CDS Industry: Zero Sum Game or Ponzi Scheme?

The CDS industry, according to its defenders, is a zero sum game. Approximately 20% of CDS is backed by an insurable interest and as such is insurance, a necessary service and a legitimate transfer of risk. The other 80% is supposedly a zero sum game, whose practitioners simply make bets among themselves, with little effect and certainly no harm done to the real world. Indeed, their bets create an umbrella of protection and exert a tremendous stabilizing influence. What follows is a simple examination of these premises and a guess at how the zero sum scenario would play out over time.

Start with 63 trillion of notional amount, reduce it by 20% to exclude the legitimate insurance transactions. Now, assume the each separate player in the game believes and intends that the profit (or loss) plus expenses of each transaction will be 1% of the notional amount, and that he will be the winner.

63 trillion x 80% is 50 trillion x 1% is 500 billion. So the gamers, collectively, incur expenses and reward themselves by claiming profits of 500 billion. One small problem, as a group they are wrong because by definition it is a zero sum game. Here's the question – where does the missing 500 billion come from? Bear in mind, the gains and losses are mostly backed by collateral, so there is a constant exchange of funds to support these obligations. Because those who consider themselves winners are withdrawing profits, in order to keep the game going more bets must be made.

Losers have two options: they can accept their losses and leave the game, or they can double down. A vast majority elect to double down, driving the cost of CDS protection ever higher. The result is that gains and losses are magnified beyond any semblance of reality.

Drawing in innocent outsiders, in the form of those who buy or insure synthetic CDOs, or those who own equity interests in referenced entities or assets, extends the game but does not fund it. The outsiders are the subject of the bets, and their all too real losses are mirrored and multiplied in the game as losers double down and winners enlarge their positions. Mark to market accounting ensures that the losses are tallied every quarter, at which point they enter the real world.

Consider the falling dominoes of the financial system: Bear Stearns, Lehman Brothers (LEHMQ.PK), and American International Group (AIG). Demonstrably the game has had effects in the real world – the failure of two major investment banks and one large insurer - and the need to add huge amounts of capital to the system – new funding for players such as Goldman Sachs (GS) and Morgan Stanley (MS), investment banks seeking refuge under the guise of commercial banks. MBIA (MBI) and Ambac (ABK) continue under pressure due to their limited role in the game. MBIA insured 100 billion of synthetic CDOs, nothing more than a bundle of adverse selected CDS.

Alan Greenspan, noting that half the problem went away after Paulson added 250 billion to the system, opines that it will be solved when another 250 billion has been added. I disagree: the problem will be solved when the game is broken up. CDS is not a zero sum game: it is a negative vortex of speculative activity – a huge Ponzi scheme, 10 times as big as Madoff''s paltry 50 billion.

Comments

[fatcat:]

Aren't premiums paid to buy protection like any insurance?The problem lies in the reserves for losses,which apparently are non-existent with many co.s writing swaps.When losses or marks come piling in,the problems are exposed and spread to other counterparties.

The author is assuming that the 1% comes out of the gross...It's premium expense,like your Blue Cross....I guess....

2008 Dec 21 10:22 AM

[Make Money:]

Want to make money off of CDS? Buy stocks like Fairfax Financial (FFH). The guy understands this Ponzi Scheme and profiting from it.

2008 Dec 21 11:39 AM

[Reinko:]

The CDS is only a small fraction of total over the counter derivates that total to about 600 trillion of notional amount.

These contracts did cost about 14.5 trillion or roughly one US GDP.

In terms of leverage it is about 1:40.

As usual the problem with stuff like this: Only a small rimple of a few percent in the 600 trillion fantasy world triggers and entire GDP size chunk of money to be paid.

Hardly a 'protective umbrella' after my humble opinion.

2008 Dec 21 11:44 AM

[SW Richmond:]

CDS are madness, just madness.

From a piece by Antal Fekete:

"‘Progressive’ banks were free to heap debt upon debt in the asset column of the balance sheet without any regard to reserve ratios, in a mad chase of illusory paper profits. If the balance sheet was not big enough, why, they could simply go ‘off balance sheet’ to add more debt."

"You cannot hedge these risks through owning more debt ― the liability of someone else. A hedge that is subject to exactly the same risks would not diminish but magnify risks."

"For a true hedge, you need an ultimate asset that is not the liability of anyone."

The world is coming to terms with what the phrase "counterparty risk" really means. If counterparties were solvent and fully capable of meeting their CDS obligations, there'd be no need for keeping AIG et alia out of BK court, would there?

2008 Dec 21 01:21 PM

[JudeJin:]

although the transaction fees and expenses may not be as high as 1% of the notional, i do agree with the author that it is not a zero sum game. traders and traders' firms are taking money out of this ponzi scheme just like Madoff's.

this is a casino that dwarfs vegas.

2008 Dec 21 08:15 PM

[Ishortyou:]

I just made a jump in the CDS market by promising insurance on derivatives for 250k for 1Mil over 1 year, but the thing is I dont have the money or any reserves to show off for, but hey this market is not regulated so no body can tell me anything, and if the time to pay claims come I just simply file for bankruptcy and go to Brazil to dance la lambada. Man I love America!

2008 Dec 22 12:43 PM

[strabo:]

When the author asks a question like "where does the missing 500 billion come from?" he clearly reveals that he simply doesn't understand what zeroe sum game actually means.

I wonder what is source of the statisitc quoted "A vast majority elect to double down", my hunch is his feversih imagination.

Bottm line, this article article' conclusion (CDS is not a zero sum game: it is a negative vortex of speculative activity – a huge Ponzi scheme,) is sheer unadulterated rubbish. What pure nonsense!

Don't be scammed by the pretzel logic of articles like this!

2008 Dec 23 03:36 AM

[Ishortyou:]

Simply put the CDS market needs insurance regulation.

2008 Dec 29 12:43 PM