Credit Default Swaps

Credit Default Swaps and other Derivatives

May 21, 2009 | Information Processing

Highly recommended: FT journalist Gillian Tett, a PhD in social anthropology, discusses her book on the financial crisis: Fool's Gold, at an LSE public lecture.

I haven't read the book yet, but it's on my list :-) Here are two nice excerpts that appeared in the FT. She does a great job of covering the birth and development of credit derivatives, CDOs, etc.

Genesis of the debt crisis

How panic gripped the world's biggest banks

Below is a discussion of correlation from the first excerpt.

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of “correlation”, or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn’t deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody’s had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody’s had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn’t want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS). But then came Amherst Holdings.

A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default. The writer of the CDS sells insurance against an event of default. The insurance premium is the price of the CDS. The buyer of the CDS buys insurance against default. If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.

An obvious problem with CDS is that you do not have to have an insurable interest to purchase the insurance it provides. You have an insurable interest, as a purchaser of insurance, if the occurrence of the contingency you are insuring against would not make you better off (even when the insurance pays out). However, the CDS market is first and foremost a betting shop. You can buy CDS written on a given class of bonds, in amounts well in excess of the total face value of the bonds you own in that class. Indeed you may not own any bonds in that class and still buy CDS that pay off in the event a default occurs on bonds in that class. That is, CDS can be used not to hedge risk you already are exposed to, but to take on additional risk. CDS can be used to place pure bets.

The morality of gambling, through CDS or any other way

Betting and gambling, including lotteries, are frowned upon by many religions and by many who do not have a religious conviction. Gambling is not explicitly forbidden in the Bible, but it is a vice that goes against many biblical principles. It sits uncomfortably with the great command “love your neighbour as yourself”, it exploits the poor (gambling is regressive), it undermines the work ethic, it encourages greed and covetousness, it violates responsible stewardship of the resources one is entrusted with, it ‘leads into temptation’, and it can be highly addictive. It is also often associated with deception. Against that, ‘casting lots’ is a common way of making decisions in the Old Testament especially. The phrase ‘casting lots’ is used 70 times in the Old Testament and seven times in the New Testament (including the reference to the soldiers at the cross casting lots for Christ’s garments).

Classical Judaism shares the views on gambling found in the Hebrew Scriptures with Christianity, but also draws on more recent traditions. As I understand it, the classical Jewish tradition says that it is forbidden to make gambling your occupation, but it does not forbid a little friendly gambling every now and then. Islam prohibits gambling. It also prohibits any game or other activity which involves betting, that is, which has an element of gambling in it. The Prophet Mohammed says, ‘He who says to his friend: ‘Come, let us gamble,’ must give charity’ (in penance).

The fact that gambling, including betting and lotteries, is both addictive and regressive in its distributional impact has not stopped governments all over the world from encouraging and promoting it. It is just too useful a source of revenue to resist. Even countries like the UK that do not tax the winnings from gambling (whence the explosion of structures, like spread betting, that turn contingent financial claims into bets), do tax the profits of the gambling industry. State lotteries are ubiquitous. Indian reservations in the US, which have a form of sovereignty or extraterritoriality in certain matters, have been allowed to open casinos in states where this is not otherwise legal. All derivatives trading is, from a mathematical point of view and in economic substance, equivalent to the creation of lotteries. Sometimes these lotteries are used to hedge risk (when the purchaser of the lottery ticket has an insurable interest; other times and, I would argue, most of the time, these derivative-mediated lotteries are designed and used to take on additional risk - to gamble - generally with other people’s money. The indulgent attitude of the government towards these activities can be explained, as with conventional gambling, by the important source of government revenue that the profits from derivatives trading represent.

Moral hazard

All these religious and moral objections (including objections based on the addictive powers of gambling and its regressive distributional impact) apply even to bets or gambles where the event that is the subject of the bet or the gamble cannot be influenced by those participating in the bet or gamble. That is, in the context of betting by buying or selling CDS, it applies even if there is no moral hazard involved in the relationship established by the contract.

Traditional moral hazard occurs when the insured party (in the CDS example the purchaser of the CDS) can influence the likelihood of the insured against event occurring (in the CDS example, if the purchaser of the CDS can influence the likelihood of default on the underlying security in a way that cannot be fully reflected in the terms of the contract). There is asymmetric information in the insured-insurer relationship, and the insured party has the informational advantage - private information.

The standard economics or insurance story of moral hazard involves an informational advantage for the purchaser of the insurance. With no-fault automobile insurance and third-party coverage, I may drive less carefully. If I could take out life insurance on a third party, I might be able to expedite the demise of the insured party.

In the CDS world, the most common reported abuse of the instrument involved a party that owned both CDS and the underlying security, but had a net short position in the security. To be precise, assume I own $X worth of bonds of type j (at face value) and have purchased CDS on bond j that will pay out $Z if default occurs. If X < Z, I don’t have an insurable interest in bonds of type j: I am better off if default occurs.

Now assume that, as a bond holder, I can influence the likelihood of a default occurring. A possible scenario is where the company that issued the bond is in dire straits, but has a good enough chance of recovery and survival, that, from a social or economic efficiency perspective, it is undesirable to incur the real resource costs associated with a default. Assume the issuer of the bond has asked the holders of the bond to roll over the bonds, or to voluntarily extend their maturity. All bondholders but me have agreed. I am the holdout and the veto player. By refusing to go along with the voluntary restructuring (which, by assumption, would not be an act of default), I now can trigger a default, making a gain of $(Z-X). It’s socially inefficient; it may cause unnecessary human misery, but it is profitable and so, as homo economicus, I do it. Because of my hold-out position, I can drive the probability of default to unity, or 100 percent. This is the mother of moral hazard.

But now comes the mother-in-law of moral hazard. This time it is not the purchaser of the CDS (the insured party) who is afflicted by extreme moral hazard, but the writer of the CDS, the insurer. There is asymmetric information, but the informational advantage is with the insurer. Assume there is an amount $X of some bond of type j outstanding. Assume that the issuer of the bond is generally considered to be at significant risk of default. I now write (sell) CDS on that bond. Because there is no limit to the amount of CDS I can issue as long as there are willing takers, I can sell CDS to anyone who wants to have a flutter on the default of that bond. If I price my CDS aggressively (accept a low insurance premium per $ of bond j insured), I may be able to have a revenue from the sale of these CDS, $R, say, that exceeds the face value of the total stock of bond j outstanding. This would only happen if the total notional value of the CDS I sell (the total value they would pay out in the event of a default on bond j) is a multiple of the face value of bond j outstanding.

Having received revenue from the sale of CDS written on bond j well in excess of the face value of the entire stock of bond j outstanding, I then buy up, at a price above the prevailing market price (if necessary at face value or even above it!), the entire outstanding stock of bond j. As long as I can be sure I have the entire stock of bond j in my possession, I can be sure than no event of default will ever be declared for that bond. I, the writer of the CDS on bond j , and now also the owner of the entire outstanding stock of bond j , could simply forgive the debt I just acquired. The insurer has, ex-post, reduced the probability of default to zero. Those who bought the insurance (bought the CDS), wasted their money (their insurance premia).

Instead of buying up the entire outstanding stock of the bond directly and holding the bonds to maturity without calling a default, or forgiving the debt, I could instead, if the bond were some asset-backed security, purchase enough of the assets underlying the bond at prices in excess of their fair value to ensure that the issuer of the bond would have sufficient funds to pay off all the bond holders, should the bond be ‘called’, that is, retired prematurely. If in addition, I could make sure that the bond would indeed be called, I would again, through this financial manipulation, have reduced the probability of default on the bond to zero.

The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal.

This in essence, is what has been reported to have happened recently, when a small Austin Texas-based brokerage , Amherst Holdings, which had sold CDS (default protection insurance) on mortgage bonds, then purchased the property loans underlying these bonds at above-market prices to prevent a default that would trigger payments to buyers of the contracts.

Some mortgage bonds can be “called,” or retired early, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults. The mortgage bonds targeted by Amherst fell into that category. So the mechanism through which Amherst made sure enough money would be available to the issuer of the mortgage bonds to pay the obligations due on these bonds, also caused the bonds to be called. The bonds were paid off in full, and the CDS Amherst had sold on these mortgage bonds became worthless.

Many household names in Wall Street and the City of London were at the wrong end of this transaction. Amherst has been reported as selling more than $100 million worth of CDS on $29 million of mortgage bonds outstanding - a tidy profit of at least $70 million. It certainly beats working for a living.

The problem of moral hazard on the holder’s side or on the writer’s side of the CDS market is not a market design problem that can be addressed by creating a central clearing facility and requiring all CDS to be traded on organised exchanges. Requiring writers of CDS to post collateral or, in the case of an organised exchange, requiring a variation margin or maintenance margin (a daily offsetting of profits and losses between the short and long positions on the exchange, made possible by mark-to-market and the fact that the number of long contracts has to equal the number of short contracts) would not solve the problem that both holders and writers of CDS can, under many circumstances, influence the likelihood of default on the asset the CDS are written on.

The first of the two real-world examples I referred to had the holder of the CDS (the purchaser of the default insurance protection) raise the probability of default on the underlying security to 1, that is, to 100 percent, because he also owned a small amount of the underlying security and was in a position to trigger an event of default. The second example had the writer of the CDS (the seller of the default insurance) reduce the probability of default to zero, by causing the bonds to be called after making sure that the issuer had enough money to pay off all the bond holders in full.

Both practices and anything like them are unethical and quite likely socially inefficient and harmful. The way to stop them is to destroy the incentive to issue CDS with a notional value in excess of the underlying securities these CDS are written on.

Conclusion

This post does not lead to a proposal for banning the writing and owning of CDS. Provided the purchasing party has an insurable interest, CDS are useful instruments for hedging risk. It is an argument for requiring that a claim for payment of $X under a CDS contract written on security j , when the default event has indeed occurred, is valid and enforceable only if the owner of the CDS can hand over $X worth of security j when he submits his CDS claim. The moral hazard that can afflict both sides of the CDS market is such that requiring a CDS owner to have an insurable interest seems the only reasonable response.

June 14, 2009 12:36pm in Culture, Economics, Ethics, Financial Markets, Monetary Policy, Politics, Religion | 31 comments

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1. True, but then not true. The whole construction of money in a capitalist society is a gamble based on trust. Buying interest rate products is a gamble, though it can be a hedge. Buying currencies is a gamble, though it can be a hedge. Buying bonds is a gamble, though it can be an investment. The whole idea about current capital markets is that is allows you to take a view on future events and profit from that view in the case you are right. Lose in the case you are wrong. Credit Default Swaps are no different to that.
Obviously to have better laws that will help to avoid situations as with Amherst would be good, but cannot completely be avoided. However, trading CDS only when there is an insurable interest goes past the notion that CDS are also vary valuable to hedge for example counterparty risk. No need to hold a bond in order to have risk to a certain counterparty. Also the writer of a cds would then be always supposed to be short the bond, whilst that might not fit his view of the insurable interest (he might just see a temporary move in credit spread he can profit from rather than a full blown credit event).

Posted by: M | June 14 02:17pm | Report this comment
2. Would not the requirement of the full use of an exchange (including the publishing of all details of every trade except the identities of those involved) also solve the problem? That way everybody can see when the notional value of all the CDS contracts issued is approaching the maximum (i.e. non-default) value of the underlying securities.

Posted by: User3509011 | June 14 05:35pm | Report this comment
3. I am not sure that requiring a CDS owner to have an insurable interest is a reasonable and all the more sufficient response to reduce the moral hazard component and avoid gambling.
I still contend that CDSs are not only what investor Warren Buffet once described derivatives as "financial weapons of mass destruction" but also financial weapons of wealth destruction. Given the skewed incentives embedded in CDSs they are more and more licenses to kill some investments and investors.

http://mgiannini.blogspot.com/2009/03/securitisation-and-integrity-of-online.html

Posted by: M.G. in Progress | June 14 07:13pm | Report this comment
4. I might have misunderstood, but it doesn't seem so bad to me. They were insuring against the cost default, and this company ensured there was no default. If I found out in ten years time that my house had not been burgled because the Halifax (who insure it) had somehoe ensured there would be no burglaries, would I be angry? And why?

Posted by: User4450069 | June 14 08:15pm | Report this comment
5. This is spot on...weren't CDS originally created so that banks could exchange interests if they were overally concentrated in one sector or industry due to geographic constraints? For example if an Australian Bank heavy with miners wants to swap some of its interest in, say, BHP for an interest in Dow from a US bank heavy with chemicalsthen each bank wins by diversifying its credit exposure. So in this instance thee insurable interest may not exactly fit. But the fact that CDS have morphed into trading tools from hedging tools is the real reason for this mess. At the core and in the original iteration these are brilliant products but like most things in finance in the past 10 years or so they have been brutalised and we are all paying the price now.

Posted by: Grizzly | June 15 02:46am | Report this comment
6. By extension Buiter must regard the entire world of derivatives as gambling - evil and insidious and something to be banned.

And on this particular matter, the banks have lost money simply because they thought they were trading these CDS contracts to make money, but they failed to read the small print. How loudly did Buiter moan when consumers were on the other end of this?

Very scary that this guy was on the MPC.

Posted by: User3823616 | June 15 11:49am | Report this comment
7. Excellent summary of the issue and classical background. To me, if we cannot enforce the same collateral and margin requirements on CDS as cash spot and forward contracts, which seemingly do function as hedge instruments, then CDS must go. The infinite leverage of CDS dealer activities led to the AIG simulation of infinite insurance via same. In that light, CDS is a predatory form of gambling countenanced by governments in the same way as other lotteries.

Posted by: rc whalen | June 15 11:56am | Report this comment
8. If proving that one has an insurable interest becomes necessary for trading in CDS "an industry" is likely to emerge that will devote itself to supplying such proof... and over time will any such regulatory prohibition meaningless.

Would it not be better to require trading of all CDS on centralized exchanges and immediate public disclosure of the identity of the parties to the trade as well as the details of the trade?

Wouldn't such transparency be a more powerful control mechanism than requiring proof of insurable interest? Furthermore transparency is not a rule that can be gamed over time...

Posted by: Pawel D. | June 15 12:40pm | Report this comment
9. Re Pawel D: Trading of all CDS on centralised exchanges and immediate disclosure of the identities of the parties trading, and all details of the trade would not help mitigate the moral hazard problems I describe, because the information that is needed includes the ownership of the underlying assets (the bonds) and, in the case of the Amherst ploy, full details about the securities backing the mortgage bonds that the CDS had been written on.

It would not be necessary to prove one has an insurable interest when trading in CDS. All that would be needed is that a party presenting a claim under a CDS contract would be required to produce proof of ownership of the same face value of defaulted bonds (of the exact type he is claiming a default protection payout for).

Posted by: Willem Buiter | June 15 02:37pm | Report this comment
10. A couple of observations from the sell-side: first, the growth in CDS was largely a function of the terrible liquidity and lack of transparency in the corporate bond market (and the lack of an intelligent regulatory capital regime covering CDS). If the corporate bond market were efficient there would have been less need for CDS. Ten years ago one could not find bid/offer prices for coporate bonds on any pricing service. The CDS market changed that -- for the better. Much of the growth I've seen in CDS was from the investor side: why establish a portfolio of corproate bonds where the investor has to cross large bid/offer spreads with a market maker who knew whether the investor was a buyer or a seller? Hedging was next to impossible.

Second, if we want to get biblical, we probably shouldn't be lending each other money. The abuse of CDS boils down to excessive leverage. It is no different from the LTCM meltdown. Banks got into trouble with LTCM because they assumed credit risk and market risk without collateral. Investment banks bought massive amounts of equity options from LTCM without margin, should we ban equity options (another form of betting? where if you get big enough you can control the market -- Porsche?) or should we require banks involved in these products to hold adequate collateral to protect their shareholders. The real moral hazard was a function of the banks' (and insurance companies') ability to build massive CDS portfolios and sidestep regulatory capital requirements. We should devote our intellectual energy to fixing this regulatory problem.

Posted by: sgeo | June 15 02:39pm | Report this comment
11. Come on. This transaction doesn't fly if even ONE of the parties buying the CDSs has an insurable interest and refuses to sell. These boys were all playing naked, and things happen when you play naked. Tough.

Since when has crying become fashionable on Wall Street?

Posted by: Benedict@Large | June 15 02:42pm | Report this comment
12. For those who think that WB whose concern about the mroal hazard associated with CDSs should read Peter J. Wallace's defense of them - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told -
http://www.rgemonitor.com/financemarkets-monitor/255257/everything_you_wanted_to_know_about_credit_default_swaps--but_were_never_told - 25 Jan. A former lawyer, Wallace holds the Arthur F. Burns Chair in Financial Policy Studies at the American Enterprise Institute for Public Policy Research, where he codirects the Institute’s program on financial market deregulation. One of their "noted" speakers recently was Dick Cheney.

In a few days' time, they are holding a one-day conference: The Financial Crisis: Failure of Capitalism or Failure of Government Policy?, co-Sponsored by The Aspen Institute (of Aspen, Colorado [nice] on Thursday, June 18, 2009. You can find them at http://www.aei.org/home.

As this piece is held on Roubini's web site, this renders Roubini's opinions morally hazardous in themselves.

Posted by: the.Duke.of.URL | June 15 03:05pm | Report this comment
13. Correction: "WB whose concern about the mroal hazard associated with CDSs" should be replaced by "WB's concern with the moral hazard associated with CDSs is misplaced or excessive".

Posted by: the.Duke.of.URL | June 15 03:09pm | Report this comment
14. @ Benedict@Large

In the financial field, this is not quite what "naked" means. Deutsche Bank has been accused of 'naked short selling', which is not what you suggest it is. Unfortunately, naked short selling appears to be legal. The SEC has claimed that such a practice is beneficial for market liquidity. The moral hazard, indeed dangerousness, of this practice should be sufficient for it to be banned. But alas ... .

Posted by: the.Duke.of.URL | June 15 03:16pm | Report this comment
15. Correction: @Benedict@Large, I should have said that, in WB's account, not all players were 'naked'. One implication of your comment is that boys should be allowed to play with their toys whatever the social and other costs. IAs far as I am concerned, if they don't like playing by new rules, they can take their balls and go home.

Posted by: the.Duke.of.URL | June 15 03:21pm | Report this comment
16. I'm not sure if Willem Buiter present the requirement for an insurable interest as a means to preclude the type of transaction Amherst engaged in, but if so I don't see how it would achieve that outcome. Whether or not the buyers of insurance had an insurable interest, isn't the point that Amherst de facto engaged in market manipulation (whether it can be considered as such de jure is another matter).

Posted by: True Blue | June 15 04:33pm | Report this comment
17. I don't see that much wrong with what Amherst did, because they essentially fleeced the gamblers without hurting those that were genuinely looking for insurance. Those who were using CDS to hedge against risk to a real insurable interest got exactly what they wanted and paid for: no default. They maybe even got it cheaper because Amherst was desperate to sell as much protection as possible. Other holders of those bonds who didn't buy protection basically got free protection when they were able to unload their bonds onto Amherst. The people who lost were the gamblers that thought they could make free money. Even their loss is useful if it serves as a warning to other would-be excessive risk-takers.

I do like your suggestion that we require handing over the actual securities in order to claim payment on a CDS in the event of a default, though I'd like to point out that even that may not guarantee that the value of the protection sold will not exceed the value of the underlying asset. CDS purchasers could always rely on a strategy of buying the distressed assets at the last minute in order use for their claims. As long as the CDS market is not very transparent, it's still very possible that far too many bets will be placed and some of the gamblers will find themselves unable to collect their winnings. I'm not sure this is actually a bad thing, and it might in fact provide partial protection to bond-holders that didn't invest in it through the creation of a market for the assets immediately after the default.

Posted by: Victor Galis | June 15 06:06pm | Report this comment
18. Nice post, but your comment on Amherst's profit from the trade needs clarification. Amherst's profits arose from the premia charged on the amount of loans for which they wrote protection, not the amount insured itself. Most accounts I've read indicate that Amherst sold approx. $130 million of protection at a premia of between 80 and 90 cents for every dollar of insurance. Using the lower end of that range results in revenue to Amherst of about $100 million.

One other note on the absurdity of some aspects of the CDS market: CDS spreads on 10-yr US Treasuries have increased to 40 cents from just over 1.5 cents two years ago. This very well may be a reasonable increase in light of the state of the economy, deficits and the amount of government borrowings. However, given the dire circumstances implied by the US actually defaulting on its debt, I'm curious as to how the purchasers of CDS protection expect to collect. To me, it's quite doubtful that any protection seller will have the means to satisfy its obligations should a US government default occur.

Posted by: User4690594 | June 15 08:26pm | Report this comment
19. I'm generally a huge fan of Buiter, but this makes no sense. If actions like Amherst's became common than only the people who actually wanted to insure their debts would buy credit default swaps, and which is exactly what Buiter wants.

Posted by: User3436365 | June 15 10:27pm | Report this comment
20. Requiring to have an insurable interest may reduce the moral hazard but it does not reduce the systemic risk, leverage and speculative trades (crowding) produced by and with CDS contracts. If the detailed information about an existing CDS contract, other than the insurable interest, is not available to the market CDS will always be a problem. Somehow CDS are "toxic" derivatives so the market should know everything and label them accordingly. To have an insurable interest in the cds market would not have avoided or prevented the systemic and conterpart risk and excessive leverage, like the concentration of CDS in few hands. For instance did banks know that they were playing with CDS with the same counterpart? Pooling of cds contracts is dangerous.

Posted by: M.G. in Progress | June 16 06:23am | Report this comment
21. Yet to hear a convincing argument, or indeed, any argument, from Prof. Buiter as to why it's ok to trade equity put options naked but not CDS. Willem, are you reading?

Posted by: Anon | June 16 02:41pm | Report this comment
22. Bonds were honoured and all bond-holders got their money's worth from their purchase of CDS from Amherst. The only people damaged by Amherst manipulations were those who had no insurable interest in their purchase of CDS. Serves them right.

Posted by: D. Mario Nuti | June 17 06:50am | Report this comment
23. @D Mario Nuti

I understand what you are saying, but do you not think that the disbenefits of CDSs outweighs their reputed benefits? Nuclear power stations are beneficial, but the waste produced as a by-product is substantially disbeneficial, indeed incredibly dangerous.

Posted by: the.Duke.of.URL | June 17 08:34am | Report this comment
24. @D Mario Nuti

Also, the bonds were honored, true. But WB's point is that they were manipulated. What was done by Amherst, clever as it was, is legally but not formally different from insider trading, I would have thought.

Posted by: the.Duke.of.URL | June 17 08:36am | Report this comment
25. When companies need concessions from bond holders something has gone wrong already.
Maybe their business is not profitable.
Maybe management looted the company.
Maybe unwise acquisitions were pursued.

Why then is it a bad thing if such a company is liquidated.

Capitalism works well if competition and survival of the fittest drive the evolution of corporations. A necessary part of that is the death of the unfit.

Posted by: User3467732 | June 17 10:24am | Report this comment
26. Re Anon: I would extend the requirement that you must have an insurable interest in order to buy insurance to all contracts that are, from an economic perspective, equivalent to insurance contracts. This would mean no naked equity puts. To acquire a put, you would have to own (at least) the corresponding amount of equity. The easiest way to implement this is that equity puts cannot be sold on their own but only bundled with (embedded in) equity.

Posted by: Willem Buiter | June 17 01:00pm | Report this comment
27. Essentially in this and similar CDS transactions the seller, Amherst, was acting like a bookmaker rather than an insurance provider. There are no regulations on the size of bets a bookmaker can take, and no concept of insurable interest.

But a bookmaker who took a large number of bets on a particular horse (in this case bankruptcy) and then nobbled the horse so that it could not possibly win would be behaving fraudulently. Real world bookmakers and casinos are regulated in ways which stop them from doing this - casinos cannot change the odds on the fruit machines, bookmakers in the UK are (I think) barred from owning or training horses. Bookmakers and casinos also have a reputational incentive to behave honestly, so that they will lose business in future if it is known that they tried to manipulate outcomes. I don't imagine smart investors will want to buy CDS from Amherst in future, but the owners may not be too concerned given the profits their behaviour has earned them.

Incidentally, the bookmaker analogy also shows up the argument that Amherst's behaviour is a good thing, since it will discourage investors from buying naked CDS in future. Would we really argue that a cheating casino is desirable, and should not be punished, because it discourages gambling?

Posted by: William Peterson | June 17 04:58pm | Report this comment
28. "I would extend the requirement that you must have an insurable interest in order to buy insurance to all contracts that are, from an economic perspective, equivalent to insurance contracts."

Thank you for your reply. I take it that buying calls will be treated in a similar manner in order to avoid any asymmetry that would promote asset price bubbles. If this is correct, then what you propose is tantamount to banning any speculative options trading, which will radically reduce liquidity available to hedgers.

Posted by: StillAnon | June 17 06:22pm | Report this comment
29. I think the idea of having to deliver a bond to get the payments from a cds is a good one. Together with some transparency about the amount of outstanding cds this would prevent this type of manipulation. Speculation and hedging for counterparty risk could still be done. If too many contracts are written prices would adjust.

This would of course not prevent the other type of manipulation where the cds buyer holds some bonds and wants the company to default but it is a start. Another solution could be limitations for bondholders that have cds protection in bancruptcy negotiations.

As for naked shorts and the like. There is clearly a need for some regulation in the option markets. Just look at the Porsche/VW story. Common sense says this is market manipulation but the current law does probably not allow any sanctions. Here you can also argue that the call option writers were just speculators. I do not think speculation is a bad thing. It creates information and liquidity but there should be laws to sanction clear abuses.

There might be some changes now after this crisis but as long as the people in the regulating bodies come from the corporations they should regulate and go back there afterward (à la Goldman Sachs) it won't be effective for long.

Posted by: Mark | June 18 10:20pm | Report this comment
30. What is the value to the market of allowing naked bets via CDS? It certainly is a good way to make a lot of money if your bets are correct, but what value does it have for the market if you don't have an insurable interest per se?

Posted by: realestatesean | June 19 08:27pm | Report this comment
31. StillAnon,

And "reducing liquidity available to hedgers" is a BAD thing? Seems to me that it is a VERY GOOD thing. Hedging promotes stupidity and reduces the incentive for full due diligence. The mere existence of hedging reduces the value of all personally held retirement savings because hedging such as short sales are forbidden in tax sheltered accounts.

Generally speaking, hedging is just one more way for Wall Street professionals to shear the sheep.

Posted by: Anandakos | June 20 04:34pm | Report this comment

Credit Default Swaps: Problem Child of the Global Financial Crisis

by Satyajit Das

April 13, 2009

Credit default swaps (CDS) are complex and powerful financial instruments that frequently have unforeseen consequences for market participants and the financial system. As former New York Federal Reserve President Gerald Corrigan told policymakers and financiers on 16 May, 2007: "Anyone who thinks they understand this stuff is living in la-la land." Recent events highlight the continuing problems.

The CDS contract is triggered by a "credit event;" broadly, this equates to default by the reference entity. CDS contracts on Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac") were triggered as a result of the "conservatorship."

This may seem odd given the government actions were specifically designed to allow Fannie and Freddie to continue fully honoring their obligations. However, "conservatorship" is specifically included within the definition of "bankruptcy" in the CDS contract, resulting in a "technical" triggering of the contracts. This necessitated settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion.

The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.

Observing protocols
In recent years, practical restrictions on settling CDS contracts has forced the use of "protocols" – in which any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection-buyer based on the market price of defaulted bonds established through an "auction" system.

Recent cases highlight some of the issues in respect of the protocol and auction mechanism. The auction prices in the settlement of CDS on Fannie and Freddie (paid by sellers of protection) were as follows:

Fannie Mae – around 8.49% for senior debt and 0.01% for subordinated debt.
Freddie Mac – around 6% for senior debt and 2 % for subordinated debt.

Holders of subordinated debt rank behind senior debt holders and would generally be expected to suffer larger losses in bankruptcy. The lower payout on the subordinated debt probably resulted from subordinated-protection-buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. The differences in the payouts between the two entities are also puzzling given the fact that they are both under identical "conservatorship" arrangements and the ultimate risk in both cases is the U.S. government.

In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large relative to historical default loss statistics. This may reflect poor economic conditions but are more likely driven by technical issues related to the CDS market. Skewed payouts do not assist confidence in CDS contracts as a mechanism for hedging

It's only a flesh wound!
The derivative industry's indefatigable support of the market centers on the fact that all the CDS contracts related to the high profile defaults in 2008 settled and the overall net settlement amounts were small. Strictly speaking, this is correct. Closer scrutiny suggests caution.

In practice, there are actually two settlements – the "real" settlement in which genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds or loans and were hedging), and the parallel universe in which dealers and large hedge funds settle via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).

Take the case of Lehman Brothers. Its net settlement figure of $6 billion is frequently quoted, but that refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300 billion to $400 billion. Some banks and investors that had sold protection on Lehman did not participate in the auction. They chose to take delivery of defaulted Lehman debt, resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that were worth $30 million at current market values.

There were no failures in settlement of the CDS contracts because, in part, some sellers of protection (such as banks and some insurers) were supported by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses, reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown. As a former U.S. Sen. Everett Dirksen once noted: "A billion here, a billion there, and pretty soon you're talking about real money."

CDS contracts did, in all probability, amplify losses in the credit market in recent defaults. For example, when Lehman Brothers defaulted, the firm had around $600 billion in debt. This would have been the maximum loss to creditors in the case of default. According to market estimates, there were CDS contracts of around $400 billion to $500 billion where Lehmans was the reference entity. The outstanding volume of CDS contracts is not known with certainty, reflecting the lack of transparency about trading in the OTC market.

If used for hedging, the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250 billion to $350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200 billion to $300 billion) are in addition to the $600 billion.

"I" or Innovation Dysfunction
Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by acolytes and fans, generally those promoting the product.

The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offer these advantages. However, when CDS are not used for hedging, it is not clear how this assists in capital formation and enhancing efficiency of markets.

CDS contracts, also, are claimed to improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowering trading costs. But when the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice. Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premiums, compensation for volatility of credit spreads and other factors.

CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the "negative basis trade" is predicated on pricing inefficiency. In a negative basis transaction, commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.

In early 2009, for example, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid, a U.K. utility, were around 2% per annum compared to National Grid's credit spread to government of around 3.30%. Similarly, Tesco, the U.K. retailer, had CDS fees of around 1.40% against a credit spread to government of around 2.50%.

Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated "A" were trading at a higher credit spread than bonds of borrowers rated lower (say "B") in the bond market. At the same times, CDS fees for borrowers rated "A" were trading at a lower level than CDS fees of borrowers rated lower (say "B") in the credit derivatives market.

CDS contracts also are supposed to enhance information efficiency by improving availability of market prices for credit risk, thus allowing more informed decisions by market participants. But CDS contracts traded in the private OTC derivative markets provide limited dissemination of market prices, thereby limiting price discovery and any informational benefits. In reality, pricing and trading information is only available readily to large active dealers in CDS contracts – knowledge that may allow these dealers to earn economic profits.

Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. While CDS contracts did not cause the current financial crisis (excessive reliance of debt did), they may have exacerbated the problems and complicated the process of dealing with the issues.

Risk reduction or risk creation?
The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. Even this hedging application is dogged by some of the identified documentary issues that may reduce the effectiveness of CDS contracts as a hedge. Such problems may well be fundamental to the nature of the instrument and incapable of remedy, at least easily.

In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent, the CDS market has detached from the underlying "real" credit market. If defaults rise, the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems.

The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the United States. The fee for hedging against losses on $10 million of Treasurys currently peaked at about 1% per annum or 10 years (equivalent to $100,000 annually). This is an increase from 0.01% per annum ($1,000) in 2007.

The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.

The unpalatable reality that very few, self-interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.

In October 2008, former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong to oppose regulation of CDS. "Credit default swaps, I think, have serious problems associated with them," he admitted to a Congressional hearing. This from the man who on July 30, 1998, stated that: "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."

On March 6 of this year, Bloomberg News reported that Myron Scholes, the Nobel prize winning co-creator of the eponymous Black-Scholes-Merton option pricing model, observed that the derivative markets have stopped functioning and are creating problems in resolving the global financial crisis. Scholes was quoted as saying that: " [The] solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and … start over…''

As the global economy slows and the risk of corporate default increases, it remains to be seen whether CDS contracts act as instruments of risk reduction or amplify risk. Recent debates about and regulatory proposals to regulate CDS markets show a disappointing and limited awareness of these issues, most worryingly amongst people who claim to know!

Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).

Views are as of April 13, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Federated Equity Management Company of Pennsylvania.

Credit Default Swaps and other Derivatives

[Jul 3, 2009] Gillian Tett at LSE

May 21, 2009 | Information Processing

[Jun 14, 2009] FT.com Willem Buiter's Maverecon The magical world of credit default swaps once again

Credit Default Swaps: Problem Child of the Global Financial Crisis