CDS: The Less You Know, the Worse They Look

For those of you who like your CDS exposés presented in the mellow tones of Leonard Lopate and Jesse Eisinger over the course of a leisurely half-hour, here you go.

This is a sober public radio progam, not a finger-pointing piece of populism like the awful 60 Minutes piece on the same subject. But it's worth noting a broader dynamic, wherein the least informed commentators are also the most alarmist.

Think of a spectrum of opinion, with "credit default swaps are the root of all evil" on the left, and "credit default swaps are a brilliant invention which helped spread risk and mitigate the effects of the financial crisis" on the right. I'm a right-winger, on this spectrum, albeit not a rabid one: I think that a large part of the financial crisis was caused by unfunded super-senior CDO tranches, which were made possible only by misusing CDS technology.

Jesse's to the left of me; I'd say he's center-left in terms of financial journalists generally. Most market participants are to the right of Jesse, somewhere in my neighborhood. But Lopate is clearly to the left of Jesse: He keeps on wanting to lay enormous amounts of blame on credit derivatives and the people who structured them, drawing unhelpful parallels with Bankers Trust and generally asking leading questions of Jesse, who then finds himself having to tell Lopate that it's really not as egregious as all that.

60 Minutes, of course, went further still, and entitled its segment "Financial Weapons of Mass Destruction", making the now-common claim that Warren Buffett had described credit default swaps thusly. But Buffett wasn't talking about CDS when he used that famous phrase, he was talking about common-or-garden derivatives which no one seems to be worrying about at all.

Or rather, everybody seems to be using the term "derivatives" interchangeably with "credit default swaps" -- which is just plain weird. Are CDS dangerous because they're derivatives? Well, in that case there are much bigger problems than the CDS market, which is a small fraction of the total derivatives market. Are they dangerous because they're not exchange-traded, instead changing hands in the OTC market? Again, just look at interest-rate derivatives, where the OTC market dwarfs any exchange.

60 Minutes is probably the worst offender here: It claims that the CDS market "blew up Wall Street", for all the world as if we would have been just fine with falling housing prices, just so long as no mortgages were hedged with CDS. But no one ever seems compelled to mention that CDS, like all derivatives, are a zero-sum game with just as many winners as losers -- unlike mortgages, where it's entirely possible for everyone to be a loser. If the losses in the economy are widespread, and they are, then that can't be due to CDS: If the only winners you can find are a couple of smart-or-lucky hedge fund managers like John Paulson and Andrew Lahde, then total losses on credit default swaps simply can't have been all that big.

I had lunch yesterday with Shane Akeroyd of Markit, and he had a more sophisticated take on what we're seeing. The problem isn't CDS specifically or even derivatives in general, he said: The problem is that the world had an enormous amount of leverage, and all that leverage is now being unwound at once. Do CDS make it easier to firms to lever up? Yes -- but if CDS hadn't been around, some other instrument would have been found which had the same effect. Blaming CDS for the market meltdown is like blaming Microsoft Word for a magazine article you don't like: It might have made things easier, but it was hardly necessary.

Credit existed as an asset class long before CDS came along. That's one of the reasons that the Treasury and rates markets are so liquid: Anybody wanting to make a pure credit play would take a position in corporate bonds, say, and then hedge their interest-rate exposure. But corporate bonds can be illiquid, and hard to find or short, so the arrival of the CDS market made it much easier to trade credit. That's a good thing -- as I've said before, if it weren't for the CDS market, none of the the credit world would be functioning right now, and we'd be in an even worse situation.

But it's always easier to look for someone to blame than it is to really try to understand the dynamics of a highly complicated financial crisis. If that blame can be laid at the feet of a market no one's ever heard of, and especially if you can put huge scary numbers like $58 trillion in headlines, no matter how misleading notional numbers are in the world of derivatives, then few editors are going to complain.

And one final note on big scary numbers: Elisa Parisi-Capone asked last week what happened to all the missing Lehman Brothers CDS. The DTCC saw only $72 billion of the $400 billion in outstanding Lehman CDS, she says: Where's the other $328 billion?

The answer is that there never was $400 billion in outstanding Lehman CDS. That number was a quick-and-dirty Citigroup estimate which became conventional wisdom very quickly, even though it was later revised down substantially. In general, the media loves to latch on to the biggest number it can find, and so the $400 billion gained a lot of currency even though it was pretty much pulled out of thin air.

As a general rule, then, it's worth taking anything you read or hear about credit default swaps with a very large grain of salt. It's not an easy subject to understand, and it's much easier to jump to conclusions than it is to do laborious homework and end up with a nuanced position. Besides, bankers who weren't involved in the CDS market love it when people start blaming CDS, because doing so implicitly leaves them with less blame for themselves. They should take more responsibility, and journalists shouldn't be so quick to let them off the hook.

Comments

[whidbey:]

CDS are like adultery, much discussed by those with little experience. Those who know what they are talking about never bring such subject up. I can say that as a former nun task with advising with the wayward.

But my point is we all love to talk about things about things of which we known little or nothing. Personally I have some experience with CDS in my job as trader. They are rather straight forward providing you don't insist on knowing what they are worth. The price however is very revealing I think.

2008 Oct 29 07:03 PM

[PainfullyAware:]

I would say that it is not what you call your financial engineering; it is the opacity and exposure that are the issue.

The reason the banks won't lend is because they do not want throw money into a possible money hole.

Fear of the unknown will always overpower the fear of the known.

2008 Oct 29 07:30 PM

[Frogman:]

Well the "notional value" is a headline grabber no question yet most people don't realize that once the price is locked between the two counterparties it is zero-sum and then each party pays respectfullly based on the move from that said baseline price so it appears far worse to the uninformed.

What I do have a problem with is that there is no "Vetting" or regulation as to the creditworthyness of either counter party and that no reserves are kept to or regulated to pay-off these hedges or "bets" that have now blown up....i.e. Lehman, AIG, etc..... To thee extent that they are good instruments (which I agree to in principle) but the financial orgy that ensued along with the TOTAL disregard for risk management is absolutely ridiculous! That is why CDS gets a bad name....if you feel that the CDS market is being unjustly blamed perhaps someone from "Market it " should have grown a pair and rasied some concerns.

2008 Oct 29 08:57 PM

[jadziasman:]

Well Felix,

Using a network TV "news" magazine to support your argument is laughable.

Of course '60 minutes' will not cover this subject in the depth required. '60 minutes' exists to supplement 22 minutes of commercials.

CDS are very risky to the sellers in a declining market since the the CDS seller's porfolio usually will contain instruments which need to be marked down after a speculative bubble pops i.e, the mortgage backed securities. The CDS seller's capital reserves then decrease and the ratings agencies then downgrade the CDS seller. Collateral calls on the CDS protection they sold follow the downgrade. Remember AIG? The reason the feds needed to rescue AIG was because AIG could not meet the collateral calls on all the CDS contracts they sold.

Why are banks buying CDS protection anyway? Right, you said it above. CDS' allowed banks to increase their leverage. You didn't say how. CDS' were being used as a substitute for capital instead of actual capital. Since the banks held the bonds and swapped the default risk to companies like AIG, this in theory changed the bonds into capital. If these CDS sellers could not meet their obligation to the banks, then the banks would have been seriously undercapitalized right?

It's not necessarily a zero sum game in a declining market, you might have to get the feds to bail you out.

2008 Oct 29 10:00 PM

[Emerald:]

Well put, jadziaman! It is more than just the "risk management" problems that companies ignored. They were gaming the system with substitute capital. Caveat Emptor.

2008 Oct 30 10:31 AM

[Bill Herbert:]

Felix,

Sounds interesting, and I know Eisinger is a good, sound analyst.

Please provide a link or identify the source of the radio program, I'd like to hear the actual broadcast.

Thx

CopperBaron

2008 Oct 30 04:20 PM

[David Levner:]

I think a CDS is really a zero-sum game **only** if 1) there are no defaults, or 2) if the counter-party makes good after a default. Consider the following scenario:

ABC Investment Bank sells bonds to pension fund PQR. PQR gets worried about ABC's ability to repay and buys a CDS from hedge fund HIJ. A year later, ABC declares bankruptcy and defaults on its bonds. However, HIJ doesn't have enough money to pay PQR the amount it has lost because of ABC's default, and HIJ also declares bankruptcy. Who is the winner here? Perhaps ABC, because it took PQR's money for the bond and didn't pay it back. Or maybe HIJ is a winner, because it took PQR's money for the CDS and didn't make good when ABC defaulted. However, both the "winners" are bankrupt and have broken their contracts.

The essential problem is that no one required HIJ to have enough reserves/collateral to make good on all the CDS contracts it wrote.

If I have misunderstood the transaction described above, I would appreciate it if someone would correct my description.

2008 Oct 31 01:42 AM

[TheEconomyK...:]

Jadziasman and Levner hit the nail right on the hammer. Zero sum is thrown right out the window once the defaults get rolling.

While Felix may not be writing accurate articles as of late, the discussions following tend to shed some more light on the issues.

2008 Oct 31 11:34 AM

[Stimpy:]

"CDS, the less you know, the more you write about it" seems more to the point, Felix

Look, these things have managed, single handedly, to virtually DESTRY capitalism as we know it.

It may be a newsflash to some of you, but the money markets have seized up.

Let me say that again:

THE MONEY MARKETS HAVE SEIZED UP.

LIBOR and commercial paper now require Government guarantees to stay liquid.

THAT IS A DIRECT RESULT OF THE UNCERTAINTY THAT CDS NOW INFECT BALANCE SHEETS WITH ACROSS THE GLOBE.

LEH fails.

The Reserve Fund, the largest owner of LEH CP, breaks the buck.

The money markets are now closed.

The reason is CDS.

They make a bankruptcy filing CERTAIN when an exogenous credit event shakes a dealer.

The resulting collateral run as counterparties look to get flat and ratings downgrades driven by reference entity buying on the dealer cause new collateral calls on threshold ratings changes.

Delaers re-hypothicate that collateral, Felix.

They don't have it when everybody wants it back, and higher funding costs make reversing it in impossible.

The cross default language in your ISDA documents means one failure to deliver voids ALL OUTSTANDING CDS.


And here is the bad news--that frantic effort to dmeet calls and stay hedged makes it 100% certain that the Company has virtually no assets when they do finally file and THAT means creditors in the conventional sense (AKA CP)--even at the top of the balance sheet--are screwed when the chickens are finally counted.

That means money market funds cannot price risk.

As long as CDS exist the Government will be picking winners and losers in the those money markets with guarantees.

Those lucky (or connected) enough to have them are incented to sit on the money until those that don't collapse and can be bought for free.

I don't know what that is, but it isn't capitalism.


CDS are a cancer in the system.

Simple as that.

2008 Nov 03 10:30 AM