Morgenson: Time to Unravel the Knot of Credit-Default Swaps
Below is the link to the NYT column today by Gretchen Morgenson regarding Credit Default Swaps. I really appreciate her attention to me and my firm, but more for leading with Sylvain Raynes and also including Robert Arvanitis, both of whom have helped me enormously over the past year to sharpen my distinctions on risk.
Time to Unravel the Knot of Credit-Default Swaps
http://www.nytimes.com/2009/01/25/business/25gret.html
Of interest, I agree with Bob’s view that as much as half of the remaining CDS is not an issue since many of these positions do match against opposite exposures, but the remainder is a rancid pile of under-collateralized wagers on default events that are all heading toward 1 in terms of P(D). Thank to the FASB and the SEC for accelerating the deflation via fair value accounting! Who would have thought that accountants, who are some of the nicest, smartest people you will ever know, would destroy the world!
One of the key insights I have gained from my conversations with Bob Arvanitis over the last year is the high-beta character of CDS and the way in which this fact only grows overall market risk. The NYT editors greatly simplified Mogenson’s piece for the level of the generalist reader, but there are some powerful issues raised in the article that will be part of the public debate.
Here are the last two comments we posted on CDS last week FYI.
‘To Stabilize Global Banks, First Tame Credit Default Swaps’, Janury 21, 2009
‘Does Fair Value Accounting + Credit Default Swaps = Global Deflation?’, January 23, 2009
I am especially interested in your comments on
1) the issue of what to do with CDS written against the top four money center banks, which are all under de facto public ownership as will become apparent as loss rates eat remaining private common and preferred; and
2) how to bifurcate the functionality of current CDS into a) an exchanged traded, index like product that tracks the spread/volatility of a corporate single name issuer and b) an exchange traded form of bond insurance with minimum 50% collateral vs net exposure (par less current estimated recovery rate, which will vary with spreads).
Thoughts?
Chris
January 25th, 2009 at 11:06 am
I am especially interested in your comments on
1) the issue of what to do with CDS written against the top four money center banks, which are all under de facto public ownership as will become apparent as loss rates eat remaining private common and preferred; and
Do exactly with the CDS as we should do with home ownership: Honor the contracts. And if honoring the contracts bankrupts the firms (or people), then put them through bankruptcy. Deal with any cascading defaults by putting those entities through bankruptcy too. We need to purge the stupidity.
There is absolutely nothing to be gained by pretending that a bankrupt person or institution is anything other than bankrupt. In fact, there is a lot to lose by pretending that a bankrupt person or institution is something other than bankrupt. The bankrupt entity will continue spending money that it does not have. (I’m looking at you Merrill, especially with your bonuses.)
January 25th, 2009 at 11:23 am
Barry whats the diff. A property that returns rent is valued at what some one will pay for it, buy the market. NO matter how much rent is return, the valuation is based on risk. I understand CDS return a premium (rent) so why should they not be valued at market values, no matter what the premium (rent) is. Also the accounting used on the way up from 2003 to 2007 was just fine then ( bonuses paid etc), so whats so bad on the way down. Also how can some one value a CDS if it is very complicated and not transparent, if you have a property with a complicated lease agreement your valuation is very much effected. Once again the valuation and associated risk are equal. It seams to me the Accountants are the HEROS out there, the whistle blowers. Just how many SP500 banks balance sheets are 100% transparent then ? ( add GE to this list). I say get a real market (exchange) for the CDS for better or worse valuation, dont blame the accountants.
January 25th, 2009 at 11:53 am
Chris,
isn’t the likely course here (based on the seeming momentum) going to be something like: ruling suspends payout on CDS’s of bailout firms, market refuses to underwrite further protections without transparent clauses, protection therefore is not available going forward, market contracts anyway, and stays risk averse doubling (or more) the time to correct in lieu of depth of price movement….? Am I way off? Is this not a possibility?
January 25th, 2009 at 11:58 am
have to agree w/icm63 and jpm. this ‘gordian’ knot will only be unraveled by the hatchet of the market; as unpleasant as it will be. but this is america. if you don’t like the out come, simply change the rules. as nationalization continues, and it will, the public will end up eating the CDS’, along with a multitude of other instruments. there’s no end in site to the depth of this rabbit hole as long as we keep feeding the rabbit.
January 25th, 2009 at 12:09 pm
jpm says”
“Do exactly with the CDS as we should do with home ownership: Honor the contracts. And if honoring the contracts bankrupts the firms (or people), then put them through bankruptcy. Deal with any cascading defaults by putting those entities through bankruptcy too. We need to purge the stupidity.
There is absolutely nothing to be gained by pretending that a bankrupt person or institution is anything other than bankrupt. In fact, there is a lot to lose by pretending that a bankrupt person or institution is something other than bankrupt. The bankrupt entity will continue spending money that it does not have. (I’m looking at you Merrill, especially with your bonuses.)”
Reply:
Well said. They created the CDS market w/out supervision, let ‘em unwind it the same way.
January 25th, 2009 at 12:15 pm
“Believe us when we say that we have seen the wild eyed, “don’t you get it” look from the proponents of FVA in our colleagues in the XBRL community.”
LOL. You are at the right place here!
I gave up arguing for the suspension of Fasb 157 and predicting its aftermath months ago. In perfect conditions it acts as a “lock limit down” scenario, not unlike the trading limits on the S&P futures back in Oct 87 with the same results. You will notice they changed the S&P limits after that debacle. They will do the same this time but only after the damage has been done.
January 25th, 2009 at 12:17 pm
Regrettably “force majeure” will need to be used to annul these contracts. There appear to be too many unreserved CDS’s written without offsetting counterpart positions. Once a major bankruptcy occurs on which a lot of these open, unreserved positions were written the whole house of cards will come tumbling down. Taking down responsible entities who wrote and hedged their positions is not an option when unreserved hedges begin to go bad. Unfortunately “force majeure” will also cause losses but has the advantage of putting a cap on those losses at what would have occured in any case without the cascading effect.
January 25th, 2009 at 12:21 pm
A basic concept in life insurance is “insurable interest.” If CDS had been regulated as the insurance contracts they were, and the concept of insurable interest applied, much of this mess would have been averted. Thank you Mssrs. Rubin, Summers and Greenspan with a special shout out to Mr. Gramm.
January 25th, 2009 at 12:30 pm
SS @ 12:17
Even assuming that Obama and the Congress would be willing abrogate all existing CDS contracts (by “force majeure”), what are the odds that the courts would go along?
I think the odds are slim to none.
January 25th, 2009 at 12:38 pm
SS says:
“Once a major bankruptcy occurs on which a lot of these open, unreserved positions were written the whole house of cards will come tumbling down.”
Reply: We can only hope.
“Taking down responsible entities who wrote and hedged their positions is not an option when unreserved hedges begin to go bad. ”
Reply: Find me a “responsible entity” that was at the same time writing CDS.
Gambling sucks when you lose. Responsible entities, like responsible people, do not wager their future for a few pennies today. The way to encourage responsibility is not to try and legislate morality. It’s to allow bad bets to be collected. If bankruptcy obtains, well that’s BK is for, and might just force folks into being more “responsible” and aware of risks.
January 25th, 2009 at 12:43 pm
One thing that I don’t understand is why there hasn’t been a moratorium imposed on the issuance of new CDS contracts. That’s just a no-brainer; I don’t understand where the opposition for such an idea might be coming from.
Such a moratorium should remain in place until rules are set up for dramatically increasing transparency, and imposing capital requirements, at least for newly issued CDS contracts.
January 25th, 2009 at 12:44 pm
Just more good ideas that Will Not Be Acted Upon.
Similar approaches to restructuring failing mortgages have been obvious for over two years not, and we are still pouring money into the poor, impoverished fat cat bankers while millions of homeowners (some of whom are clearly deserving of their fates, but no more than the corrupt lenders onto whom we are showering billions) are driven into bankruptcy and dispossessed of their homes.
To repeat — Nice Ideas, but They Ain’t Gonna Happen.
January 25th, 2009 at 12:59 pm
The hysterically funny (insert deranged laughter here) part of all this is that these restructuring proposals (CDS, mortgages, etc) would cost next to nothing to implement, the costs being entirely borne by the participants in the contracts.
Same thing with restructuring mortgages — the costs can be folded into the restructured mortgage, and borne equally by both sides of the contract.
But why should any side of a bad deal be held to account for it when the taxpayer can be repeatedly raped to cover the losses?
January 25th, 2009 at 1:16 pm
We read that dramatic action is urgently needed in solving the global banking problem. Why keep dancing around nationalization? The zombie money center banks that pose global systemic risk cannot nor should not be recapitalized while toxic assets remain on balance sheets. It is unjust to protect equity holders with public funds. We must face reality.
January 25th, 2009 at 1:16 pm
There is an endgame scenario I worried about, but I have no idea if its possible. Maybe someone can tell me?
My understanding is that JPMorgan swallowed Bear Stearns and this caused a whole pile of derivatives contracts to be ripped up because both sides of the contracts became the same entity. Where as if Bear had truly just failed JP would have taken big losses.
If some or all of the big commercial banks became could some sort of similar zero-sum magic be applied? All the derivatives between the majors just winking out of existence into some single entity. Or could such a feat be pulled off with some sort of bad bank?
Just a random thought I had when I heard about Britain’s nationalization stuff. I thought maybe all the countries will end up nationalizing their banks and combining away all the derivatives. lol.
January 25th, 2009 at 1:18 pm
That should say “If some or all of the big commercial banks became nationalized could….”
January 25th, 2009 at 1:28 pm
If some or all of the big commercial banks became nationalized could some sort of similar zero-sum magic be applied?
It would happen among the insolvent institutions even without creating a monster superbank.
But the bigger problem is when the CDS obligations cross over to an entity not part of the nationalization. Sure would be nice to know what fraction would do that, but of course, none of this is centralized.
January 25th, 2009 at 1:31 pm
toneybrooks @ 1:16
Of the various people who have come out in favor of nationalization, I have yet to see even one of them comment on the question of the cost (if any) to taxpayers.
I, for one, would oppose nationalization, at least until such time as someone will weigh in on this question.
January 25th, 2009 at 1:40 pm
Blamimg the accountants is like taking the position that the gov’t can’t change contact terms. Strike 2 Barry.
January 25th, 2009 at 1:51 pm
Of the various people who have come out in favor of nationalization, I have yet to see even one of them comment on the question of the cost (if any) to taxpayers.
Can you comment on the cost of not nationalizing? At this point, we know the bare minimum is $700B, half of which is sunk cost. And I do mean sunk.
January 25th, 2009 at 2:10 pm
Chris:
“Thanks to the FASB and the SEC for accelerating the deflation via fair value accounting!”
Your Jan 23 article on FVA+ CDS = Global Deflation was most insightful. I should hope everyone on Ritholtz’s blog reads it soon. To recap several highlights:
1) FVA makes an expression of long term value of assets impossible. Low-vol, low-risk hold to maturity vehicles can not exist in such an accounting world.
2) the net effect of FVA is not greater understanding of valuations by fear, panic and systemic instability.
3) Graham and Dodd taught 80 years ago that the more speculative and unstable the data inputs (say in this case FVA) the less the analysis matters.
To understand the FVA + CDS = Deflation, one has to flip back to Chris’ previous article on why taming CDS is a prequisite to stabilizing banks.
1)the reason for the continued heebie-jeebies in bank equity and debt stems from the unfinished business in the market for credit default swaps or “CDS.”
2)Most crucially, because the Fed refuses to enforce any type of credit margin discipline over the CDS markets by raising collateral requirementsto realistic levels, the short-selling pressure of C and other wounded money centers is magnified many times above the true pool of investors with hedging needs.
3) grossly under-collaterized, CDSs make it possible to run short positions against banks and other entities with virtually no collateral behind them. Chris asks, “Why should the citizens of the industrial nations tolerate the existence of this unsafe and unsound market for another moment longer?”
3)By failing to enforce margin limits on CDS leverage while investing new capital in C, BAC and other large banks via the TARP, the Fed and Treasury are essentially trying to fill up a bucket with a hole in the bottom. Providing new capital to wounded banks is pointless if you are going to allow the remaining street dealers to short bank stocks with impunity and virtually no collateral.
4)CDS are a great tool for playing/managing volatility in time of low or no defaults.
5)But now that all types of default rates are rising and credit spreads are widening, the cost to the system of a CDS contract — which requires the seller to fund the par value of the underlying security, less recovery value — is a dead weight around the neck of the global financial system.
6)As corporate defaults rise and recovery rates fall, the net funding required to perform on single name CDS must approach 100% of par. In such an event, the exercise of extant CDS contracts could theoretically consume all of the capital in the global banking system, several times over. How is this good public policy? Indeed, viewed from an actuarial perspective, the world of CDS makes no sense at all.
7)Unless and until Chairman Bernanke and the other regulator are willing to tame the CDS tiger, there will be no success in bringing stability to the US banking system or foreign banking markets.We have the power to fix this aspect of the financial crisis immediately, but do our leaders have the courage and the vision to close down this reckless, speculative market before it destroys what remains of our economy?
And from Alex Pollock
1) regarding the inception of FVA in 1998 Pollock had a two part plan. Part one, tar. Part two, feathers. Unfortunately, Pollock laments, it was never implemented! lol
2)Pollock asks, “What kind of theory is FVA when applied to debt instruments?” Fine in stable periods when “prices are equilibrium seeking. No so in a “period of dynamic disequilibrium.
3) Pollock proposes fixing FVA. “Somebody needs to simply overrule FASB. If the SEC won’t do it, then who? Well, FASB is a government-sponsored entity, which ultimately works for and has its funding mandated by Congress.” So, the onus would fall to Congress.
Combined the darkside of FVA policies+ unregulated under-collateralized CDS’ are lethal in d period of dynamic disequilibrium. Solving these two problems is largely a function of Congress. Whether they know they can become a part of the solution is unknown. So many of them are wholly uncertain as to what needs to be done, they have simply followed the lead of Bernanke and Paulson to date. Hopefully, they are studying how to become a part of the solution. This will require them to stop drinking the kool-aid refreshments (ad hoc solutions presented by Bernanke and the US Treasury). It is not too late for them to pay attention to outside sources for their role in these matters. One can only hope more legislators are beginning to read your blog Barry, and more from Chris.
Many thanks to you too Chris for helping us layfolk understand the nature of the many problems we face. Getting our arms around the problems is the first step towards solving them. In this respect it is no different than tackling an opponent in football. You can’t tackle problems with one arm or ne arm tied behind our backs, you got to wrap both arms around the ball carrier’s legs or waist and keep driving until the ball carrier goes down and the whistle is blown.
If we fail to first wrap our arms around the source of problem (not the head or the shoulders, or the symptoms) the problem can easily sidestep, stiff arm or otherwise break our tackling of the problem.
January 25th, 2009 at 2:39 pm
jpm @ 1:51
“Can you comment on the cost of not nationalizing? At this point, we know the bare minimum is $700B, half of which is sunk cost”.
The cost of “not nationalizing”…. it’s whatever the politicians want to spend.
No matter what we do or don’t do, there’s going to be a cost. If we do nothing, and force the large banks into bankruptcy (my preferred option), there’s going to be a huge cost in terms of reduced tax receipts, and reduced employment.
But of course, politically, it’s far easier to just pile 5 trillion dollars (or so) onto our national debt and give the money to the banks … the sh*t for that course of action won’t really hit the fan in a big way for several more years.
I’m simply trying to find out which will cost the taxpayers less… nationalization, or the course that Bush/Obama have taken and will take. I don’t know the answer…. my point is that of the people who advocate nationalization, none have yet tackled this question (that I’ve seen).
January 25th, 2009 at 2:56 pm
If you believe Treasuries are accurately priced, then defaults will be unprecedentedly massive. If you don’t they won’t.
January 25th, 2009 at 3:09 pm
W/o cds tranparency, how does one accurately value the worth of any corporate entity. Hell, AIG was bragging that they stopped writing and it turned out it was only one sub. Other entities within AIG were getting hand cramps writing these toxic piles of garbage.
January 25th, 2009 at 3:13 pm
not sure why fair value accounting is a big problem. since it makes those who own securities account (and mortgages have become just that) for the value of same. and because a lot of the capital a bank has is in mortgages they didn’t write. but in some cases the wrote insurance type contracts for others. how stupid was that?
and who believes that any bank (or other) is going to keep these securities for the life of the contract? that was how it used to work. not any more.
and while nationalization is where we will probably end up, as those who oppose say let them fail. remember Lehmans? and it wasn’t even a commercial bank. and those who say just let them go bankrupt. who will pick up the pieces of that bank if its Citi or BOFA? is there any bank that big that could? or would? and the banks can’t get private capital any more. the market has spoken. its treating them as bankrupt as they stand right now. and the cost of leaving them as is, in 8 trillion and rising. and that just the cost the government has sunk now. never mind the cost investors have lots as they drag every other business with them. and consumer. and the country also.
January 25th, 2009 at 3:22 pm
1) the issue of what to do with CDS written against the top four money center banks, which are all under de facto public ownership as will become apparent as loss rates eat remaining private common and preferred
These contracts must be honored in full unless you want to take a major swipe at a bedrock principle of our capitalist system: basic property rights and contract law. The cure shouldn’t be worse than the disease.
2) how to bifurcate the functionality of current CDS into a) an exchanged traded, index like product that tracks the spread/volatility of a corporate single name issuer and b) an exchange traded form of bond insurance with minimum 50% collateral vs net exposure (par less current estimated recovery rate, which will vary with spreads)
Barry, I don’t see the difference between (a) and (b). I don’t understand why you are trying to differentiate between “tracking” vs “trading.”
January 25th, 2009 at 3:24 pm
mr whalen et al –
i’ve yet to see anyone directly address the difficulty of inversion with respect to the synthetic CDO. it has seemed to our office that any act broadly nullifying the CDS will necessarily as a byproduct render null better than a trillion dollars of assets held for the most part by banks, pension funds and like institutionals. the largely-unfunded multiparty CDS structures that are probably going to, as you say, head toward 1 in terms of P(D) in 2009 are a massive condition of any regulatory inversion, are they not?
January 25th, 2009 at 3:42 pm
DL,
“Nationalization” of certain banks will happen exactly because the tax payers will have footed a massive bill that simply can not be repaid while the creditors are getting back 100% of their money even though it’s the creditors that got us into this problem. Citigroup has something like $200 BILLION of public debt outstanding. If we nationalize Citi and make the creditors pay, then we will have saved the taxpayers huge amounts of money. It’s not very complicated.
January 25th, 2009 at 3:48 pm
gaius marius,
Don’t worry about “inversion.” It’s the stupidest idea I’ve heard so far and it will go nowhere. Inversion amounts to a direct transfer of wealth from the person who bet correctly that spreads would widen to the idiot who sold CDS. The fact that this idea made it into Gretchen’s article would have made Tanta’s blood boil. The article itself is full of other nonsense.
January 25th, 2009 at 4:07 pm
“johnbougearel Says: …the reason for the continued heebie-jeebies in bank equity and debt stems from the unfinished business in the market for credit default swaps or “CDS.””
WRONG. Banks are insolvent. Their debts are higher than their assets and their business model, i.e., extension of credit, is evaporating. In other words, the money they’ve lent isn’t coming back and the people/business that can qualify for loans don’t want them.
January 25th, 2009 at 4:25 pm
Myr @ 3:42
Fine. That’s more of an explanation than I’ve seen anywhere else.
If it’s really true that nationalization will cost the taxpayers a lot less than the Bush/Obama alternative, then sign me up. I’m now a socialist.
January 25th, 2009 at 4:42 pm
Moving forward no CDS contract should be allowed unless the buyer holds the underlying debt. The seller must include the obligation as part of a liability on the books. The sum total of insurance cannot exceed the PAR value of the bonds. No entity, including Private Hedge Funds, should be able to write the contract and collect the premium unless it is part of some required financial disclosure.
January 25th, 2009 at 4:48 pm
jpm is right. This isn’t about tough love. This is about reality. So let’s look at the people in the cucoon of high finance who are pulling for the massive banking bailout.
“The financial system is frozen largely because of credit-default swaps.”
The financial system? No, it’s certain people in certain positions in the “financial system” which are “frozen”. THEY authorized CDS bets without adequete collateral (100% or more, not 50%. This collateral value must be based on a smoothed assessment, not some recently inflated value). Now THEY want ME and YOU to cover their ass.
Solution: Pool 90% of all the assets of the individuals who, as decision makers, authorized the CDSs. Use these assets to reinforce the collateral on the CDSs. And here is where we run into the old standby corporate dodge, LIMITED LIABILITY. We need to eliminate this dodge. Get past the “financial system” monicker and get to individual names and things will be resolved quickly.
Barry, I know that language requires some generalizations but we live in a high tech world. T he data is there. The tracks of every transaction are there. The brokers and their bosses’ names are there. It’s not that hard.
Finally, the credit system isn’t frozen. Jubak from Microsoft Money just mentioned that money market accounts have over 3 trillion dollars parked in them right now. Regional banks have money and they are lending it with adequate collateral. All the wailing and nashing of teeth is because many businesses have had their collateral reassesed as well as their good will in the current environment. They simply are not as much of “going concerns” as they thought they were. That’s business. Why should the taxpayer have to cover rsik when the taxpayer isn’t EVER cut any slack by the same businesses? I say let supply and demand run free. Make sure people are provided basic needs but don’t give handouts to business gluttons.
January 25th, 2009 at 4:53 pm
@johnbougearel: Thank you for your most excellent post. For those who have not played football or served in an under-committed military operation: Learn what it take to exterminate rats. As in actual living mammalian rats. The greatest danger in trying to control rats is to not administer enough rat poison or traps in the first attempt to control the problem. IF you don’t kill the rats on the first dose, rats (as all mammals do) acclimate (build up a tolerance for, or “learn”) the control mechanism. The next dose MUST be MUCH higher, as the animal has acclimated to the previous dose. Given the acclimation, will the next dose be enough? In practice…not very often.
Half measures (bailouts, preferred shares, changes to accounting standards, etc.) only acclimate the system (such as giving bailout money which then goes to bonuses – thereby reinforcing the very behavior which it was supposed to exterminate).
You cannot stop rats from raiding your pantry by putting out food. It works for a little while, but then they come back – stronger and even more numerous than before.
January 25th, 2009 at 4:56 pm
Tom K,
If you read this, I just want you know I take back anything insulting I said about you and I apologize. Just remember that you don’t know me either. I exercise one hour and a half every weekday and at 62, my blood pressure is 120 over 72 on average. I’m no couch potato. My main beef is ascribing blame to the common man for finacial dificulties when the main cause of bankruptcy in the USA is medical costs. I have taken care of myself but I don’t think it’s fair to judge people who have health problems and consequently can’t work as hard as you or me. Maybe I’m wrong, but the signal I get from you is that you don’t give a damn about helping someone down on their luck because you think everyone makes their own luck. I think this thinking is wrong but I respect you opinion.
January 25th, 2009 at 5:17 pm
A dead man has no ability to talk at his funeral. A bankrupt banker has no money to lend. A CDS is not worth the paper it isn’t printed on. The Real Economie has no time for phantom worlds.
CDO’s and their devil spawn CDS’ had no function except to generate commissions for computer screen pirates. The flood gate open monetary policies of Greenspan and his FED compadres created a fiscal mirage. The “ghost” economy. The longer we pretend that it existed and that it needs to be resucitated with electric paddle monetary stimulus the longer we empower the criminals who created the biggest ponzi scheme in history. ”
Liar’s Poker” author Micheal Lewis writes an inciteful perspective in his article “The End.” (portfolio.com dec 2008) Here’s the “engine of doom.” “The first tower is made of the original subprime laons that had been piled together. At the top of this tower is AA tranche, just below it the AA tranche and so on down to the riskiest the BBB tranche…But Wall Street had used these BBB tranches-the worst of the worst-to build another tower of particularly egregious C.D.O. The reason that they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans would pronounce most of them AAA. These bonds would be sold to investors, pension funds, insurance companies-who were allowed to invest in only highly rated securities.”
“When a party bought a Credit Default Swap they allowed Goldaman Sachs, Deutsche Bank et all to “create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds wer the side bets.” The criminal bankers weren’t satisfied with getting unqualified borrowers to borrow…CDS was a fantasy football game where Peyton Manning could be cloned forever.
They created a phantom world where law, morality and real economie magically disappeared. The distinction in the CDO and CDS contractual arrangements is who are the criminals and who are the victims? Criminals need to pay victims and the veil of corporate indemnity will not shield obligations owed.
Separation of powers. Political. Cultural. Economic. Kevin Phillips has written about the problems and solutions. “The Arrogance of Capital” etc. ThreeFold Commonwealth now.
January 25th, 2009 at 5:50 pm
This is not meant as an argument, but merely a question — haven’t there already been a number of major bankruptcies (notably Lehman, but also the Icelandic banks & a few others) in which the CDS clearance basically went off without much of a problem? Surely, there are some potential landmines out there, but isn’t there some evidence that this market has been more risk-aware than the doomsayers claim? i mean, the problem with AIG (so far) isn’t that they’ve had to pay out on their swaps, they’ve just had to raise more collateral. It’s just weird how, on the one hand, people complain about how mysterious and untransparent the market, and on the other, they turn around and make all these strong factual statements about the reckoning that lies ahead. It all confuses me.
January 25th, 2009 at 6:11 pm
johnnyvee,
your point about bank insolvencies in the broad context screwing us over is well-taken. My post was highlighting excerpts from Whalen’s recent articles detailing the nuances that are exacerbating the crisis. Shown out of context as it was in my post, it does appear to misdirect from the broad issue. For that reason, I would encourage you to read Chris Whalen’s recent articles on FVA and CDS pose. They make a bad situation, insofar as FVA + CDS = even worse solvency issues.
January 25th, 2009 at 7:09 pm
Guess that’s a question for Uncle Sam… when you take over a bank, presumably you are acting as the bankruptcy judge and choosing how much a haircut each of the creditors gets. Since every bond issuer pays a higher yield because of some default risk, closing out all the bondholders at par is indeed a subsidy to those who bet on a losing horse.
Now, it’s easy to see, given the cross-borrowing, how too aggressive of a haircut creates another of those deflationary black hole spirals. That’s somewhat separate of a problem, however, and needs independent treatment.
January 25th, 2009 at 9:07 pm
I see that the consensus is to let the Financial houses lay in the bed that they made. I concur, but how about a Chinese twist? Public beheadings would be a hit on Broadway! As far as FVA goes, if the investing public sits still for it, who else cares? Fortunately, I can read a balance sheet and income statement whether its Mark to Market or FVA.
January 25th, 2009 at 9:17 pm
God I love this blog when it gets contributions like the one …
@johnbougearel. Thank you. What an enlightening spot. Homework. Honest. Real.
@BR: Don’t take offense. This is your blog. You’re the man.
January 25th, 2009 at 9:33 pm
johnbougearel
How can FVA + CDS make an insolvent bank situation worse? It seems like a mere distraction from the real issue.
January 25th, 2009 at 11:24 pm
Why not get rid of the equity option market as well. While we’re at it, the levered ETF market, especially the inverse ETFs to bet against financial institutions. CDS is no different than equity options. Do all option buyers or sellers have a position in the underlying? Of course not and the same is true for CDS, they are the exact same thing, but for fixed income products. Are there problems, sure, but some of these discussions are ridiculous. Most CDS contracts require initial margin and then collateral is exchanged on a daily basis, with the flow of funds dependent on the mark-to-market. Putting them on central clearinghouses makes sense, but getting rid of the entire market? Please. Like I said, unless we are ready to get rid of options and a number of other derivative markets, this doomsday talk is a bit over the top.
January 25th, 2009 at 11:48 pm
Reading most of the comments here, it appears that emotions and ‘fairness’ is dominating the public opinion on what should be done.
have to leave an unpopular post here: while we’re still in the witch-hunting mode, all we will get is crisis spreading from one area to the next, and ever more public funds needed. (I’ve to declare here i’ve never worked on wall street nor made any of the huge salaries in the financial sector. And I’ve personally suffered financial losses, so I’m no different from the average man on the street) I’m all for catching the arsonists – AFTER we put out the fire.
So, keeping emotions and ‘fairness’ aside:
On Chris’s suggestion that we ban CDS on institutions running on public money: the intentions are good, except that it’s based on the premise that evil speculators are causing financial ruin in those companies. It could have been true before, but hedge funds are now mostly in ICU (half is wiped out), so I doubt they have appetite to take much risk to move markets. If most of the exposure then is by commerical firms e.g. corporates with exposures to certain banks due to their business dealings, are we unfairly denying them of their ability to seek insurance? Next, if US govt money is propping up the bank, and protection on the bank is not available, the market will always seek the alternative: buying protection on US govt itself (which is available, btw, just not as liquid yet).
The issue with CDS posing systemic risk is two-fold. First, how the market (and regulators) treat it, and Second, too much leverage – which magnifies any problems. Chris suggestion of posing significant margins is good in that it reduces the implied leverage. But again, it should not drive out any genuine hedgers. Alternatives such as options is fine, but not if everyone is doing it. We do need a wide pool of alternatives to suit individual needs and prevent concentration risks.
This still doesn’t change how the market/regulators is treating CDS. If more people buy more insurance on my life, it doesn’t drive me to die faster. But unfortunately, this is happening for companies due to accounting requirements, and banks are hit doubly hard due to capital requirements. This silly issue is pretty fundamental, and needs to be fixed.
I hope that while we seek solutions to shore up balance sheets to meet acctg financial ratios so as to restore confidence (e.g. banks are insolvent/risky because xx% is breached), we don’t forget that the ultimate goal: Confidence/trust, not $$, is the fundamental basis of credit. Recall JP Morgan’s quote: “Because a man I do not trust could not get money from me on all the bonds in Christendom.” Pujo hearings, 1912-1913
January 25th, 2009 at 11:49 pm
@jdnc123 You make some interesting points, and bring up a recall that there once was a line of distinction between financial institutions (read banks) and speculative markets (read commodities, options and casinos). Sure anything goes when its understood to be within speculative gambling establishments. Buyer beware. Just ask Madoff clients.
If your point is that cds are perfectly legit outside banking and insurance circles I don’t have a problem. But otherwise I do. Interestingly enough, you conjure up a more appropriate question. How was it banks saw it within their domain to gamble with cds?
So a better issue might be not to kill cds, but to ban them from banks.
January 26th, 2009 at 12:43 am
johnnyvee,
I hear ya man. I cede you your point a second time. The broader issue trumps the nuances and nuances should not trump the broader issue. It is hoped however, that being as smart as we are, we can grasp both concepts simultaneously.
CS: one of CWs point was specifically that CDSs are high beta, high correlated, under-collateralized junk that only increases the volatility on the downside when everything is in dynamic disequilibrium. And sdince that is precisely what they are not be designed to be, they are flawed instruments only exacerbating the broader problem being underscored by johnnyvee.
January 26th, 2009 at 3:53 am
not to worry. nothing is going to happen to Swaps. The “investments” banks are the government. After 4 or 5 years of hoarding to build reserves while living the good life, they’ll twist their own arm and get about settling things out. Right now they are too scared as are their proxies in govt. and academia.
January 26th, 2009 at 12:13 pm
My understanding is that there is not enough money in the world to pay out all of the CDS’s that are expected to be coming due. The fairest thing to do would be to mandate that the issuer honor its obligations to the point of bankruptcy. End of game, then.
It is particularly ironic that the investment banks’ rebuke to those who believed the fraudulent Tiple A ratings on the garbage they sold, “do better due diligence,” does not apply to these banks when they whine to Geithner about AIG’s inability to honor its contracts.
This CDS and synthetic CDO business is a pure fantasy and taxpayers should cease paying out on this nonsense as they are in the AIG bailouts.
I will applaud the cleverness of the investment banks who have filled their pockets in every possible way, but it is time to end this game. Colluding with the rating agencies to issue fraudulent ratings on the MBS’ and other garbage you sell is bad enough, but to then use your knowledge of how worthless this highly rated garbage is and to take out insurance against it, and then demand that taxpayers pay when AIG cannot is absolutely outrageous.
Where is Elliott Ness when you need him?
January 26th, 2009 at 12:45 pm
For CDS, the notional sizes involved are gigantic but the risk dollars are not that large. Still, CDSs pose systemic risks. Not because of the large amount of payments required in the unlikely case of default, but more because they amplify the counterparty risk . When everyone is nervous and wants to hedge, the market might experience an equivalent of bank run. The roots of the problem may lie in the disconnect between the amount of debt and CDS referencing it. More comments on: http://creditnotes.blogspot.com/2009/01/cds-market-size-is-concern.html