” idea permits that. If I buy a bond, and the last owner didn’t hedge it, and I want to partially hedge my holding why should I be denied because someone went short?

            Moreover, back to our house example, if you have no underlying interest, and you can only insure half the value of your neighbor’s house because he insured half the value, you still have an incentive to torch it.

            And there are other destructive games you can play with CDS besides buying the bonds to block a renegotiation. It is much easier to do a bear raid in CDS than in stocks (and I am not opposed to naked shorts in stocks, with an uptick rule in place, stock shorts are not pernicious). For credit dependent companies, having their cost of funding rise a lot is destructive to them (and it does, via arbitrage, their debt issuance costs rise).

          1. RueTheDay

            Ok, my apologies for attributing to you a quote that was actually Ed’s. With bloggers quoting other bloggers quoting other bloggers, it is often difficult to discern the correct attribution of the indented text.

      2. Yves Smith Post author

        Insurance markets, which surely you must know ARE a market, witness Lloyds of London and reinsurance, outlawed insurance contracts where there was no “insurable interest” in the late 1700s precisely because without that limitation, there was massive incentive to commit fraud, and indeed, large scale frauds had occurred.

        The real issue is that CDS are not a capital market product; I suggest you read Chris Whalen on this topic. They are in no way, shape or from a derivative; they are not price in relationship to an “underlying”; none of the Black Scholes or related models apply here. They are an insurance product and should be treated as such.

        And the comparison to short selling in equities is misguided. The volume of shorts in equities is a fraction, and not a large one, of total outstandings. In CDS, it is a significant multiple (4 times? maybe more) of the total value of the bond market. The side bets are vastly larger than the underlying useful economic activity.

        As Keynes noted, “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” And Keynes was a very successful speculator. The capital market do not have any inherent right to exist, nor are they inherently virtuous, your ideology to the contrary.

        1. Kid Dynamite

          Yves- I only mentioned short selling to show how silly the “no social value” argument is – as you can replace “CDS” with “Short Selling” in Einhorn’s piece and it will still make perfect sense.

          by the way – you continue to prove my point for me – the problem is not that CDS is insurance – the problem is the OVERINSURANCE you cited – where the CDS outstanding is multiples of the underlying which it insures. THAT IS THE PROBLEM! THAT is where the perverse incentive occurs.

          1. Yves Smith Post author

            You are again incorrect. Look at the simple example of insuring your neighbor’s house and torching it. That isn’t overinsurance.

            You also ignored the comment of another reader, who pointed out that a cap (which would be operationally a nightmare to implement and enforce, another issue you see not to have thought through) would deny some longs the opportunity to hedge.

          2. IF

            If CDS is just like short selling, then
            a) how does one lose a borrow with a CDS?
            b) how does one lock in a short for 5 years at _constant_ interest?

        2. anon

          To repeat, KD is quite right in this debate, and in this particular example:

          “You are again incorrect. Look at the simple example of insuring your neighbour’s house and torching it. That isn’t overinsurance.”

          It certainly is overinsurance. You don’t own your neighbour’s house.

          That means your insured interest is zero; i.e. it is an absence of an insured interest.

          The effect is the same as if you owned your neighbour’s house (i.e. it was your house), and you double insured it. The absence of an insured interest is just a special case of overinsurance.

          1. Yves Smith Post author


            No, you are misreading KD’s argument or are assuming everyone insurer their house/their bonds, which does not occur.

            He is calling for the notional amount of CDS to be limited to the amount of the underlying.

            If your neighbor did not insure his house, you could.

        3. anon

          I don’t believe I’m misreading him; unfortunately I don’t understand your interpretation. Let me try again.

          What I’m saying is that insuring your neighbour’s house is an example of where you don’t have an insurable interest (because you don’t own the house), and that if you take out insurance on it, it is an example of overinsurance. It’s an example of overinsurance because your insurable interest is zero, but you have insurance.

          This is completely independent of whether your neighbour, who definitely has at least a potential insurable interest, because he owns his house, has insured it or not.

          The status of insurable interest and overinsurance is specific to the party who has the actual or potential insurance long position, and whether that party has an insurable interest. In this case, we are talking about your status, not your neighbour’s. You don’t have an insurable interest, but you are considering insurance.

          Your neighbour has a potential insurance position against his insurable interest – could be no insurance, matched insurance, or overinsurance.

          You have a potential insurance position against a position that is your neighbour’s insurable interest but not your insurable interest. Therefore your potential insurance position is only degrees of overinsurance, because you have no insurable interest with respect to your neighbour’s house, because its not your house.

          That seems long winded I suspect, but that’s my logic, and that’s the way I read KD, at least implicitly. Also, I don’t see how your arguments disprove my logic.

          1. Yves Smith Post author

            KD did allow for an investor being short and not owning the bonds, which is analogous to buying fire insurance on your neighbors’ house:

            ” if JHF does not own bonds in XYZ, it doesn’t matter how much CDS he purchases – but at no point when he owns the underlying bonds, or eventually purchases the underlying bonds, should he be allowed to own CDS greater than the notional of his bond position.”

            He contemplates being naked short, but notice WHEN he owns bonds, he is not permitted to overhedge. This was his response to the BK complaint, that investors had voted to block BKs because they were NET short. They used their smaller long position to give them a seat at the table and vote against a reorganization outside the bankruptcy court, thus forcing a BK filing and a payout on the CDS. But he is fine with short and no underlying long.

          2. Yves Smith Post author

            No problem, and sorry if I got a bit testy with you, he seemed to be arguing several things, not all of them consistent.

          3. Skippy

            Nice thread.

            But I’ll go long on Yves with a wee mezzanine al la Iontheballpatriot and short Kid Dynamite/Einhorn (on the QT idealogical master was a druggie/CEO has an addiction problem), by bonds on Ruetheday, CDS^2 the hole f*kin enchilada and if it doesn’t wash…fax the FED and state, is the *gun loaded*, do you wish to find out…really?.

            Skippy…Damn these Little Creature pale ale’s go down good whilst I’m making a buck…next!

  2. fresno dan

    I read once that someone was trying to sell a CDS for the end of the world. I thought that was pretty stupid to buy a CDS for such a contingency, but the guy selling it is pretty sharp – making money on sales, but not being around if there ever was a claim (the world is gone). (NOTE – AIG was forced by the gubermint to make whole on its contracts, and the gubermint gave, uh, I mean loaned them …?85 billion?)

    “CDS are not economic if adequately margined.”
    Hmmm…with my naive econ 1a understanding, why would anyone buy them?
    Now I realize the sellers AND buyers were pretty sharp – the gubermint would back them up! Its the taxpayers that are stupid… (O-OH…thats me!_

    1. craazyman

      Yeah, that was Catholic Church and they used the money to pay for the Crusades and Michaelangelo and all those pretty statues — which made for great advertising too.

      It was a good business. They took in the cash but never had to pay a penny out in claims.

      The banksters can only look on all that with envy and lust.


  3. Roberspiere

    Recently It was made public that a big financial institution was selling CDOs knowing that they were defective (not worth the paper they were written on). While they were selling these CDOs they were also investing their firm’s money in a way that would benefit the firm when the CDOs blew up. When asked about this, this company indicated that the buyers should have know about the quality of the CDOs and therefore the firm was not responsible. Now, wasn’t that the same argument that tobacco companies made about smoking? I seem to remember that they argument was that the public had been aware of the “side effects” of their products. Now, my question is: Why isn’t any AG (federal or state) filing a class action suite against these firms for selling a product they knew was defective?

  4. i on the ball patriot

    Sour grapes here?

    This sounds a bit like the Roger Ehrenberg piece in that it is the same lament — Its vanilla greed whining about pernicious greed cleaning its clocks and ruining the party.

    You say;

    “Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant. And I don’t mean the failure of AIG, either.”

    Credit itself (talk about Orwellian branding) has no redeeming social value when it is centered in the hands of a few and has exorbitant costs that support only a very few fat ass do nothing greedy bankers. The world did not function “perfectly well” in the “pre credit default swaps” past. Credit, pre credit default swaps, was then, and is now, an outrageously enslaving usurious fee machine, bought with corruption of government, for the benefit of the vanilla greed ruling elite.

    Credit — pre credit default swaps — has become, and now still is, a tool of dominance as it controls market forces by determining; who uses money, the use of money, the amount of money used, and the terms of indenture (paying back the money plus interest). As such it is a major factor in controlling resource distribution — division of the pie. When credit is extended deviously and usuriously, by an elite and wealthy vanilla greedy few, as it has been, and is still now, it only serves to enslave and exploit others.

    The root problem here is aggregate generational corruption that has twisted the ‘rule of law’ into a non responsive to the people scam machine.

    Killing CDS is like moving a microscopic speck of dirt from the kitchen to the living room when the whole house needs a thorough cleaning.

    Deception is the strongest political force on the planet.

    1. Yves Smith Post author

      i on the ball,

      Credit is essential to the functioning of an economy. No credit puts you at the barter stage. When I provide services and bill my clients, I am extending to credit, they have an account payable (my invoice) and I have an account receivable (what they owe me). You cannot have commerce on any scale without credit.

      So we need to talk about productive versus unproductive uses of credit, not “lets’ get rid of credit.”

      1. i on the ball patriot

        Errrrr …. I was talking about “productive versus unproductive uses of credit” and I did not say “lets’ get rid of credit.” I pointed out that the world did not function “perfectly well” in the “pre credit default swaps” past as you said in your article. The world was not functioning “perfectly well” because credit was not being used productively. It was, and still is, concentrated in the hands of a self serving, wealthy elite, vanilla greedy few, that in total represent a parasitic drag on fair and honest markets. They have misdirected resource consumption to the benefit of their pocket books and to the detriment of the society at large.

  5. Kid Dynamite

    Yves – i am a HUGE Einhorn fan, but i think the “no redeeming social value” argument is a dead end… he wrote:

    “CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company.”

    hmmm – couldn’t we change “CDS to “short selling” and have those sentences be equally as true?

    “Short Selling is “anti-social”, because those who sell stocks short often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company.”

    and yes – i fully understand how an investor can be long $100MM in bonds and short a billion in CDS and have an incentive to force the company into bankruptcy.

    one could argue that mergers have no redeeming social value because they reduce competition and result in job losses. Social value is not a requirement in capital markets.

    1. DownSouth

      The claim that “Social value is not a requirement in capital markets” carries us off into the wacky sociopathic world of Ayn Rand. That “capital markets” should be allowed to exist, even if they are beneficial to some individuals but poison to society as a whole, is certainly one of the most pernicious ideologies ever concocted by the missionaries of selfishness and greed.

    2. Fair Economist

      As a practical matter short volumes are rarely (ever?) many multiples of the company value so situations where there’s a large interest by shorts to destroy the company (in comparison to the longs) are rare at best. OTOH, CDS many times the value of the company bonds are not unusual at all. So although in theory short interest creates comparable pathological interests in reality it’s a much bigger problem for CDS.

      1. Kid Dynamite

        you are proving that the problem is NOT CDS itself, but rather the fact that CDS (insurance) is allowed to exceed the notional value of the underlying bond. THAT is what needs to be fixed

        I think the way to fix it is NOT to require anyone purchasing protection (CDS) to own the underlying bond – but rather to impose contract limits, which of course would require centralization and standardization, which is a whole other problem

        1. IF

          Lets assume your limit is reached and a bond holder would like to buy a CDS. Well, he can’t, even though he has a real interest, because some people have become net short while he is forced to stay long. How do you justify that?

          1. Kid Dynamite

            good question. i would respond that if you banned CDS, he’d also be forced to stay long! and the same thing happens with stocks in which there is no borrow – sometimes you just can’t short them. it happens.

  6. Kid Dynamite

    oooh – another thing – the problem is NOT the buyers of CDS.. the problem is the sellers of CDS. yes – the buyers of CDS can certainly have disincentives to negotiate in bankruptcy, IF they have managed to obtain massive amounts of CDS protection. We need to regulate the SELLERS of CDS – both in terms of absolute notional sold (just like contract limits on the MERC, CBOE, CBOT), and in terms of collateral posted (LOTS MORE!). If this kills the CDS market, then it kills the market.

    1. MrM

      A point related to Kid’s comment

      CDS speculators win if companies die.

      This is rubbish.
      The CDS market is a zero sum market – for every speculator betting on a company dying (=CDS buyer)there is a speculator betting on the same company not dying (=CDS seller).

      1. craazyman

        For every buyer there is indeed a seller. They cancel out.

        But you could have a situation where 10 buyers each pay $1 per year to 10 sellers for $100 of protection.

        Say in year 2 the reference entity explodes (who could have imagined?? LOL).

        So the Buyers pay 10 x 2 x $1 = $20
        The Buyers receive 10 x 100 = $1000

        Buyers pay $20 and get $1000
        Sellers get $20 and pay $1000

        That $1000 didn’t exists, a priori, in a vault someplace. It was raised through hedges that worked or didn’t work, or from some other potentially destabilizing process that might demand liquidity when it’s least available.

        Speculators (buyers in this case) win.

        But how can you margin something like that, because you’d need some math to work the probabilities? And then you get judgment calls and lobbyists and wining and dining and cigars and night clubs and lap dances and etc. etc. And the probabilities would get slimmer and slimmer and slimmer until they’d disappear into a Black-Schole. Isn’t this sort of deja vu?

        Eventually the math goes out the window while the money comes in — courtesy of U.S. middle-class taxpayers.

        If they don’t want the credit risk, they should sell the damn bonds and leave “the populace” alone to our backyards and football games and dogs and cats and hunting and fishing and Sunday sermons and keg parties and garden clubs I don’t want to subsidize Wall Street’s “efficiency”. I want inefficiency, imagination, laziness, dreams, languidness, squalor and inebriation, lassitude and laying around, creativity, conscience, holisticism, wholeness, long weekends and evenings and mornings that last like days of dreams. To hell with “efficiency”. It’s a Godless Moron with three-heads, each one uglier than the next, and it will eat the world alive with its steel jaws.

        1. MrM

          Why can’t you request the required margin to be equal to the notional, and it can be in cash or in the bonds issued by the same entity?
          a) You do not have to worry about subjective probabilities
          b) You solve the problem with overinsurance by making “naked” CDS writing very capital intensive.
          Anything wrong with this approach?

          1. craazyman

            If there’s adequate collateralization, I don’t see why it couldn’t work, although I wonder in what cases it would be useful versus just buying/selling the bonds themselves, considering that bonds are fairly fungible in terms of payoff profiles and a lot of alternatives exist with the same “math”. If I own a certain bond that I want protected, and the swap seller is definitively secure, then what the heck, why not? Although the cost of a regulatory regime and enforcement may be sort of socially onerous vs. just banning the damned things — and it will produce even more employment for lawyers, which is a dubious social cost that is hard to quantify and may be determinative in the ultimate decision to just ban them and turn it all over to the DA (that’s only one lawyer — plus staff). I will defer to others here who know more about the topic than me, my knowledge is limited and I’m on my 4th glass of wine for the evening. Ho ho ho. My view is very biased in that I want a much smaller finance industry and much, much more manufacturing, including lots of arts and crafts like furniture and baskets. I even want them to bring back the subway token booth attendants. The machines are ridiculous. Fifty five or sixty touch screen presses (OK maybe 20) just to get your Metro card refilled. And what are the token both people doing now? God knows. They’re not lawyers or bio-tech drug designers. I shudder to contemplate. I’d say they’re praying to the Lord. Bring them back and give them a job that serves Mankind. And ban the CDS.

          2. craazyman

            Yes and one more thing about the token booth clerks. It’s strange. They always struck me as a peculiar cross section of humanity, like taxi drivers, but even more diverse. Some would be lost in drudgery and cloistered rage, disheveled and unkept and scattered, sort of contained explosions in the glass box. And others would be impeccably groomed and lithe and intelligent — like saints or philosophers and it was easy to look at them and see sort of an enromous energy radiating from them that made a mockery of their station and they floated above themselves as if they were only an apparition and the real self was only spirit. I wouldn’t say that they were gods. But there was a containment, a grace, that was sort of celestial, and at 3 or 4 a.m. when they were there in the booth, alone, it was almost a grandeur. Just them and the empty station, and whatever happened at 3 a.m. It was like being a God, in a way. It’s tough to have a job like that, I would imagine. I was a bank teller once. And that was an ordeal.

  7. DoctoRx

    The sham of CDS, which are simply unregulated unreserved-for insurance products, being in Yves’ words hedged by another line extension, interest rate swaps, makes me think they both ought to go into runoff mode.

    The real solution is for systemically necessary banking functions–the plain vanilla ones– be performed by companies that do nothing else and are heavily regulated a la electric utilities.

    Then the rest of the world can gamble as much as they want.
    But they won’t, because there’s no economic ‘there’ there for most of these deals. Most of these ‘swaps’ would then just fade away.

    Kid Dynamite asks a good question. Why can’t you express a view on a company’s credit quality? Yes you can and “they” do. Think of Moody’s etc. Write an article, speak to whomever you want. But to equate a CDS backed by no reserves with a (legal, not naked) short shale is silly.

    1. i on the ball patriot

      “The real solution is for systemically necessary banking functions–the plain vanilla ones– be performed by companies that do nothing else and are heavily regulated a la electric utilities.”

      Good diagnosis DoctoRx and a really great prescription!
      No where’s the pharmacy that will fill it?

    2. DownSouth

      DoctoRx said: “The real solution is for systemically necessary banking functions–the plain vanilla ones– be performed by companies that do nothing else and are heavily regulated a la electric utilities. Then the rest of the world can gamble as much as they want.”

      In a perfect world that might work. But as studies (Yves has linked to some of these, and if my memory serves me correctly they were by Rogoff et al) have shown, private blow ups have a way of becoming public obligations. This is a fact of life that libertarians absolutely fail to acknowledge.

      In this most recent world-wide financial crisis, the blow up of the traditional (government regulated) banking sector paled in comparison to the implosion of the shadow-banking (unregulated) sector.

      Regulation, if it is to be effective, must extend to all sectors of the financial sector that have the potential to be socially destructive.

      1. i on the ball patriot

        DownSouth you make a good point with this;

        “Regulation, if it is to be effective, must extend to all sectors of the financial sector that have the potential to be socially destructive.”

        I would say that concept should be carried to ALL social entities, especially corporations. Once any segment gets large enough to potentially negatively impact the society as a whole the state not only has a right but an obligation to limit that impact.

        It is not just finance that is corrupt and unwieldy. The whole enchilada is rotten and needs to be tossed. It is interesting to see the vanilla greed vs pernicious greed struggle being played out now not only in finance but also in all other sectors as well. It is a reflection of the fact that elite pernicious control has taken the reins of power. The financial sector is their engine and rudder. It is the same old shit in a new neocon inspired suit — Aristotle descending Plato rising.

        Deception is the strongest political force on the planet.

    3. Kid Dynamite

      DocRX – i’m not talking about “expressing a view” via an op-ed in the WSJ or a blog post – i’m talking about a financial view!

      you’re write – writing CDS (that’s the SELLER that’s the problem again – note – NOT the buyer) with no reserves is silly. that’s exactly the problem – there needs to be margin posted by the SELLERS of CDS – and lots of it.

      1. Yves Smith Post author

        This vitiates your “capital markets” defense.

        The point of financial markets is to support the real economy, not to allow investors a venue for gambling. Casinos serve that function. And BTW, casinos are better regulated in term of making sure the house can make good than the CDS market is.

  8. Skippy

    Is not *insurance* in its self just the old monkey mind trying to fake its self out, like every thing is copacetic, but in reality anything could happen.

    CDS or any of its kin are to me like buying land mine insurance, some sleep better, a pacifier to the mind, but like many (Katrina victims and AIG et al) it never really holds up to the sales pitch, does it.

    If wall st burnt down we would feel it, but life would go on and maybe, just maybe we could find better works for humanity to engage in. Really, think of all the time and effort put into wall st and the out comes of the last 100 years. Pretty damn poor track record if you ask me and it keeps trying to kill us, what else do you need for proof, a hole in your head, pitchfork in your gut?

    Skippy…Its a Cult pure and simple and many have been seduced by its charms, aided and abetted by MSM, university’s, economists, politicians and anyone that makes a buck off it.

  9. Allen C

    The bankers have proved over and over that they eventually corrupt the system requiring a bailout.

    In the end, all these fancy financial products are no more than a high tech shell game.

    The first step towards a solution is to realize that our elected officials are in on the game.

    Whomever is in office, vote them out!!

  10. jake chase

    The case against CDS is identical to the case against all the other OTC derivatives: nobody knows who is exposed to what risk and with what leverage until a bomb explodes. You may as well eliminate accounting entirely, since the published financial statements of all the important players are simply fiction. Welcome to a world where no investor can protect himself. You have to hand it to the ISDA. They sold the ultimate Ponzi scheme and are still running it while poor Bernie MadeOff rots in the can.

    If you can’t simply prohibit OTC derivatives, at least tax them heavily enough to pay for the next bailout, for which I doubt we will have to wait very long.

  11. RueTheDay

    Great post. I have argued for some time that CDS impede the effective functioning of the interest rate mechanism which is supposed to adjust the interest rate to reflect risk. Particularly when the selling of CDS is concentrated in a small number of firms which do not (or cannot) adequately reserve for future credit events. This leads to systemic underpricing of risk followed by an oversupply of credit from creditors who (mistakenly) believe they are protected followed by a meltdown.

  12. MrM

    CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis.

    Then let the market sort it out: if it is not economic, nobody will participate in the market. And if somebody’s bets will go spectacularly wrong, if they are properly margined there will be risk of not paying. So deal with the problem of defining processes for unwinding insolvent financial institutions directly, instead of outlawing one of the ways they can blow themselves up.

    1. MrM

      And if somebody’s bets will go spectacularly wrong, if they are properly margined there will be risk of not paying.

      And if somebody’s bets will go spectacularly wrong, if they are properly margined, there will NO be risk of not paying.
      Typo fixed. Sorry.

  13. MrM

    In the world of old-fashioned fixed income investing, creditors would evaluate a borrower to make sure it had good odds of meeting its obligations. The lender could and usually did make inquiries about the borrower’s income, and its other commitments. If it was a business, the bank might also want to assess information that would help it evaluate the stability of the borrowers income (for instance, learning who its main customers were to determine how diverse and solid they were).
    Just as with securitization, credit default swaps lower the incentive to do borrower due diligence. Why bother, when the CDS spreads on the reference entity tells you what the market thinks and you can use CDS to reduce or lay off the credit risk? But the original lender is in a privileged position; he is able to gather data from the borrower that it non-public and thus will not be incorporated in a market price. Thus giving creditors an incentive not to do that work systematically lower the quality of credit decisions.

    Yves, this is exactly backward: Since the lender has privileged access to information about the credit health of a company, the lender will have huge incentives to capitalize on this informational advantage by arbitraging CDS written on that company. Again, all you need is proper margins to ensure that if this lender is wrong in its analysis, it can go BK, but its CDS contracts will still pay off.
    If anything, the CDS market allows the proprietary information about a company become more available to other investors. If properly margined.

  14. Fair Economist

    On a side note – in a environment where large changes in inflation and exchanges rates are possible in short periods “vanilla” interest and currency swaps are no longer so benign. With QE creating heavily distorted M0 ratios that’s not just a theoretical possibility.

  15. Mannwich

    Be careful peeling this rotten onion layer after layer. Peel enough layers away and we’ll soon find that very little of what Wall Street does has little, if any, real redeeming “social value”. It’s one big circle jerk with the Feds providing the lubrication.

    1. Michel Delving

      Good on you, Mannwich!

      “CDSs are “anti-social”, he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company.”

      This scheme strategy plays out in same egregious pattern with CDS shorting mortgage debt. When viewed from perspective of a mortgaged homeowner, these CDS shorts become weapons of class destruction as well. Little do victims of mortgage servicing fraud realize that it was complicit mortgage servicers, subsidiaries of the mega banks who greased the skids, gaming lucrative CDS bets for their proprietary traders.

      Furthermore, despite $27,349,230,000 committed to mortgage servicers as incentive payments for mortgage modifications as part of the administration’s HAMP program, servicers have been deincentivized from supporting this program because CDS payouts rigged on insider knowledge that servicers manufacture defaults are so much greater.

      Short CDS holders want these credit events, they want these bogus defaults and illegal foreclosures so they can collect on highly leveraged bets. They don’t care that fraud is perpetrated in order to collect their winnings. They don’t give a rat’s ass about Main Street homeowners at all. They are actively hoping to profit from their demise. This extreme anti-social behavior is well on its way to pushing U.S. foreclosures well past 3 million this year.

  16. Siggy

    Very interesting post and thread.

    Of all of the arguments that have appeared here there is one that has had limited expression. As regards the seller of CDS, the critical issue is as to whether he will be able to perform if the stipulated event occurs.

    If you execute a contract which you cannot honor you, at the least, are commiting a tort and more probably a fraud.

    AIGFP is reported to have sold/executed 44,000 CDS contracts. It appears that those contracts were executed in the full knowledge that AIGFP could not honor the contracts in total nor in part.

    The instrument of resolution of the AIG failure has been the pass-thru buyout by the Treasury of a substantial number of contracts at 100 cents on the dollar. The notable counterparties being a small group of ‘primary dealer’ institutions. Todate, I’ve not seen any comment on the fact that a monumental FRAUD has been perpetrated.

      1. Siggy

        Thank you for that. Makes my point. When the hell are we going to have some criminal prosecutions? Contingent contracts that are not adequately hedged and/or collateralized are a contingent fraud. Everything that has been discussed here is a side show. Its an exercise in dilatantism. The issue is criminal financial fraud.

        Now I am aware that the fraud is multifacited and that its full prosecution would have the potential of bringing down the global financial system. Over the mid to long term, that might actually be a really good idea.

  17. Frank T,

    If the Federal Reserve were prohibited from making good on CDS obligations, then the risk would rest where it belongs — with those who buy and sell them. This can be done via legislation. But as things now stand, the Federal Reserve = Moral Hazard.

  18. winterwarlock

    Unfortunately, these instruments balance all the unfunded liabilities on the books, and many are not going to voluntarily walk away from a pension, a protected job, or a lucrative bonus system until the bomb is ready to explode, and then it will be too late.

    If they will put their own immediate profit interests ahead of their kid’s needs, to use kids as leverage in a demographic ponzi scheme, they are certainly not going to listen to reason. Some people are just hard-wired for efficiency. Left to their own devices, they always consume and blow up the remaining economy.

  19. Rhett Anderson

    Since the quote paraphrased in the title (Shakespeare from Henry VI–‘The first thing we do, let’s kill all the lawyers’) comes from an argument in favor of lawyers, it should only be used ironically. I expected this article to be in favor of credit default swaps.

  20. i on the ball patriot

    Vanilla Out — Pernicious In

    Greed jumped up on a stool one day,
    And shouted to those standing around,
    I’m changing the rules of the greed game today,
    Pay attention or you’ll surely lose ground,

    Vanilla greed is out,
    Pernicious greed is in,
    Your greed must be destructive,
    And it must be loaded with sin,

    Your enemy as always,
    Will be others perceptions,
    I’ll leave it to you,
    To devise better deceptions,

    But make no mistake,
    About this new game we play,
    It could cost you dearly,
    If perception gains sway …

    Deception is the strongest political force on the planet.

  21. Josh

    As a credit default swap trader, I a a bit biased, but what is the difference between credit default swaps and put options? CDS contracts are essentially no more than put options on bonds. No one has a problem with put options or calls them anti-social or claims that people don’t do their homework on stocks because they can just buy put options. The problem stems from leverage. It was very easy to make very large bets with no margin. When you have that situation, companies like AIG get themselves in trouble. If they had had to put up 15% of the notional amount of the contracts they sold, they never would have been able to put the trades on. All CDS contracts are are slightly sexier bond options.

    1. IF

      I think there is agreement that CDS are
      a) non-standardized, causing difficulties later
      b) as you write encourage cheating on the collateral
      c) lead to information loss, which does not happen with stock puts
      Yves argument seems that if you fix a) and b) you get much less incentive to use CDS, while c) is inherently unfixable.

  22. Doug Terpstra

    I don’t understand any of it, which I suspect is the whole point of any shell game. Richard Smith’s “airworthiness regulations, which even libertarians accept without demur” are so self-evidently right because the economy is so esssential to national and individual health and safety. It is no longer acceptable to have these maverick gamblers going rogue when it affects the lives and welfare of so many people. (Everything else about “confabulating” and “compression ratios” that either Smith said went clear over head.)

    I can’t wait until we get AI computers running all this high-falootin’ finance for us.

  23. ScottB

    KD writes “Social value is not a requirement in capital markets.”

    Well, there you have it. When capital markets do demonstrated harm, let’s dismantle them. We limit free speech when it’s harmful, why not capital markets?

  24. postmodernprimate

    What idiot could possibly claim that the economic benefit we receive from having CDS outweighs their cost? Forget about possible future damage. These things couldn’t pay for the damage they’ve already done if you gave them 100 years. This should be the end of the debate. Their cost is orders of magnitude more than they’re worth. The debate should end here.

  25. Thinking Nationalist

    Good Discussion.

    CDSs’ as a hedge are acceptable UP TO THE NOTIONAL VALUE of the referenced security. That’s KD’s position.

    The PROBLEMS are:

    a) CDS’s outstanding are a MULTIPLE of notional value of bonds outstanding. What that means is that everything beyond this notional value is nothing more than “side bets”;

    b) The people writing these side bets (“taking the action”)
    are not required to have ANYTHING behind their position – in other words, thay may not be able to pay off on the bets;

    c) There is IMHO much merit to the idea that CDS’s may facilitate a co-ordinated, “combined arms” bear raid on a company when used in concert with naked shorting and rumor-mongering.

    “Bear Raiding” may serve a useful social function, but
    when all markets are dominated by a handful of TBTF
    institutions, what role is there for other market players
    except as designated losers?

    These things need to be standardized, exchange traded,
    and limited by regulation in both their application
    and total amount outstanding.

  26. Ankit

    This has been a very informative discussion to read. However, all this discussion revolves around a) CDSs are evil (perverse incentives, zero economic value, etc.); b) expensive to trade and c) lead to undercapitalization for the CDS writer.

    I propose a simple and cost effective solution to CDS problem. Each CDS transaction has to be publicly listed.

    I think this will have the following advantages-
    1. No interference with the free market. People are free to gamble and bet on anything they want.
    2. The public record will be a database to ascertain outstanding exposure for every counter-party. Granted TBTF. But nonetheless, most of the businesses in their right minds will buy CDSs written by a credible party.
    3. The public record will highlight all perverse incentives for a bond default. If there is a large volume of CDS outstanding vis-a-viz par value of the bonds, the CDS issuer(s) will simply buy all bonds and not let them default.

  27. Randomgleanings

    Memo to David Einhorn

    If CDS are ‘anti-social’, isn’t shorting stock also??? What do short sellers want? The stock to go to zero which is essentially bankrupt (liabilities > assets). Don’t hear anything about that from Einhorn and all the money he made shorting Lehman sending the economy into a tailspin!

    And ‘basis packages’ are not what puts companies like GGP, Capmark, CIT, etc into bankruptcy. Years of bad decisions, poor management and too much leverage did the job nicely. Basis holders are simply indifferent to a company’s last gasps for air as they meet the judge in bankruptcy court. Why is that bad?

    Solutions for CDS
    1. Throw all transactions onto an exchange to increase transparency like Trace for corporate bonds. This will decrease vampire squid profits but it will allow investors to know where the market really is.
    2. Increase collateral requirements. Among the largest sellers of CDS are CDOs which essentially are 100x leveraged and have no skin in the game. Make them cough up some $$$ which will decrease issuance. Say 15-20% of notional CDS position.
    3. A clearinghouse would require position netting which is the crux of the issue when people talk about the notional amount of CDS outstanding.
    4. Regulators need to watch market maker positions closely. No more, long, wrong one-sided bets like AIG!

  28. Hubert

    I guess we have to get rid of them asap.
    There are even more worms in that cap.

    JUst put yourself into the shoes of a cyclical or marginal profitable enterprise (95% of all). Do you really want any of these to be in a position to profit from you going 11?

    1) Your bank which might or might not roll your loans. Seniority in Bankruptcy: It is just an invitation to own loans or bonds higher than the most junior tranche which correlates with CDS.

    2) A critical supplier of yours: he may cut you off for whatever pretext

    3) A very important customer

    4) Your accountant, or a very big (future) customer of your accountant.

    5) Your controlling shareholders: They could indirectly set up a big fraud, looting the company

    Now do not say this is not possible. It is. I would like to know who had bought protection on LEH.

    “Insurable interest” is much too vague. Insider trading is illegal in equity markets. Now look at this. It has to be forbidden. VERBOTEN. There are enough reasons for the end of capitalism already. We do not have to blow the system up for a few IB to book some profits and pay some bonuses.

  29. Hubert

    In the post above I meant to write “worms in that can”, not cap.

    And I forgot to mention competitors: In banking they can force a run on you.
    In industry or insurance they might start or stop a price war.

    All these above parties have sensitive information and can work the media.

  30. Hugh

    I think to understand what we need to do about CDSs we have to understand what they represent. They are for the most part spurious hedges on highly leveraged and risky investments. Add in naked CDSs and you have a magnification of the base risk. It is that risk that has to be dealt with and there is no way of doing so short of a resolution of the paper economy itself. Modifying or putting restrictions on future CDSs will not begin to address the problem. First, in a regulatory captured environment, such changes aren’t going to happen anyway. The joke reforms coming from the Frank committee on exchanges are proof of this. Second, even if they were instituted, they would only kick the risk resolution problem down the road. A smashup would jsut happen later.

  31. Nicolaq

    Do you know what he means : ‘CDS trade compression’: the 20-40% that some commentators are so pleased about
    I understood that compression reaches 85-95%?

  32. Ed

    Can anyone name an example of a fundamentally sound company that was pushed into insolvency by another entity long its CDSs? Yves and others have alluded to this occurring in the post (para 9) and comments above, yet I have never come across a convincing example of this actually occurring.

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