Last night, I gave a presentation to the New York Chapter of the Risk Management Association regarding the US banking sector and the long-term issues facing same.  You can read a copy of my slides by clicking here.

As part of the presentation (Page 17-21), I argued that until we rid the markets of CDS, there will be no restoring investor confidence in financials. Here is how I presented the situation to about 200 finance and risk professionals in the auditorium of JPM last night.  Of note, nobody in the audience argued with me.

Start with the $50 trillion of so in extant CDS.

Assume that as default rates for all types of collateral rise over next 24-36 months, 40% of the $50 trillion in CDS goes into the money.  That is $20 trillion gross notional of CDS which must be funded.

Now assume a 25% recovery rate against that portion of all CDS that goes into the money.

That leaves you with a $15 trillion net amount that must be paid by providers of protection in CDS.  And remember, a 40% in the money assumption is VERY conservative.  Could easily be 60-70%.

Q: Does anybody really believe that the global central banks and the politicians that stand behind them are going to provide the liquidity to fund $15 trillion in CDS payouts?  Remember, less than 10% of these positions are actually hedging exposure.  The rest are speculative.

My answer is that we pay the hedge positions at face value, but the specs get pennies on the dollar of the face of CDS.  And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches anbd pitchforks catch up to them.

So we can either follow the example of Tim Geithner and Hank Paulson in AIG, paying out the CDS at face value, and embrace the Japanese model of economic stagnation for a decade.  Or we can put AIG and the other providers of protection through a bankruptcy and force the CDS market into extinction.

I’ll be expanding on this happy them Monday.  Good weekend.

Category: BP Cafe, Investing, Markets, Media

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

12 Responses to “Do We Need to Cancel ALL CDS Contracts?”

  1. john haskell says:

    this would cause the mother of all panics as HF’s, inv’t banks, commercial banks with profitable hedges find their exposures ripped up by a Treas. Dept that may or may not decide their hedges were actually “hedges.” You bought CDS’s on Citibank to hedge a portfolio of regional banks? Not a hedge. You bought BAC CDS’s to hedge against a portfolio of California MBS’s? Sorry.

    At what point do we finally realize that changing the rules midstream decreases confidence in the system? A CDS tearup would make the damage done by the short ban look like a mere flesh wound. Even worse, it would make Rafael Correa look like a friend of the bankers- holders of Ecuadorian debt would come out much better off than suckers who believed in America’s “stable legal regime.”

  2. john haskell says:

    ps this same logic was pursued (successfully) in Russian courts after the ’98 devaluation when currency hedge contracts were deemed to be unenforceable “gambling.” We had some choice words about “sanctity of contract” when the Russians were doing it.

  3. David Merkel says:

    It might not be that hard to wind out all CDS; after all, the various auctions after defaults with netting resulted in pretty low amounts of assets changing hands. That said, you don’t know what’s on the other side of the trade in each entity’s books. Canceling all CDS could have unintended second order effects. How the cash bond markets would be affected is an open question.

    When I drafted the MD Life Insurance Investment statute, I crafted it so that derivatives could only be used to lay off risk. I would suggest that that should be true of all regulated financials.

    Now, there’s a another twist on CDS contracts that I have proposed. Require insurable interest as we do with life insurance contracts. What is fair for natural persons should also work for legal persons.

    http://alephblog.com/2008/10/10/rethinking-insurable-interest/

  4. gottoroll says:

    Let all the firms that bought or wrote these private, unregulated CDS contracts fail if they cannot honor their obligations. None of this bailout money should have ever gone to any firms with CDS exposure. They are the primary cause of this turmoil. Let them fail. Let others buy the remnants. Let us suffer a swift depression and get back to business. Let us all make more-informed and safer investments in the future. Let those who take inordinate risks anticipating extraordinary rewards finally understand that they really can fail. Even if someone has an insurable interest that they hedge with a CDS contract, there is absolutely no reason they should be reimbursed by anybody except the other party to this PRIVATE, UNREGULATED contract.

  5. JasRas says:

    With all the CDS out there, and no one really knowing how much, etc., D Merkel is probably right about unintended second order effects…

    Is there a moratorium on the creation of more CDS? Is there any action to get this unregulated product corralled? Should it be considered insurance, or a derivative? Part of the problem from what I understand is CDS were designed to not be insurance, not be a derivative, and therefore be off the grid, under the radar, etc. Seems they’re kinda like Gremlins- don’t like light of day, don’t like water, …

    How did the market/regulators solve the portfolio insurance debacle of the ’80′s? Was product forced to lapse, expire, or did they force removal of it, or did it just explode into nothingness?

  6. JasRas says:

    To J Haskell’s question of changing rules mid-stream– Were CDS created specifically to avoid all rules but the contract that was written? Shouldn’t the govt. step in when a rogue product is wreaking havoc for the general good of the market? Isn’t that their purpose? The argument to let these things “play out” is akin to letting pink sheat scam artists slide because they were crafty enough to pull it off. It seems that there should be an orderly way to make this product extinct, or at least become a highly regulated instrument.

    I agree a “tear up” is probably an extreme, but an orderly demise should be possible…

  7. jonhendry says:

    Can anyone think of other examples of government action invalidating contracts, which were not particularly controversial?

    I’d think that whenever the FDA forces something off the market, there are probably contracts in effect that essentially become void as a side effect.

  8. leftback says:

    Chris – I agree with the general spirit of this idea, but there are many unintended consequences of canceling derivatives. A large number of inverse funds use some form of swap, so time would be needed to allow for an orderly unwind of positions.

  9. gottoroll says:

    If no one knows how many private, unregulated CDS contracts are out there, then throwing any amount of money at the problem is merely wishful thinking or “hope” that it will solve the problem. My educational background is in engineering. No rational engineer would quess at the solution to a loading problem. They would calculate the solution and build a safe project at the lowest cost. I realize that this problem is extremely complex and the values of many variables are simply not known. But if you cannot calculate a solution with a specified degree of probability, then you are just fiddling with the controls. Who knows what unintended, second-order effects YOU are going to have if you “provide the liquidity to fund $15 trillion in CDS payouts” (Chris’ conservative estimate). This complex problem can really only be solved by millions of individuals making individual economic decisions that are in their own best interests. The “central planning option” is the least efficient solution and is doomed to fail. It may take 68 years ( 1930-2008 ), but the chickens have come home to roost and doing more of the same is insanity ( many thought Greenspan had some unique ability to fiddle ). Let the market play out, put AIG and other providers of CDS through bankruptcy and stop using other people’s money to attempt to solve their problems.

  10. Chris Whalen says:

    The Culpables are in Command: Geithner, Summers & Rubin

    The notional amount of CDS outstanding can be verified with BIS/ISDA. $50 trillion more or less seems to be the agreed number. A trillion here, a trillion there… My basic point is that if default rates continue to climb — ie, the 20% rate for HY paper just reported and the probably 1.5-1.6% charge-off rate for all US banks in Q3 data from FDIC Tuesday — and the CDS goes from the notional to the payable in amounts that are just silly.

    Thus my question: do we need a negotiated, facilitated “tear up” as is now enabled by the good people at DTCC?.

    I appreciate all of these interesting comments. Believe me, we are gonna be talking about the CDS dung heap for months to come. I believe that this issue regarding CDS contracts and the wrong-headed approach to this by the Fed under the leadership of Tim Geithner and Ben Bernanke, Don Kohn et al at the BOG in DC with respect to Bear and AIG will become the major financial issue of 2009.

    By embracing Geithner and the AIG derivatives bailout, Obama is embracing the scheme directed by Hank Paulson et al at Goldman Sachs and executed by Tim Geithner and Ben Bernanke. Having Larry Summers waiting in the wings to replace Uncle Ben does not reassure me in the least and only confirms that the culpables are in command under whatever party pretends to hold power. Does anyone find it remarkable that members of the BIG MEDIA wax effusive about the influence of Bob “MIA” Rubin in the Obama camp as Citigroup slides into a government takeover?

    There seems to be very little “change” under Obama when it comes to the financial portfolio of the government of the United States.

  11. Guy Bazanos says:

    Chris said:

    “My answer is that we pay the hedge positions at face value, but the specs get pennies on the dollar of the face of CDS. And the specs should take the pennies gratefully and run before the crowd of angry citizens with the torches anbd pitchforks catch up to them.”

    Chris, this sounds like a good idea, but I’m so far removed the industry that I feel out of my league making recommendations.

    Questions that I have: Didn’t the Lehman bankruptcy cause the credit markets to freeze in part because counterparties didn’t know what the settlement of the CDS’s would be? Wouldn’t an AIG bankruptcy cause a similar freeze if counterparties who were speculators didn’t know what their payout would be?

  12. Chris Whalen says:

    Perhaps. I just think that instead of bailing out AIG, we should force the issue to a termination now. Time is our enemy here because as default rates rise and more of these contracts go into the money, the cash flow burden to pay out on these bets is going to be a horrible burden on the real economy. I think by the end of 2009, the average person is going to know what CDS means and they will be screaming for blood. I think that if AIG does not blow up before his confirmation, then AIG will be Tim Geithner’s undoing after.