Our story thus far:  The Commodity Futures Modernization Act of 2000, sponsored by Texas Senator Phil Gramm as a favor to his wife Wendy (who sat on the Board of Directors of Enron, which wanted to trade energy derivatives without oversight) was rushed through Congress in 2000. Unread by Congress or their staffers, it was signed into law by President Bill Clinton on the advice of his Treasury Secretary Lawrence Summers.

The CFMA radically deregulated derivatives. The law changed the Commodity Exchange Act of 1936 (CEA) to exempt derivatives transactions from regulations as either “futures” (under the CEA) or “securities” under federal securities laws. Further, the CFMA specifically exempted Credit Defaults Swaps and other derivative products from regulation by any State Insurance Board or Regulators.

This rule change exempting CDS from insurance oversight led to a very specific economic behavioral change: Companies that wrote insurance had to explicitly reserve for expected losses and eventual payout in a conservative manner. Companies that wrote Credit Defaults Swaps did not.

Hence, AIG was able to underwrite over THREE TRILLION DOLLARS worth of derivatives, reserving precisely zero dollars agianst potential claims. This was enormously lucrative, except for that whole crashing & burning into insolvency thingie.

The radical deregulation the CFMA generated led directly to the collapse of AIG, Bear Stearns and Lehman Brothers; indirectly to the collapse of Citigroup, Bank of America, and Fannie/Freddie. It was a significant factor in the near death experiences of Goldman, Morgan Stanley and others.

Despite the horrific impact this legislation had, it was never actually overturned, only modified. Obama made the personnel error of bringing back Larry Summers (he apparently had not wrought enough damage to the nation yet). Rather than admit the error of CFMA, and overturn it, Summers instead downplayed its role. Thus, the CFMA was merely modified somewhat. The same risk the CFMA presented to the economy still exists. Swaps now must be be cleared through exchanges or clearinghouses — but they are still exempt from Insurance regulations. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement. Counter-parties may or may not demand one, but the dollar amount is negotiable.

Which brings us to today.

The Greek government has been declared in default by S&P; most common sense definitions of default — failing to make payments on a timely basis, declaring your intention to default, involuntary change of loan terms by borrower, etc. — have already occurred.

That last point is especially important in light of the Greek Sovereign Debt default — which International Swaps and Derivatives Association, in a nonpublic meeting of derivatives bankers, declared to be a NONDEFAULT.

I’ll be damned if I can figure out why.

Any tradeable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year.  No interpretation required.

Yet with Greek CDS, we have a committee of bankers, lawyers, accountants and other interested (not unbiased) parties interpreting the details, weighing the circumstances, describing what happened.

Does that sound like a tradeable asset to you?  To me, it sounds more like an insurance policy dispute. Because in reality, these CDS are in fact, nothing more than an unreserved and unregulated insurance productts.  That is the legacy of the CFMA, and one that apparently has not been overturned.

The banks, hedge funds, and securities firms who are the prime dealers of these products  greatly prefer to have their derivatives supervised by Federal regulators. Why? Because the standards they use — general safety and soundness — are empty-headed nonsense, easily evaded.

The State Insurance Boards and Regulators are far more exacting, far more specific — and require boatloads more money in reserve.

Hence, this is how the Greeks have managed to default, yet an insurance-like product will not (yet) payout. With insurers or their regulators involved, this would never have happened.

Category: Derivatives, Really, really bad calls, Regulation

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.

33 Responses to “Credit Default Swaps (CDS) Are Insurance Products, Not Tradeable Assets”

  1. Jim67545 says:

    Reminds me of investors buying mortgage backed bonds consisting of primarily sub-prime mortgages because a (worthless) rating agency stuck a (worthless) AAA rating on it. Now we have investors buying sovereign debt because a (worthless) insurer stuck a (worthless) CDS to it. You would think that investors dealing in these sums would have some modicum of basic common sense. With no reserves backing the CDS is it any wonder that the insurers are finding any excuse possible not to pay? Is that really that hard to anticipate, especially given AIG just a few years ago? If the bond holders truly relied on this snake oil, who is to blame?

  2. Matt Levine says:

    So Maybe Greek CDS Won’t Be Fine, Who Knows, I Give Up

    (1) Right now you have Old Greek Bonds with a face value of 100 and a trading value of like 25
    (2) They will be exchanged for (a) New Greek Bonds with a face value of 30 and a trading value of like 10 plus (b) EFSF bonds with a face value of 15 and a trading value of 15
    (3) But the CDS auction will happen after this and the deliverable obligation specified by the CDS contract is just “Greek bonds with a face amount of 100.”
    (4) So that will mean New Greek Bonds with a face value of 100, which will have a trading value of 10/30 x 100 = 33
    (5) So the CDS reference price will end up being 33, for a payout of 67 cents on the dollar rather than 75
    (6) So if you had a bond + CDS, then you get 25 on the bond and 67 on the CDS for a 92 total
    (7) Which, you will notice upon careful examination, is less than 100
    (8) And you could monkey with that even more by for instance having New Greek Bonds with a lower face value and higher coupon, so that they might have a face of 10 and a trading value of 10, meaning that the CDS auction would clear at par and there will be no payout.

  3. Bridget says:

    As I alluded to in comments to your earlier post, ISDA: Suckers Wanted, it wouldn’t be such a bad thing if they all lost their asses. A great big “Teachable Moment”, so to speak. Assuming, of course, that Turbotax Timmie, Bernanke, Congress, and the Obama administration can all restrain themselves from “Doing Something”, and just let the chips fall where they may.

  4. DrSandman says:

    While us conservatives generally approve of laissez faire economics and find the excessive number of regulations to be a debatable proposition (you _can_ debate us, but you would be wrong!), I’m going to go out on a limb here and applaud you for your broken clock moment:

    Yes, CFMA should be repealed. Glass-Steagal should be reinstated.

    @Bridget: +100. Part of buying an insurance policy is chosing a broker that is adequately capitalized to make you whole in the event of a loss… I don’t see the due diligence of the people buying the CDS.

  5. Been Around 1963 says:

    It’s worthwhile to remember why credit default swaps were invented. Under New York State banking law, it is illegal for a bank to offer insurance products. So, with ISDA’s Orwellian turn of phrase, an insurance product suddenly became a “swap” unlike any other swap in the trading universe.

  6. SivBum says:

    Not just the 2000 Act but subsequent ammendments … The Commodity Exchange Reauthorization Act of 2005, which the Senate Agriculture Committee approved in July, proposes to make progress on portfolio margining:

    http://www.federalreserve.gov/boarddocs/testimony/2005/20050908/default.htm

    (1) by eliminating the need for margins required on security futures to be consistent with those required on comparable options and

    (2) by substituting CFTC oversight of security futures margins for joint regulation by the CFTC and the SEC under delegation from the Board. This approach would be a marked departure from the regulatory regime for security futures that was established by the CFMA.

    The Board believes that it is appropriate for the Congress to spur progress toward portfolio margining for security futures but that this can be accomplished without changing so fundamentally the regulatory regime for security futures margins. For example, the Congress could spur more-rapid progress toward portfolio margining for both security futures products and options by requiring the commissions to jointly adopt regulations permitting the use of risk-based portfolio margin requirements for security futures products within a short but reasonable time period and requiring the SEC to approve risk-based portfolio margin requirements for options within the same period.

  7. Francois says:

    Forgot to add:

    Little individual fraud? Go to jail 15 years!
    Systemic institutional fraud? (robosigning for instance) Get forbearance, cash in your bonuses, and enjoy White House support to buy State AGs.

    Got a 2nd passport?

  8. Eric Dinallo says:

    Testimony to Congress, November 2008 on (Naked) Credit Default Swaps;

    “As credit default swaps were developed, there was a question about whether or not they were insurance. Since initially they were used by owners of bonds to seek protection or insurance in the case of a default by the issuer of the bonds, this was a reasonable question. In 2000, under a prior administration, the New York Insurance Department was asked to determine if swaps were insurance and said no. That is a decision we have since revisited and reversed as incomplete”

    “In addition, since I took office in January 2007, the impact of credit default swaps has been one of the major issues we have had to confront. First, we tackled the problems of the financial guaranty companies, also known as bond insurers. Credit default swaps were a major factor in their problems. More recently, we have been involved in the rescue of AIG. Again, credit default swaps were the biggest source of that company’s problems.”

    “Originally, credit default swaps were used to transfer and thus reduce risk for the owners of bonds. If you owned a bond in company X and were concerned that the company might default, you bought the swap to protect yourself. The swaps could also be used by banks who loaned money to a company. This type of swap is still used for hedging purposes…Over time, however, swaps came to be used not to reduce risk, but to assume it. Institutions that did not own the obligation bought and sold credit default swaps to place what Wall Street calls a directional bet on a company’s creditworthiness. Swaps bought by speculators are sometimes known as “naked credit default swaps” because the swap purchasers do not own the underlying obligation. The protection becomes more valuable as the company becomes less creditworthy. This is similar to naked shorting of stocks…I have argued that these naked credit default swaps should not be called swaps because there is no transfer or swap of risk. Instead, risk is created by the transaction. For example, you have no risk on the outcome of the third race until you place a bet on horse number five to win…We believe that the first type of swap, let’s call it the covered swap, is insurance. The essence of an insurance contract is that the buyer has to have a material interest in the asset or obligation that is the subject of the contract. That means the buyer owns property or a security and can suffer a loss from damage to or the loss of value of that property. With insurance, the buyer only has a claim after actually suffering a loss…With the covered swaps, if the issuer of a bond defaults, then the owner of the bond has suffered a loss and the swap provides some recovery for that loss. The second type of swap contains none of these features.”

    “The Bank Panic of 1907 is famous for J.P. Morgan, the leading banker of the time, calling all the other bankers to a meeting and keeping them there until they agreed to form a consortium of bankers to create an emergency backstop for the banking system. At the time there was no Federal Reserve. But a more lasting result was passage of New York’s anti-bucket shop law in 1909. The law, General Business Law Section 351, made it a felony to operate or be connected with a bucket shop or “fake exchange.” Because of the specificity and severity of the much-anticipated legislation virtually all bucket shops shut down before the law came into effect, and little enforcement was necessary. Other states passed similar laws…Section 351 prohibits the making or offering of a purchase or sale of security, commodity, debt, property, options, bonds, etc. without intending a bona fide purchase or sale of the security, commodity, debt, property, options, bonds, etc. If you think that sounds exactly like a naked credit default swap, you are right. What this tells us is that back in 1909, 100 years ago, people understood the risks and potential instability that comes from betting on securities prices and outlawed it.”

    “The Commodity Futures Modernization Act of 2000 (“CFMA”), signed by President Clinton on December 21, 2000, created a “safe harbor” by (1) preempting state and local gaming and bucket shop laws except for general antifraud provisions, and (2) exempting certain derivative transaction on commodities and swap agreements, including credit default swaps, from CFTC regulation…CFMA also amended the Securities and Exchange Acts of 1933 and 1934 to make it clear that the definition of “security” does not include certain swap agreements, including credit default swaps, and that the SEC is prohibited from regulating those swap agreements, except for its anti-fraud enforcement authority…So by ruling that credit default swaps were not subject to state laws or SEC regulation, the way was cleared for the growth of the market. But there was one other issue. If the swaps were considered insurance, then they would be regulated by state insurance departments. The capital and underwriting limits in insurance regulation would threaten the rapid growth in the market for these derivatives…So at the same time, in 2000, the New York Insurance Department was asked a very carefully crafted question. “Does a credit default swap transaction, wherein the seller will make payment to the buyer upon the happening of a negative credit event and such payment is not dependent upon the buyer having suffered a loss, constitute a contract of insurance under the insurance law?”…Clearly, the question was framed to ask only about naked credit default swaps. Under the facts we were given, the swap was not insurance, because the buyer had no material interest and the filing of claim does not require a loss. But the entities involved were careful not to ask about covered credit default swaps. Nonetheless, the market took the Department’s opinion on a subset of credit default swaps as a ruling on all swaps…In sum, in 2000 as a society we chose not to regulate credit default swaps.”

  9. constantnormal says:

    Credit default swaps should be banned, period. Clearinghouses will not solve their problems. Make them illegal for publicly-traded firms to own, with an effectivity date of about 5 years hence, to provide time for an orderly exit to these disasters … and at the same time, regulate the living hell out of them, with periodic audits of the backing capital, and verification of adherence to the terms of the contracts … such audits will obviously be very expensive, given the complex and unique nature of these custom contracts, and the issuers of the swaps should bear the costs of the audits … Problem Solved.

    The world existed perfectly well before this particular “financial innovation” emerged from the swamps of someone’s fetid mind. It will somehow manage to get along without CDS.

  10. Hushed Up: Secret Panel Holds Fate of Greek CDS (WSJ)
    For Greece, a critical conference call between London and New York (Washington Post)

  11. crutcher says:

    The MSM is very, very late to the game in getting this story into the public consciousness, but not for your lack of effort!

  12. Been Around 1963 says:

    Mr. Dinallo

    Thank you very much for that clarification regarding the genesis of CDS. I hope you will also speak out about what happened with the Texas Insurance Commissioner and AIG, and also Goldman’s bad faith ploys that led up to the collapse of AIG, which, so far I can tell, have only been reported by off-the-record sources in Griftopia.

    On a different point, clearing houses simply address the issue of net counterparty risk. They do nothing to address the issue of market manipulations (e.g. round tripping, pump and dump schemes, etc.)

  13. willid3 says:

    CDS are insurance products. since insurance is basically ‘coverage’ of a specified event, to pay for losses incurred.
    the insurance business isn’t all that complex, they collect premiums, invest them, and estimate how much of their policy holders will make claims (that actuary thing), and they put that amount in reserves to cover that. failing to do that reserve means they are making a pure profit on the premiums received and will default when the policy holder makes a claim. (this would be no different if your car insurance company did the same, you wouldn’t be getting your car fixed). state insurance agencies tend to be very conservative regarding the reserves, because when an insurance company ‘fails’ in their state, they are on hook for it (otherwise that state will have a real problem getting business to move there. and banks won’t lend money for any thing in that state. why would they? they are at risk of total loss in the even of non payment of a claim by an insurance company).

    and for those who weren’t paying attention, its also basically a private version of socialism. think not? on your last claim or claims, was the total of all of your premiums up the date of the claim(s) equal the total amount of your claims? about 99% of the time, this will so be so.

  14. uzer says:

    BR: I’ll be damned if I can figure out why.

    Me: because it will collapse the CDS ponzi scam – since i don’t know what a ponzi scam looks like, smells like or quacks like, you can safely disregard

  15. fraud guy- also says:

    The comment above from Eric Dinallo is incredibly important. Dinallo was the NYS Insurance Commissioner at the time of the financial crisis (is this really Eric Dinallo commenting?) But he leaves of what is, in my opinion, the most important part of his testimony at that congressional hearing:

    “On September 22, we announced that New York State would, beginning in January,
    regulate the insurance part of the credit default swap market which has to date been
    unregulated—the part which the Insurance Department has jurisdiction to regulate.”

    http://agriculture.house.gov/testimony/110/h91120/Dinallo.pdf

    What has become of that promise to start regulating CDS in the NYS Insurance Department? I can’t find anything. I imagine what happened, particularly when Cuomo came into office was a series of chats between the big NY banks and the governor’s office (the governor appoints the insurance commissioner). They probably went something like this:

    “Look, you can regulate us if you want and effectively stop the issuance of CDS in New York. But it won’t stop us. We’ll just move the CDS desks to London or Hong Kong. So you won’t have done anything to the CDS market overall but you will lose out on all the tax revenue that is generated by CDS issuance in NY. Your choice.”

    If it was Dinallo who commented above, it would be great if he could update us on what became of the promise he made to Congress to start regulating CDS.

  16. rpatton says:

    Really good piece, BR. It’s pretty startling how something that seems so obvious can continue to be misconstrued so poorly.

  17. obsvr-1 says:

    @crutcher: The MSM is very, very late to the game in getting this story into the public consciousness, but not for your lack of effort!

    ***
    True MSM is late (more direct, they are derelict in their responsibility to inform);
    There were numerous discussions and inquiries regarding the financial crisis, specifically FCIC drilled into the CDS problem extensively. Brooksley Born was on the FCIC team and constantly drilled on the issue of unregulated derivatives and the CDS issue. She also fought the cabel (as head of the CFTC) of Clinton, Summers, Rubin, Greenspan over the CFMA and unregulated derivatives to no avail. The problem is the masses are distracted by social issues, MSM droning and the myriad of entertainment channels to call the scoundrels (oligarchs) out on their fraudulent schemes.

    good link to review: http://www.pbs.org/wgbh/pages/frontline/warning/interviews/born.html

  18. obsvr-1 says:

    Key statement from the Born interview on Frontline, Warren Buffet was correct when he said “Derivatives are financial weapons of mass destruction” … one corrections should be to add “unregulated” to the beginning of the quote.

    Excerpt:
    So we’re the losers. Who were the winners?

    I think the profits made by the over-the-counter derivatives dealers, by our largest banks and investment banks, were the upside of this. And that was shortsighted. It was short-term benefit for a few major institutions at the expense of all the people who have lost their jobs, who have lost their retirement savings, who have lost their homes.

  19. san_fran_sam says:

    so here’s my question….

    suppose someone owns Greek bonds and has a CDS as protection against default.

    They say, “Hey, Greece did not pay off the bonds i hold. They are in default. I want the counterparty to my CDS to pay up.”

    The counterparty says, “They are not in default as far as I’ve been told by the ISDA.”

    Bondholder: “Okay. Fine. See you in court.”

    Could it play out that way?

  20. Bridget says:

    “@Bridget: +100. Part of buying an insurance policy is chosing a broker that is adequately capitalized to make you whole in the event of a loss… I don’t see the due diligence of the people buying the CDS.”

    Agreed, DrSandman. That’s why it’s important that they not be bailed out if their bets go bad. Force them to do due diligence on the writer of the swaps, and there will be a whole lot less toxic assets of all kinds floating around the globe.

  21. ezzie2010 says:

    “That last point is especially important in light of the Greek Sovereign Debt default — which International Swaps and Derivatives Association, in a nonpublic meeting of derivatives bankers, declared to be a NONDEFAULT.

    I’ll be damned if I can figure out why.”

    As I understand it, a future default is obvious but has not yet occurred, and ISDA wants to stick to “objective” criteria as much as possible.

    Greece has made all of its payments on time.

    Greece has not repudiated the bonds by making the exchange offer because it has not said, without reservation, it will default on bonds that are not tendered into the exchange.

    If I remember correctly, Greece has said it will default on the bonds (by invoking the newly-minted collective action clause) if more than 90% of bonds are tendered into the exchange. It has said it may or may not default if between 75-90% of bonds are tendered into the exchange.

    If you are a Greek bondholder with CDS, Greece has no leverage over you. (The Troika is another question entirely). If you decide not to tender your bonds, Greece will either pay you, or your CDS counterparty will. If you tender, its your own decision.

  22. carleric says:

    If I was stupid enough to have bought Greek bonds I don’t think I would hold my breath waiting to get paid….what counterparty is going to belly up to the bar and what will they use for money? ROTFLMAO

  23. farmera1 says:

    Things just keep getting curiouser and curiouser. Gross is now complaining about how the ISDA voted.

    (Reuters) – Bill Gross, co-chief investment officer at PIMCO, on Thursday took issue with a derivative panel’s decision that the restructuring of Greek debt does not trigger a payout on insurance protection, even after his firm backed the move.

    http://www.reuters.com/article/2012/03/01/us-greece-bonds-pimco-idUSTRE8201D920120301

  24. [...] – Barry on credit default swaps. [...]

  25. Bridget says:

    “carleric Says:
    March 2nd, 2012 at 4:45 pm
    If I was stupid enough to have bought Greek bonds I don’t think I would hold my breath waiting to get paid….what counterparty is going to belly up to the bar and what will they use for money? ROTFLMAO”

    And that is yet another issue….how many of the clowns left holding Greek Bonds have paid anything in the vicinity of par value for them? In all likelihood, the only holders left standing are speculators who paid pennies on the dollar. Anyone with any sense of self preservation having long ago beaten a retreat.

    Do I want my government to put.my hard earned money on the hook to pay par to these folks who have bought these bonds at a huge discount, and the pay on their CDOs to boot? I think not.

  26. [...] I have no dog in this fight, other than than an interest in seeing derivatives, especially Credit Default Swaps, appropriately regulated as insurance products. [...]

  27. Defining Quality says:

    The law has clearly been ignored for anyone who can think!
    BTW this is not “your story” and countless people have been blogging on this exact subjest for several years including myself.

  28. gps says:

    Without CDS is it possible to market Sovereign Debt of Third world countries viz., Italy, Spain, Ireland and others. Its going to create huge repercussion in future. I don’t think rational investor would dare to buy those junk bonds without adequate protection. CDS – Criminals Defaulting System.

  29. Blissex says:

    «in 1909, 100 years ago, people understood the risks and potential instability that comes from betting on securities prices and outlawed it.”»

    That was exactly one of the arguments by B.Born during the debate on whether the CFTC should regulate derivatives; she made the point that if the CFTC did not regulated them, state gambling commissions would have to. So the CFMA specifically exempted betting on securities from gambling laws.

    Perhaps “covered” derivatives are insurance products, but if they are they would be impossibly expensive; but “naked” derivatives

    Wall Street and in particular also the City of London are in effect mostly nowadays running fantasy-finance games, based on gambling, where the USA and the UK governments effectively periodically hand over for free hundreds of billions of “points” to the players.

    It is a complete inversion of past regulatory practice: it is used to be that investment banks could not rely on insured deposits to finance their operations, now instead they are in practice required to do so, it used to be that it was illegal for financial companies to trade while insolvent, now instead insolvency is a nearly indispensable competitive advantage sponsored by legislation, and it used to be that bucket shops were outlawed, and now instead they are a core business of the finance system.

  30. Blissex says:

    The interview where B.Born discusses very diplomatically having derivatives subject to state gambling laws:

    http://www.derivativesstrategy.com/magazine/archive/1997/0597qa.asp
    «DS: So if the current regulatory environment ends, it’s conceivable that a legal case would challenge certain protections that these exchanges have right now.

    BB: Under the act, they also are protected from certain state laws. They also have protection from private rights of action that might otherwise exist.

    DS: So is it conceivable that state gaming laws would become applicable to trading on the CBOT or Merc?

    BB: I think that’s an issue that probably would be explored.»

    While the Democrats have a large shared of the responsibility of this evolution, it is because many have turned into Republicans. Some quote from J.K.Galbraith ‘s inestimable “The Great Crash 1929″ about this:

    page 25 “Just as Republican orators for a generation after Appomattox made use of the bloody shirt, so for a generation Democrats have been warning that to elect Republicans is to invite another disaster like that of 1929. The defeat of the Democratic candidate in 1952 was widely attributed to the unfortunate appearance at the polls of too many youths who knew only by hearsay of the horrors of those days. It would be good to know whether, indeed, we shall some day have another 1929.”

    page 48 “The purpose is to accomodate speculators and facilitate speculation. But the purposes cannot be admitted. If Wall Street confessed this purpose, many thousands of moral men and women would have no choice but to condemn it for nurturing an evil thing and calling for reform. Margin trading must be defended not on the grounds that it efficiently and ingeniously assists the speculator, but that it encourages the extra trading which changes a thin and anemic market into a thick and healthy one.”

    The overall picture has been beautifully summarized by Frum thus:

    http://nymag.com/news/politics/conservatives-david-frum-2011-11/index4.html
    “In the aftershock of 2008, large numbers of Americans feel exploited and abused. Rather than workable solutions, my party is offering low taxes for the currently rich and high spending for the currently old, to be followed by who-knows-what and who-the-hell-cares. This isn’t conservatism; it’s a going-out-of-business sale for the baby-boom generation.”

    The baby-boom generation want tax-free capital gains on their properties with one way-bets on asset prices (plus low wages for everyone else and high taxes on earned income). Wall Street is the fantasy-finance engine designed to deliver the illusion of that happening. As long as the carnies can make it appear to work.

  31. Blissex says:

    «Without CDS is it possible to market Sovereign Debt of Third world countries viz., Italy, Spain, Ireland and others. Its going to create huge repercussion in future. I don’t think rational investor would dare to buy those junk bonds without adequate protection.»

    This incredibly stupid argument is based on the assumption that protection costs a lot less than the expected cost of default. But if you buy a junk bond with a 50% probability of default, the CDS seller would be mad to charge less than 50% of face value for “protection”, so statistically you would not save a cent. Insurance is not an investment, it is a risk pooling technique, that is a way to reduce the variance of losses, not their average magnitude.

    The reason why cheap CDSes were sold on eurobonds of all countries was that major EU governments were supposed to provide repayment guarantees, and the bonds of weaker economies crashed only when major EU governments suddenly made clear that was not going to happen, actually quite the opposite:

    http://seekingalpha.com/article/297412-germany-s-catastrophic-euro-mistake
    «Problems within the euro only really started to hit the market when, on Germany’s explicit insistence, and against much opposition (most notable from ECB president Trichet), talks of a ‘haircut’ for Greek bondholders (mostly banks) became public. This spooked the markets and opened a new front in the euro crisis.

    Plans for such ‘public sector involvement’ (PSI), as this was called, date back to a meeting on October 18 2010 in Deauville where Sarkozy and Merkel not only hatched the plan for a permanent emergency fund, but also the idea of PSI.

    Word has it that Jean-Claude Trichet, the president of the ECB, goes to every meeting armed with a graph displaying interest rate differentials, which began to diverge just after that day in October, which is marked by a little flag ‘PSI’ in Trichet’s graph.

    It culminated in the second bail-out for Greece (July 21st of this year) which introduced a ‘PSI’ in the form of a one-off 21% voluntary haircut. The cat (the possibility of default on public debt within the euro area) was out of the bag, despite insistance that this was a one-off, would not be repeated, and was entirely voluntary.»

  32. Giovanni says:

    Great post and comments BR. Thank you Eric Dinallo for pointing out the plainly obvious facts (that have been known for at least 100 years). When obvious facts and risks are routinely ignored or actively repressed there can be no happy ending for the taxpayers who will ultimately have to throw hard earned good money after bad.

  33. Thank you. You hit the nail on the head and why financial uncertainty is still crippling our capital markets. As you stated:

    “Any tradeable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year. No interpretation required.

    Yet with Greek CDS, we have a committee of bankers, lawyers, accountants and other interested (not unbiased) parties interpreting the details, weighing the circumstances, describing what happened.”

    The Derivative Project tried without success to get this issue debated before Congress during the Dodd Frank hearings. In fact here is a speech given in plain English to a group of elderly ladies in February 2010 to explain a major cause of the financial crisis. The purpose of this talk was to get individuals engaged to effect change, against a powerful Wall Street Lobby on ever-increasing speculation in credit derivatives, causing increasing tax payer costs and increasing systemic risks. We stated in this speech:

    “DERIVATIVE: A derivative is a risk transfer agreement, the value of which is derived from the value of
    an underlying asset.

    Credit default swap: A contract that is a risk transfer agreement, the value of which is not derived from an underlying asset. The value is subjective.

    A former derivatives credit analyst at U.S. Bank shares a quest to have politicians, journalists and money managers protect American’s retirement savings before the 2008 stock market crash. Why wouldn’t anyone listen or speak out?”

    As we explained in this “Story”:

    “Derivatives have been used for many years as conservative hedging vehicles on both regulated exchanges and over-the- counter markets.

    Conversely, credit default swaps1, are a new “derivative” established by J. P. Morgan in the early 1990’s. They are used by entities to hedge against an “adverse credit event” of a corporation.

    We will explore why credit default swaps should be banned. As you will see from the example of AIG and Goldman there is a fundamental conflict here in derivative definitions. Credit default swaps do not have an underlying asset. They do not meet the International Swap Dealers original definition of derivatives. One cannot determine the underlying price of a credit default swap to ensure fair trade, since there is no underlying asset.”
    
























































    1
The International Swap Dealer’s Association defines credit default swap as a credit derivative contract in which one party (protection buyer) pays an periodic fee to another party (protection seller) in return for compensation for default (or similar credit event) by a reference entity. The reference entity is not a party to the credit default swap. It is not necessary for the protection buyer to suffer an actual loss to be eligible for compensation if a credit event occurs.

    Here is the link to the 2010 Speech, The Simple Story, that attempted to explain in plain English for voters why they should contact their Congressional Representatives about ensuring a debate on the role of credit default swaps in our capital markets. It is an arcane topic, but it is not complicated…yet, a sleeper for the average voter.

    Thank you very much for bringing this issue front and center. We would be pleased if The Big Picture would link to our Blog. Unfortunately, The New York Times Blog Runner Service refuses to link to our Blog, http://www.thederivativeproject.com and blog.thederivativeproject.com.

    Our goal is to put in a non-academic format concepts that the average voter can be educated on and take action on with their Congressional representatives to effect change. We have no ties to any organization and have taken no funds from anyone, so we believe we are free of monetary conflict of interest, contrary to numerous organizations, stating they are advocating for the “consumer”.