Credit default swaps played a much more central role in the financial crisis than is widely understood, and they continue to get a free pass in financial reform proposals that they do not deserve. As we have discussed on this blog, and recount in more detail in the book ECONNED, central clearing and/or putting them on exchanges are inadequate remedies. Only a small subset of CDS contracts trade often enough for to be suitable for exchange trading. As for central clearing, the logic is that this would provide for consistent and sufficiently large margin to be posted (think of it as a reserve against the ultimate possible insurance payment required on the contract). But unlike real derivatives, CDS are subject to massive price moves (“jump to default’) when a reference entity (the entity on which the CDS is written) defaults or goes into bankruptcy. That large price movement, means that the margin already posted will be insufficient, and there is no guarantee that the counterparty will be able to pony up the amount now due.
But perhaps more important, the idea that CDS have legitimate uses is questionable. They are used to hedge credit risk (sometimes) yet their pricing, per Bloomberg or any of the common commercial models, price CDS based on volatility, which is not based on any assessment of the underlying credit. So the idea that the pricing reflects default risk is spurious; indeed, CDS failed abysmally in predicting financial firm default risk during the crisis (Lehman was a particularly vivid illustration). But they serve to perpetuate the erosion of proper credit analysis (why bother if you can just lay off the risk?).
In the last two days, Gretchen Morgenson of the New York Times and Wolfgang Munchau of the Finacial Times have both launched salvos at CDS. Munchau’s is even more vituperative than Morgenson’s, which given the sober sensibilities of the Financial Times, suggests that opinion on the other side of the pond may be coalescing against the product.
Morgenson points out that even Ben Bernanke has started to question the legitimacy of CDS, but peculiarly is not as hard on his remark as she should have been:
“Using these instruments in a way that intentionally destabilizes a company or a country is — is counterproductive, and I’m sure the S.E.C. will be looking into that.”
Yves here. Huh? How, pray tell, is the SEC, of all regulators, going to look into CDS? CDS are specifically exempt from SEC regulation. If anyone has (or could decide it has) jurisdiction, it’s the Office of the Comptroller of the Currency, and the Fed. So saying that swaps are a problem, and saying that someone who cannot possibly look into them will handle them, is just a fancy form of regulatory three card monte.
And if anyone had any doubts that the CDS market is officially backstopped, look no further than the Bear Stearns and AIG rescues. To put not too find a point on it, the industry understands full well who is the ultimate bagholder:
United States commercial banks, those with insured deposits, held $13 trillion in notional value of credit derivatives at the end of the third quarter last year, according to the Office of the Comptroller of the Currency. The biggest players in this world are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs.
All of those firms fall squarely into the category of institutions that are too politically connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous, said Robert Arvanitis, chief executive of Risk Finance Advisors, a corporate advisory firm specializing in insurance.
“If companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”
Morgenson is positively tame compared to Munchau. I’m quoting him more liberally, because the tone of his remarks are remarkably pointed for him and the FT generally. Notice that he explicitly, and repeatedly, says the use of naked credit default swaps looks an awful lot like a crime:
I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer…. Unfortunately, it is legal…
A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.
Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.
Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale…
Yves here. The “tradeable” aspect is exaggerated. While standardization of contracts has helped, most CDS are not traded; dealers lay off their risks by entering into offsetting swaps. Back to Munchau:
Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.
So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work…
Yves here. Hedge funds and Wall Street prop desks replicating certain structured arb strategies that relied on CDS were far more important in the crisis than is widely understood. You’ll be hearing more about that in due course. Back to Munchau:
But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.
Where is the political response? The Germans want to bring it to the Group of 20, but they hesitate to do anything unilaterally. Christine Lagarde, the French finance minister, was recently quoted as saying: “What we are going to take away from this crisis is certainly a second look at the validity, solidity of sovereign [credit default swaps].”
A second look? I wonder what they saw when they looked the first time.
Yves here. The other defenses of CDS I’ve heard are equally dubious. One is they add to liquidity. Ahem, were corporate bond investors ever suffering from a lack of liquidity? That paper doesn’t trade much because most investors are buy and hold. Even when I was a kid, in the early 1980s, when there was as much appetite for corporate bond trading as are likely ever to see due to high uncertainty over interest rates. Yet no one complained about illiquidity in the corporate bond market (as in yes, it may not have been that liquid, but no one felt inconvenienced, dealer spreads were not seen as problematic). And as CDS drain liquidity in crises. As bond yields rise, intermediaries and hedge funds, both of whom are leveraged and normally serve as liquidity providers, have to tie up of their scarce cash and collateral in posting margins on CDS positions. So they suck liquidity out of markets are precisely the worst possible moment.
The more we can to to contain this product the better, but I am afraid it will take another meltdown to teach us the lesson we should have learned from the last one.
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See you on the WPA work crews.
pimco and other large buy-siders are against cds clearing houses: margins will be prohibitively high (5% is just as much as they can commit) and they will not be able to net contracts with counterparties thus further increasing margin requirements.
the greatest benefit of cds is their leverage which was taken away by the SEC from the equity markets. regulate cds markets and they will die as they should have already.
Yves,
I enter into a vanilla IR swap with a commercial cpty. Three years down the track, rates collapsed, and I’m massively in the money. It’s a commercial cpty, so we don’t collateralize.
Is buying a vanilla CDS on the in-the-money amount a naked or covered CDS? What if I buy a contingent CDS (where the underlying instrument is the swap I sold originally)?
I think if you want to ban, you’d have to ban entirely – and be very very careful how you do it (i.e. ban widely and in a few sentences, not pages and pages with implied loopholes)
vlade,
My view is more like yours than Munchau’s. I think the product has so few legitimate uses, versus its costs and abuses, that it needs to be shut down. The problem is that it has become so deeply enmeshed in a lot of portfolios that an immediate ban would probably produce a lot of disclocations (I am told this by experts who are as opposed to the product as I am). So I think you need to cut off its air supply first (per the comment above, higher margins will help greatly reduce usage) and then once you have skinnied the market down and can assess where the remaining exposures are, figure out a procedure and timetable for getting rid of the product completely.
It also needs to be made clear than the object of policy is to get rid of CDS, that it is on its way to being a legacy product. That may help deter use too.
Agree re immediate ban. I think the best way to deal with it is to raise capital requirements – say dropping the CR advantages to CDSes right now (which will make it more expensive right off the bat), and then incrementaly increase over 5 years (most common maturity) capital requirements for ALL CDSes to the notional of the CDS (on the writer side), and double that on things like contingent CDSes.
So, you’d be free to write a CDS for someone, but the capital requirements would make it very unattractive. Whether you’d then continue killing it is a different question.
I read Munchau as being 100% against naked CDS, and as naked CDS constitute almost all CDS (S. Das has written some 80%), he wants to ban all CDS.
Munchau continues: “There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate.”, but goes on that such difficulties should not deter us from banning CDS’s.
So I read Munchau as being for a 100% (i.e. no loopholes) of all CDS’s.
Munchau writes: “Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.”
He suggests that bank robberies have been banned.
However, they are banned for you and me, but NOT for the CEO’s and their ‘top talent’!! In the 2000 – 2007 years, mark-to-market gave banks illusionairy, paper profits. Typically half of those paper profits were robbed from the banks as bonuses, instead of remaining in the bank as reserve capital.
I accept that issuing a complete ban on all CDS, and a lot of other derivatives, can not established overnight. But at least, governments should start working towards phasing them out.
vlade,
it looks you do not understand the difference between IRS and CDS. an IRS exchanges the cash flows of of assets, CDS protects against default of the reference counterparty. you are talking about neither here, but about hedging your counterparty risk rather than a reference entity default risk. if you buy CDS protection on your counterparty, most likely your ‘massively in the money’ IRS will generate a loss unless it is stellar credit. and if it is a top notch rated company why buy protection on it from another company that has just as good credit rating?
Rest assured I do undestand both.
I won’t go into detail, but instead will just say CVA and its hedging, and leave it to the reader.
And that this is exactly what Goldman did when they bought CDSes on the out-of-money swap they did with Greece.
bb, what vlade is describing is exactly how CVA is supposed to work.
i see that you are both referring to posteriori counterparty risk management, but am still strugging to understand the economics and common sense of this whole hypothetical transaction. if you have a swap deep in the money and you decided NOT to demand collateral, you have agreed to a transaction with counterparty risk priced at 0. now you want to cover the counterparty risk just because you are making money. you never thought you’d be on the right side of this transaction at its inception? why did you enter it, just to say you are hedged and toss some money out the window? corporate treasurers!
and regarding your question: this is a NAKED CDS you are describing, because you have a contract with your counterparty and there is no reference entity on which you could buy CDS to show genuine insurable interest. and if you want to buy CDS contingent on your IRS then you are not talking about vanilla CDS as you stated in your previous sentence. and if you are talking about real life example, make sure you buy CDS with an universal default clause.
and i miseed that: buying CDS on your IRS counterparty does NOT hedge your position. your counterparty may still refuse to pay you on the IRS and not be in default because this is a commercial contract, and not the reference entity of your CDS even with an universal default clause.
Using CDSs in this way to destabilise entire nations is not only a crime, it is an act of war and terrorism and individuals who engage in such activities should be treated accordingly.
unfortunately highly profitable.
And nobody can’t stop them.
awful, awful article.
You understand nothing about how the market works.
Thanks
No, I understand it quite well and my views are consistent with those of some market participants (those not at sell side firms) and derivatives experts. If you had a real rebuttal, you’d offer it. I note the utter absence of any specific retort.
Please explain it for us then. Waiting…….
I thought it might be worthwhile reading this call from
Paul Jorion on the banning of CDS: The house is on fire
“Ladies and gentlemen of the European regulatory authorities, I am today turning to you: the house is on fire!Demands that Greece lowers its civil servants’ wages will not save her. Your prodding Greece to tackle tax evasion will not save her. Your offer to establish a… piggy bank (how laughable an idea!), will not save her either. All that is far too little, far too late. It is also beside the point..”
http://www.pauljorion.com/blog_en/?p=200
Gary Gensler ( chaiman of the CFTC ) also had an interesting op-ed in the FT on 24.02: “How to stop another derivatives inferno”
“And if anyone had any doubts that the CDS market is officially backstopped, look no further than the Bear Stearns and AIG rescues. To put not too find a point on it, the industry understands full well who is the ultimate bagholder…”. I don’t think that any CEO of a large bank can believe that taxpayers will once again backstop the failure of a major counterparty. Next time round it will be “burn, baby, burn”.
huh? Greece obviously prove otherwise. that CDS related trade will ultimately be paid by sovereign state money.
Look at Ireland. It has a small economy, but the bank had huge CDS debt they can’t pay. That debt was then backed by ireland. Now ireland is in deep debt. Now, if you push Ireland debt spread to the moon, that country will default/needing bail out, unless euro crash.
Same with Spain, italy. These are relatively OK albeit weak government balance before crisis.
To bring this further. Imagine Israel start bombing Iran and Oil goes $120. Nobody can pay their debt! Not even germany or US.
I would ban them immediately, and take my chances with causing dislocations. (I’d treat any adverse effects as crimes on the part of the designers, peddlers, and aggressive collateral-callers like Goldman with AIG.)
The “TBTF” system’s been rigged specifically to guarantee that withdrawal incurs pain. That’s how they try to enforce the protection racket. They’ve bet, so far correctly, that governments and peoples are too weak and cowardly to undergo some short term pain for the sake of freedom and recovered economic self-determination. It’s as if the heroin could speak to the junkie, threatening him with the withdrawal pains he’ll undergo if he doesn’t keep shooting up.
Taleb invoked Churchill’s 1940 defiance in saying we must be willing to undergo “blood, sweat, and tears” to free ourselves of these gangsters.
Ban CDS immediately.
attempter,
I agree. Ban CDS immediately!
Unfortunately, Europe, like the US, has decided to go George Bush. By that I mean it has decided to commit to mind numbing stupidity. Munchau laments:
I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer…. Unfortunately, it is legal…
But absolutely nothing will be done. Nothing!
Sitting here in Mexico, I feel exactly the way I did when the US reelected George Bush in 2004. I and all my Mexican friends were in a state of total shock and disbelief. And as I look across the Atlantic now I’m struck by the same sentiments. How could any group of people be so fucking stupid?
Being stupid is an inherent attribute of most people in any assembled body of people. Walk into a room, 90% of the occupants will be of average to retarded mental capacity. The remaining 10% in their superior menatal capacity will be vulnerable to various neurotic disorders. It’s a fact of life. No one’s perfect an we all suffer from the distorting lens of our degree of aculturation.
Add to the foregoing the fact that the elimination of the CDS trade will erase a lot of rice-bowls and you have the howl of the speculators hiding in the self defined rainment of hedgers.
As to the naked CDS, what has the seller of such a contract done when the contingency occurs and it is time to pay and he says: “Sorry, I can’t honor the contract”. I consider that to be the perpetration of a fraud. I say prosecute and fine him the notional amount of the fraud.
I agree that CDS should be banned altogether. I would ban all new contracts and demand the liquidation of all outstanding contracts over a three year time frame. I would also enact laws that clarify the fraud that has been inherent in the motivation of the current financial crisis.
See typing and spelling are not my highest skill.
If you cannot shut down the casino at least start to tax it heavily. It will go out of business…A finacial transaction tax is a painless way to go about.
Watered down or washed out? No doubt you’ve already seen this.
http://mobile.bloomberg.com/apps/news?pid=2065100&sid=aoPs44KpdxUg
As I’ve been saying for 2 years, reform stops at recapitalizing the banking industry.
For years everyone loved CDS because it allowed borrowers to borrow more. Now everyone hates it. You liken it to robbing a bank. I think it is the best thing we have going for us.
CDC highlights our weakness. We (globally) are too heavily in debt. Those with the biggest debts and biggest problems will have the highest CDS spread. I would take a read from the CDS market before I looked at Moody’s or S&P. This is just a different form of disclosure folks. It aint going away. You can’t legislate it if you tried. Better to rejoice the benefits than to crap on the consequences.
For companies maybe, but not for governments or the states they represent.
The government is not just another corporation. It has a different (legal and societal) status and purpose and as such are not subject to the same rules as corporations.
JPM betting on the demise of GS I have no problem with. Doing the same with an entire nation is just financial terrorism.
Protecting yourself against the default of a country = terrorism. alrighty then.
By the way, some of these countries have currencies that trade on markets. I better not catch you selling any of those currencies short unless you can demonstrate that you have definite, provable cash flows in that currency.
Submit documentation (in quadruplicate) to: Ministerstvo Finansov, Rybny pereulok, Moscow Russia.
Protecting against an event is not the same as actively making something happen through your actions and that’s what we are talking about here.
The market moves because of the actions of a few large players which can move the market anyway they want. Same is true for forex markets, however there at least you have margin requirements which do not exist for CDS.
Besides the correct address is
109097, Москва,
Ул. Ильинка, 9
or
109097, Moscow,
Ilinka Str. 9
Why would you rely upon the CDS market for credit info, given all the problems associated with it?
As Yves pointed out, the vega is incredible, leaving you possibly with a position that reflects your views 180%. No liquidity, no bid/asks, very few participants setting the prices. Negotiated settlements. All the facets of a rigged market. When you need it most — at times of stress, again as Yves pointed out — it offers the worst opinions.
Typical economist, one who overlooks clear evidence because it doesn’t fit the classical view. Also, thanks for telling us why you choose one over the other, otherwise called backing up your argument. I am Bruce Krasting and I think this doesn’t carry any weight.
Bruce Krasting,
What you are saying is “Don’t shoot the messenger!” The messenger in your case is the market and the underlying assumption is that the market always speaks the truth.
But what if the messenger is like the little boy crying wolf? Or worse, what if the messenger is like the person who yells “Fire!” in a crowded theater?
Our current reality is even worse than that, for what we have is a situation where the messenger who yells “Fire!” also stands to gain from the pile of trampled bodies. And furthermore, our hidden puppeteer had a hand in creating the crowded theater to begin with, that is in loading his victims up with debt, preferably denominated in a currency over which they have no control.
Whether there is or isn’t a fire is really of no importance to our hidden puppeteer. What is important is convincing enough people that there is a fire, and thus precipitating the stampede.
So the market in this case acts not a conveyor of information or truth, but as a carrier of tales—-of distortions, half-truths and outright lies. The trick for our hidden puppeteer is, with its bellicose dogmatism, to convince enough people that the market is the potentia absoluta, and not the great deceiver.
billy blog does a superb job of deconstructing the workings of our hidden puppeteer, that is the international criminal banking cartel(see today’s Links). It’s a great read that I highly recommend. Here’s the diamond that I plucked from the article:
The clear lesson is that sovereign governments are not necessarily at the hostage of global financial markets.
I think commenter RueTheDay summed it up best the other day:
Home Run!!!!
Yves,
Give this guy a cigar. If the Yield Curve is to have any meaning, you have to erase CDS.
Krasting,
If you think that CDS function as a barometer of risk/reward conditions you have a mental capacity problem!
Siggy,
As you’ve said many times, the rub doesn’t come from the fact that someone underpriced the risk. The rub comes from the fact that the ones who underpriced the risk got paid billions of dollars for doing so and, when it came time to ante up for all their bad bets, it was not them or their firms but the taxpayer who got stuck with the tab.
Layered on top of this are the highly corrosive social consequences—-the turmoil inflicted upon households, businesses and sovereign states that were extended credit they never should have received; the destruction of trust, cooperation and social cohesion; the precipitation of a global financial tidal wave that engulfed many innocent people.
And just imagine, it was all legal!
Surely this ranks right alongside the legalization of racism as one of the greatest miscarriages of justice in human history. As Martin Luther King once observed:
We must never forget that everything that Hitler did in Germany was “legal.” It was illegal to aid and comfort a Jew, in the days of Hitler’s Germany.
–Martin Luther King, “Love, Law, and Civil Disobedience,” address before the annual meeting of the Fellowship of the Concerned on 16 November 1961
I am unconvinced that AIG’s inability to honor its CDS contracts was/is, in fact, legal. I’m not a lawyer, nonetheless, if AIG did not commit a felony, they did commit an eggregious tort.
This business of allowing parties to take out insurance on something they don’t own or have a direct interest in is nothing more than bucket-shop speculation. The bastards need to be prosecuted and if not that then led to the bankruptcy court.
There is a piece in this blog that refers to the idiocy of CDS. It goes to the price signal that was once inherent in the interest rate of a loan. CDS have distorted that price/risk signal.
I am convinced that most of these firms should have been nationalized, the unserviceable debt repudiated and that we should have had one hellacious depression. What we are doing now is not going to solve the problem in any way imagineable.
It’s the currency coupled with fractional reserve banking coupled with some goofy Ayn Randian nonsense and the ruminations of a cadre of academics who can’t conceptulize beyond their nifty little least square algorithms.
It does not help one bit if this and a few other blogs are the principal voices of truth. It’s not enough to impress the body politic. They may well have large student loans to payoff; but, my impression is that did not get fair value for their education dollar.
This business with CDS, CDO and financial derivatives is not esoteric mathematics. The reality is that a nine year old can do the calculations. The further reality is that you cannot and never could calculate away inherent risk.
Thank you for your kind observation.
Siggy, you wrote that allowing parties to take out insurance on something the have no interest in is just bucket-shop speculation and that a CDS distorts the price signal.
I thought that a CDS provides a price signal? I mean, it’s basically the result of people making bets based on inside information (and therefore not bucketshop speculation), is it not?
Again, other than knowing the basics about how CDS’s work, I’m pretty much in the dark. I’m just trying to understand the issue more, so please bear with me.
oops–nevermind. I re-read something Yves wrote, and it makes more sense now.
How about the use of CDS to hedge sovereign counterparties who don’t post collateral?
The mainstream press has done a very poor job of handling the financial meltdown. When AIG required the big bailout, a couple of sources (like Bloomberg) carried articles that an almost unheard of organization called the International Bank of Settlements (IBS) claimed that there were almost $700T of Credit Default Swaps in play, worldwide. This number seemed unbelievable, given that the world GDP is just over $50T. How could even a small fraction of these “contracts” be paid off if there were any sizable defaults amount those being “insured”. A few papers, and I think PBS’s Frontline made an effort to investigate Credit Default Swaps, and it became clear that this was a huge casino for very wealthy individuals, and Investment Banksters.
Congress has made the most feeble attempts to understand these instruments. They even approved the appointment of Gary Ginsler as the chairman of the U.S. Commodity Futures Trading Commission. Ginsler was a big supporter of Credit Default Swaps back in 1998 when Clinton signed the bill taking CDSs out of the purview of government “oversight” by the way.
In short, it’s not at all clear that most professional politicians have the slightest idea what a Credit Default Swap is, or just how instrumental they have been to this current crisis.
It’s really difficult to see how they do any “good”, and it’s very easy to see how they do a lot of “bad”–particularly with people like Barack Obama willing to bail out every Investment Banker from here to Mars with US Taxpayer funds.
I vote to ban these things–starting yesterday!!
Yves “I think the product has so few legitimate uses, versus its costs and abuses, that it needs to be shut down.”
I don’t see how your argument is any different from those I’ve seen against short-selling, or even those (generally hypothetical) arguments that one should not be able to sell a security one owns… all stemming from an apparent belief that downward forces are detrimental and unnecessary in a market.
First of all, cds representing the preferred form of counter party protection, and massive (and systemic) counter party risk being introduced by the derivative market generally, I don’t see how you could ban one without the other. Getting rid of cds would not be an isolated economic “hit job”, it would represent an unbalancing of a financial system very near a cliff.
Furthermore, since cds do not create risk of default – they were created simply to hedge against it – by removing them you remove the accepted price mechanism for this risk. How do you plan to “fix” a market – in the beneficial sense – by removing information or unhinging price discovery? If it were the case that every lender was dependent upon the cds market, and that the market was additionally proven to be manipulated, you could argue that risks are being distorted. But as it stands cds are no monopoly, they are simply watched by the majority of lenders —
— because they’ve been ACCURATE. Pin-point accurate, compared to economic “visionaries” like Bernanke, whom you propose empowering. Your point about Lehman is grossly misleading. Highly leveraged firms with short-term obligations can tank in a day if lending dries up – such is the pace of modern finance. But how you can allege that credit markets didn’t predict the Lehman collapse, which was prima facie caused by the closure of credit markets, is far, far beyond me. Would you prefer 30-day notice, written? CDS were quite clear, with longer duration, on the big banks, WaMu being a prime example.
While it’s amusing to hear the complaints of those who believe that governments should always have captive buyers of debt, what cds are accomplishing in Greece is this: they’re forcing resolution of problems which, if left to themselves, would only grow worse. The EU cast a blind eye, voters were paralyzed, and I suspect that the role of private markets in holding accountable governmental malfeasance in Greece is especially galling to folks of a certain philosophical slant *cough*. The kind who believe government is “self-correcting”. Folks who knew nothing, said nothing, and who now complain about the unfairness of forcing an entity with power of taxation to balance its budget. In my mind, the same kinds of folks who, with Rome burning, would stand and b@tch about the fairness of the bucket brigades.
That cds are compelling firms (and countries) to reduce leverage is, in my mind, a far greater good than any evils you attribute to them – evils which in any event seem to be no more than conjecture and ideological distaste.
Costard,
With all due respect, your argument is intellectually dishonest. And I say that because you look savvy enough to know better.
There is no comparison between using CDS to short and shorting stocks. First, you need to have or be able to borrow the stock. Second, given the margin requirements and the liquidity of the underlying assets, counterparty failures to perform do not pose a systemic risk or create other widespread collateral damage. Just look at the casualties caused by the monoline actual and de facto failures, a topic that seldom gets the coverage it deserves.
I suggest you read Chapter 9 of my book. I demonstrate, using names of particular players and providing detail as to how the strategy worked, how a SINGLE firm played a large and heretofore undisclosed role in turning the subprime bubble into a systemic crisis. CDS were THE reason subprime was not “contained” because it not only multiplied exposures well beyond that of the actual market, it concentrated them in the tranches first to take losses, BBB tranches of subprime bonds.
OK, Yves, I am not part of the industry and therefore don’t know better, so could you please explain if upfront margin requirements would help make the CDS market less systematically risky and more useful as a financial (indicator and gambling) instrument? I assume (again, please correct me if I am way off) that given the choice between buying a CDS and shorting a bond, I would want the latter, because I wouldn’t want to be squeezed out of my position, or have the lender demand repayment at an inopportune time. From a market point of view, a big enough margin requirement would increase the price of the CDS, thereby reducing the leverage employed (I think?)
Sorry if this is an overly stupid question, but I can also theoretically buy a CDS on a CDS, correct? If so, does that
Some of us have been saying this since the meltdown in September 2008, nullify naked CDS. If you can’t prove you held the underlying instrument at the time the CDS was purchased, you’re out. Amortize risk on existing CDS where the underlying asset is held. Ban future CDS and direct those who want to hedge to a reputable regulated insurance company.
None of this will happen because we face not just casino capitalism but crony casino capitalism. Thus the question about the next financial collapse is not if but when.
I am no CDS expert, so please enlighten me if I am off base here. I just have a few thoughts that I would like someone to clarify. I don’t really understand the argument of how CDS should be banned because “It’s like buying insurance on your neighbours house”. Speaking of CDS on corporate debt, I ask myself what the difference is between buying credit protection and buying a naked put on the company’s equity? Let’s say I wanted to profit from the upcoming default of a company. I then began contemplating what instrument to purchase to make money from this. If I purchase credit protection I obviously get a payout if the company defaults, but assuming some recovery rate larger than zero for the bonds I don’t get 100% of face value. The equity, on the other hand, will get completely wiped out and my put will render a larger payout than the CDS contract. So, being the greedy and evil speculator that I am, I of course want to make as much as possible from the default which I know (?) is upcoming and therefore I don’t use the CDS.
I guess an argument could be made then that equity options are different because the dealer who sold me the put will probably take a short position in the stock. Therefore there is not a larger outstanding notional value in the derivative contracts than the market value of the equity and no additional distress is created in case of a default. From this argument one concludes that it is not the payout structure of a CDS that is the problem, but rather that some dealers sell them without hedging them and therefore end up with a lot of onesided risk. So, shouldn’t the regulation of this market start with this end of the equation instead? This is to me a much stronger argument than the “burning house argument” which kind of misses the point since similar payout structures can be created with different derivatives. I have not thought about this for terribly long, and might be wrong as I previously warned. If that is the case, I´d be happy to be enlightened.
“Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.”
“Dead peasants” insurance policies….
Yves – I traded CDS for 5yrs and I would say that you make some very good and also some very poor points in your argument. In particular on the issues of pricing, you seem to be mixing your thoughts – bloomberg does not price CDS, buyers and sellers price CDS (just like every other traded market) – bloomberg provides a common termination (tear-up) pricing model – this is not in any way how CDS are actually priced.
The crux of your argument, to simplify in common language, is that you believe the trading/repackaging of credit, that was not initially intended should be illegal?
As you are no doubt aware CDS are just a morphed, standardized version of a banking instrument that has existed for hundreds of years, namely the letter of credit. You are also no doubt aware that the underlying instrument in most insurance contracts is also a letter of credit. For example if xyz occurs I will pay you $abc.
So lets all wake up here – ban CDS so what? – do you not think banks will just get around this by trading LOC’s, making greater use of assignments…or whatever.
Your arguments largely deal with the particular nuances of the CDS market – these as you know are just red herrings.
Your baseline argument is that the trading of credit, other than that which is intended to be traded (eg corporate bonds), should not. Make your case on this rather than try to fool your readers by suggesting that it is the deep and dirty world of CDS that you object to.
Love the blog
Gary,
With all due respect, your reasonable tone masks an argument made entirely of straw men:
1. Bloomberg has never served as a transaction platform, while it does provide quite a few pricing aids, both real time indicative prices and pricing tools. You somehow suggest that I was saying Bloomberg was a mechanism for conducting trades, when the post says no such thing.
2. CDS bear no resemblance to letters of credit (I’ve done letter of credit studies). There are two types of LOC, financial and documentary. Both are used to facilitate COMMERCIAL transactions. They have a clear, socially productive role in specific, real economy transactions. That is not the case with CDS.
3. Banks long before CDS existed, could and did assign loans. So?
4. You ignore the main abuses of CDS, that first, they create synthetic exposures that exceed the underlying real economy exposure, thus greatly magnifying loses when they occur. CDS massively increased the total damage of the subprime crisis via synthetic and hybrid ABS CDOs. Second, they create perverse incentives, that of making it more profitable to drive companies into bankruptcy when an out of court renegotiation of the debt would yield better real economy outcomes (earlier intervention, lower legal costs and fees to all participants).
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Yves – I am not here to justify CDS, I have seen first hand their destructive capacity. I have also seen their capacity to keep the market honest, much faster than the average passive fund manager.
To clarify some points:
– Creating synthetic CDS does not magnify losses – WRONG -for every winner their is a loser in the synthetic game (its just an off market bet)- this is a zero sum game – pls show me how the losses were magnified. It allowed the losers to lose ever more, but equally the winners won even more.
– CDS bear no resemblance to LOC’s? Really I suggest you get a legal opinion on this – I certainly have from one of NYC’s most reputable law firms. To such a degree that we used to hedge underlying customer unconditional LOC exposures with CDS under a side umbrella agreement which essentially conformed the two instruments – all backed by a gold plated legal opinion. At their base they are both instruments that say if XYZ doesn’t do something (or pay) I will do something (or pay, or get someone else to so it for you). Please explain how you think and unconditional LOC and a CDS differ – cause the greatest legal minds in NYC were sure enough to issue an opinion.
My point is Yves – its not CDS that is the villian. Anything you can do with a CDS you can do in any number of ways with “so called” banking technology.
The major issues you raise really all come back to the agency/moral hazard issues evident in trading something that was not intended to be traded/repackaged. And that any attempt to shut down the CDS market in a narrow sense will fail.
Best regards,
Gary
Gary J,
I Googled “unconditional letter of credit” and “credit default swap”. I got 132 references, and my reading and checking of these references showed these were disparate and unrelated mention. Please provide a link or PDF of the opinion letter by a top tier law firm(s) that you claim exists, since I see no evidence of ANY such view, much the less an legal opinion to that effect.
As I stated, LOCs are used to facilitate specific commercial transactions. CDS do not relate in any concrete fashion to specific commercial transactions, and they do not even relate in a clean way to particular bond issues. As you know full well, they are on “reference entities” with the best prices available in particular maturities that often do not align tidily with particular bond issues. Satyajit Das has discussed numerous practical problems with CDS in the case of mergers or divestitures that do not plague bondholders, as well as the CDS not matching the defaulting entity for other reasons.
Your arguments about neutrality are also counterfactual. Take the simple example of someone buying insurance on a house he does not own. This gives him an incentive to commit arson. In that case, you not only have a transfer from the guarantor to the person who bought the insurance policy, but also a loss related to the torched house as well, either suffered by the homeowner or his insurer, if he had insurance. So you have TWO losses suffered, only one party profiting. That is precisely why requiring the party getting insurance have an “insurable interest”, as in a legitimate economic reason NOT to want to see the property insured suffer, is a LONG standing feature of insurance law.
CDS have also been a major contributor to what amounts to bonus fraud. Google “negative basis trade”. I discuss that at some length in my book.
Moreover CDS are subject to massive wrong way risk, as in the same set of events that will lead the protection seller to make a payout is likely to impair the protection seller. Thus the fact that CDS have in effect been government backstopped is no accident; the product was from the get go likely to lead to widespread counterparty defaults.
And that is before we get into further complications. These transactions are not frictionless, particularly given that CDS are often used as constituents to other products, in particular, synthetic or hybrid CDOs. With synthetics and hybrids, the AAA tranche buyer was often the bank originating the deal, who laid off his risk (or being ready to fund the CDS) via a CDS with AIG or a monoline. We know how that movie ended with AIG. With the monolines, unlike AIG, their contracts did not require collateral posting, so when the dealer had to fund the CDO, he unexpectedly (to him) had to come out of pocket. This was one of the major detonators of the crisis. But even though the monoline agreements meant that they were unlikely to have to pony up for the losses for a VERY long time (in many cases, decades), they suffered MTM losses that led to downgrades that put them in a death spiral. So again, one winner (people who bought CDS that went into a synthetic CDO), two losers (dealer and monoline). And that is before you get into even greater systemic ramifications.
I’d also point out another important destabilizing element of CDS; how CDS payments are treated (preferentially) in bankruptcy which amplifies wrong way riskiness.
Among other things, we should include a discussion of how the ISDA protocols need be modified to eliminate the bankruptcy arb opportunity between CDS and other claims on the CDS counterparty firm in the debate about how/should we eliminate systemic risks through CDS.
One interesting thing to me re the monolines, is that the MTM reporting requiremnet exposed the massive losses they were facing,and the monoline counterparties were forced to write off the impaired insurance receivables. Sounds fair to me.
Buyers of synthetic CDS protection sold as structured notes were made whole at the expense of the synthetic CDS note buyers. We’ll have to wait and see how that plays out in the courts over the next few years, but at this point it looks like the protection buyers haven’t suffered and got 100c on the dollar for the CDS.
In the AIG situation (and Lehman and Bear) the CDS counterparty payments were backstopped by the govt.
Same product, different protections.
If the viablility of the product depends on the status of the CDS seller (TBTF vs NTBTF) then any argument about the product’s generic goodness/badness is hopelessly undermined.
I think what Gary J is alluding to is that you’ll fail if you try to regulate the CDS market while it appears Yves seems to think that simply banning CDS trading will somehow fix the problem.
Take a step back and look at the so-called anti-social issues that have been raised in support of a ban – related to it being more profitable to go into bankruptcy rather than work-through for a CDS holder. This all really depends on whose profitability you are defining. There have been many times in history even long before CDS ever existed where THE PROFITABLE (or best business decision) was actually to seek bankruptcy protection rather than continue as a going concern. SHouldn’t that be considered anti-social behaviour then and be banned? the reasons include a variety of issues that can include wresting control from equity holders, unloading pension obligations, negotiating better business terms with stakeholders (like unions) etc.
Airlines for example found it great business to ‘go bankrupt’ and then offload their pension plans to the PBGC (government) and then emerge ‘stronger.’ Great anti-social behaviour there to shove your not-properly-thought-through promises of the past to the every warm and friendly government. Even look at Trump Casinos which has entered bankruptcy for the THIRD time. None of these ‘bankruptcies’ invovled CDS but someone else’s strategic use of tactics or force to get to a desired outcome. If i’m not mistaken AMR is the only major traditional type of airline to have not yet gone bankrupt yet we still have northwest, delta, us air and continental still flying high in and out of bankruptcy. Donald is trying to regain control of Trump for the third time. And in some cases it seems as if each time these ‘strategic bankruptcies’ occur, their proponents manage to get a good asset for a cheaper and cheaper price. Who loses? its the former equityholders and sub debt holders all the while (in some cases) the original guys are still in the drivers seat. And guess who owns that equity and sub-debt? – that would include public pension funds and mutual funds who basically still pass on the cost of this ‘anti-social’ behaviour to the public.
If Donald’s ‘strategic anti-social’ behaviour in ripping money out of the former equityholders and some of the bondholders is properly legitimized in finance, why are CDS holders singlely-being charged with anti-social behaviour? it appears there may be deeper issues to tackle including the ranking of creditor claims in bankruptcy, a better way to sort through legalities and a re-working of the penalties of going into bankruptcy in the first place that would do more good than simply banning CDS.
Before CDS, in cases like Delta Airlines’ bankruptcy or a Trump Casino bankruptcy, there was maybe a couple guys who stood to benefit from it (yes sometimes there are parties that benefit from bankruptcy – in fact correct that, there often always are winners though they may not always be involved until after the bankruptcy since they come in and are able to pickup assets on the cheap a la foreclosed home sales). This sometimes included existing management teams, senior bondholders, long-term creditors (i.e. like a landlord or boeing or airbus that benefits from their clients not being bogged down with pension obligations so they have more than enough money to pay for their planes in the future). CDS has essentially broadened the spectrum of possible ‘investors’ that can now share in the benefits of bankruptcies and yes it defintiely appears that sometimes this can be anti-social like the recent issue with YRC but then so can some of the other non-CDS related bankruptcies that occur.
even take a look at the recent prepackaged GM bankruptcy. For everyone’s cries about overpaid executives, is it anti-social behaviour to think that if only CDS holders could have forced a bankruptcy ‘the proper way’ (as in not prepackaged as a government bailout) that none of the same guys who ran the old GM show would be there AND making just as much as lloyd blankfein! (see the story today about how the pay czar approved a $10 million annualized pay for a GM exec). Instead you have a multi-government bailout (yes canada was also involved) that essentially kept the status quo even if it probably ended up costing more to society.
There is a fundamental difference between naked CDSs and insurance without insurable interest. The latter would lead to a proliferation of risk in the form of betting, while the former doesn’t precisely because it is structured as a swap as opposed to be cash settled. To go by the letter of CDS contracts, Upon default, a CDS protection buyer needs to pass suitable collateral to the protection seller. If he does not own collateral, he has to procure it on the open market, thus causing the insurance collateral to appreciate. In reality, CDSs are often settled in cash but only after an auction takes place which mimics the appreciation effects to the satisfaction of the market participants.
The net effect is that the total loss amount at risk stays precisely the same and equals the non-recoverable loss of bonds issued by the reference name in question. The presence of synthetic CDS contracts only dilutes this same total loss among a broader number of participants. In fact, bond holders benefit greatly of the existence of a parallel CDS market in case of default as this creates demand for their defaulted bonds.
The fundamental problem I have with CDS is that they encourage the systemic underpricing of risk.
The interest rate itself is supposed to reflect a risk premium. CDS eliminate the need for that risk premium. In THEORY, the cost of purchasing a CDS to insure a bond should be exactly equal to the interest rate risk premium foregone on the bond. In this case, CDS simply would not exist. In REALITY, CDS do exist, which means that handling credit risk via CDS is cheaper than handling it with the interest rate mechanism. IMO, the reason for this is simply the fact that any reasonable large and well respected entity (e.g., AIG prior to September 2008) can write CDS contracts without having any ability to make good on them. This encourages economic agents to take risks they ordinarily would not because of the false sense of security it provides, not to mention the artificially lower borrowing costs created.
“The fundamental problem I have with CDS is that they encourage the systemic underpricing of risk.”
Then why would anybody sell them? You say that it’s because AIG et al don’t plan to make good on them, but in that case, the problem could probably be solved by accounting rules rather than an outright ban. It also means that the value of the CDS varies depending on the probability + credit rating of the government backing them.
“This encourages economic agents to take risks they ordinarily would not because of the false sense of security it provides, not to mention the artificially lower borrowing costs created.”
Well, then what’s the difference between a CDS and a CDO?
CDS for simplicity sake is like an insurance contract. it pays you (assuming you bot a CDS) only in the event of a bankruptcy or default.
CDO is basically the same as any other kind of bond. it pays you (assuming you bot a CDO) regular payments of interest and/or principal. where these payments are coming from (i.e. the assets in the cdo) and the order that these payments can me made can be extremely complicated but that is irrelevant for explaining the diff between a cds and a cdo.
sometimes people get confused when they are mentioned in the same sentence and this is usually because people don’t realize that CDS can be a type of ‘asset’ that can be included in a CDO. as if to make things a little more confusing, CDS can also be bot referencing a CDO (i.e. buying insurance on a CDO)
Let’s assume regulatory capture and complexities will insure that nothing is going to be done to dampen the systemic risk of Credit Default Swaps, particularly at a global level.
Let’s also assume the next time there’s a systemic crisis that the public will likely be ready to lynch any poltician who promotes a bailout. Not going to happen.
Now, how does the average individual protect his assets from this impending meltdown that will have no bailout?
Can we start with who are the top ten players in this casino?
RE LCs, typically the amount is capped by your revolver or line of credit – usually it’s a carveout and much less than the overall line. So that’s entirely different from CDS which have no cap per se.
LCs are also pretty short in duration…60-90-180 days – maybe a year for financials in some cases. The typical trade LC is for overseas buyers and sellers protection – you ship a good to me, you give me an LC for 90 days and if it doesn’t show up or I don’t pay for it you collect on the LC (from the issuing bank).
These are very importatant points in trying to compare them (I think unreasonably) compare them to CDS.
Also, you have to post collateral AND pay a spread on LCs (when drawn) or issuance fees. This is for each and every LC (which there are literally thousands of, it’s not like you just issue one big LC and are done).
LCs typically don’t trade as well (I never saw them trade, why would they? They are for smaller to midsize companies deemed to have counterparty risk. roll over endlessly, and are in various smaller sizes).
Some points on CDS: the CDS market is still largely unregulated and has massive counterparty risk. It makes no sense for short term speculators to be able to bet against fundamental underpinnings of society like sovereigns and local and state govenerments.
They might have a use on the corporate side (e.g. for banks to protect themselves when holding loans/bonds) but in general they are just another product that banks love bc they generate big fee – that’s why the traders like them (esp if you trade CDS and have a job!) and banks do too. (esp now when banks realize that they are TBTF).