CDS and the Looting of AIG 27 comments
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After yesterday’s AIG (AIG) news, I am amazed that the Obama Administration hasn’t announced an immediate suspension of the sale of new credit default swaps. Perhaps it will take a total meltdown of the financial system for the government to finally admit that Warren Buffett was right, credit default swaps are weapons of financial mass destruction.
The justification that I keep on hearing for credit default swaps is that they are needed for price discovery. Well, yesterday we had a new type of price discovery; we discovered that AIG is costing more than any other financial fiasco in the history of the United States and the reason that it is so costly is because AIG has been looted by credit default swap counterparties and American taxpayers are paying for the loss. $1,400 per taxpayer family is the price that we discovered today.
A few months ago I wrote two articles on credit default swaps (click here and here to read the articles). In one of the articles I argued that credit default swaps are either insurance contracts or are legalized gambling, but either way they should be immediately banned in their current form. In the other article I wrote that credit default swaps are starting to find their way into commercial loan agreements and are going to destroy Main Street. What I wrote in November and December is truer today than it was a few months ago.
By the way, I know who credit default swaps are good for. They are good for the traders and speculators who effectively made one-way bets with AIG and are now making a fortune at the expense of taxpayers. Make no mistake about it, most credit default swaps are speculative and are a “zero sum” game. Money is transferred from one party to another but without any underlying economic activity or hedging of real risk. Speculative credit default swaps are like going to the craps tables. Either the shooter wins or the house wins. And, right now the shooter is playing with loaded dice.
Someone in Washington with responsibility has to stop this insanity. Just like Humpty Dumpty couldn’t be put back together again neither can old credit default swaps be undone. But why hasn’t the government imposed common sense regulation of new credit default swaps? New naked credit default swaps that are merely for speculation should immediately be declared gambling contracts and illegal and new credit default swaps that are used to hedge real risk should be immediately declared insurance contracts and regulated as such.
I just hope that President Obama has appointed officials who are tired of AIG’s kind of price discovery.
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While I understand that the government's propping up of AIG is meant to keep CDS counterparties solvent I am deeply disturbed by the lack of transparency in the process. Is the government allowing AIG to pay out all CDS claims or only those which can prove actual losses/ownership of underlying bonds? I am not happy about but can accept the need to have the government pay (via AIG) claims on CDS which are tied to actual securities but cannot see the legitimacy of paying naked CDS claims.
There's something hugely wrong with pretending that gambling is insurance. And I resent having to cover the gamblers' losses.
AIG's model (actually, no one's- what does that tell you?) did not adequately account for the drop in home values across the entire country springing from the rational actions of consumers looking at 2-3X impacts to debt service requirements. Remember, for every additional dollar of increased interest rate payments banks require an additional dollar or two of income in order for their ratios to be maintained. So the 400 basis point increase created a downdraft we're still fighting.
While the Fed is peddling hard with near zero rates that are allowing banks to make a bit more profit, there is no way they, or the Federal government, can replace the tens of trillions of lost credit in the economy. It will only be when the prospect of renewed inflation- not deflation- gives prospective debtors the confidence that tomorrow's repayment money will be less expensive than today's debt that entrepreneurs (let alone consumers) will start to borrow again and reflate our credit-based economy.
And without these entrepreneurs, the prospects for commercial real estate look pretty bleak to me, and I think we'll continue to see big losses. I only hope today's CDS have much higher down payment requirements- but it seems pretty easy to me to come up with a scenario where half the retail and office space in the country is not really needed for 5-10 years...
Naked CDS creates moral hazard: its availability is an invitation to the financial equivalent of arson. AIG sold CDS protection subject to a requirment of collateral in the event of a downgrade. As such, they wrote more than they had capital to handle. They evaded insurance regulation by putting the operation under the OTS, a wimpy regulator if ever their was one.
Any financial recovery will be fragile until CDS are properly regulated.
Btw I 100% agree that the no collateral for AAA-rated institutions should be removed.
AIG were a bunch of tools, and Bernanke is correct to be p*ssed off at them, but don't hate tha game hate tha playa.
I actually believe this to be untrue. If Congress wanted to, they could pass a law immediately invalidating all CDS contracts where one of the counterparties didn't actually own the debt being insured. That would end all speculation in (and manipulation of) corporate fortunes. With the stroke of a pen, problem solved.
And at the same time, our government needs to enforce the laws against naked short selling. The practice is already illegal, so why does our government continue to turn a blind eye and let it go on daily? Actually, I never understood rules that allowed someone to sell something they don't own, anyways. It's basically authorized fraud. If it's necessary for price discovery or to protect against bubbles, then fine. Say that covered shorts can be used whenever a company's stock price exceeds its trailing 3-year average. But once it hits that point or lower, then bubbling is no longer a concern and short selling should be forbidden. That way, real market forces (actual owners who wish to sell and legitimate buyers) can determine price equilibrium. But we don't need speculators and vultures trying to skew the game for a quick buck.
We have an elite class of capitalist which simply loots all others below them. In other words, a parasitic ruling class. It's not going to end, they must be forced out of power and the only way to do that is with the mobilization of the masses. Until that happens, the looting will continue.
Larrysyr,
I don't think we're covering the "gambler's" losses. We're covering the "house's" losses. The gamblers made millions of tiny bets on double-zero, and double-zero came up. At 35 to 1 those tiny bets suddenly become a stupendous burden.
I agree with Philip Gvinter's point that CDS claims by holders of the actual bonds secured should absolutely be paid. Those claimants were purchasing insurance from the world's largest insurer. They have a reasonable expectation that their claims will be honored.
The naked CDS purchasers are gamblers pure and simple -- especially the hedgies -- and if ever in the history of the Republic there was a just cause for an ex post facto law, one banning all such CDS contracts is it. The purchasers should all be locked up and the keys melted down to make more bars. These people have done more to cause human misery than any group since the Khmer Rouge and the machete crazed Hutus in Rwanda.
I honestly believe that before this global meltdown ends there will be more people who die as a result of it than any one thing that's happened since, including Bush's wars.
On Mar 04 10:30 AM Larrysyr wrote:
> There's nothing wrong with gambling. And there's nothing wrong with
> insurance.
>
> There's something hugely wrong with pretending that gambling is insurance.
> And I resent having to cover the gamblers' losses.
CDS FTW,
It is "naked" (third party) CDS contracts which are gambling. That is because the purchaser of the contract has no insurable interest, by definition. Essentially "A" is betting against "B" that "C" will default.
This creates moral hazard because "A" has a financial incentive to undermine confidence in "C" or impair its operations in some way thereby increasing the likelihood that "C" will fail, triggering "A's" claim on "B".
For the first few decades of life insurance back in the sixteenth century, Joe Doakes could buy a policy on Count Castle who passed by Doakes' house a few times a month on his way to or from his country estate. Do you think that Doakes would be pleased if by some greatest misfortune the Count were to perish because his carriage ran off the cliff a mile and a half down the road from Doakes' house?
After a rash of such "accidents", the insurers began refusing to sell a policy to anyone other than the "life". This is no different.
On Mar 04 10:53 AM cds ftw wrote:
> How are CDS any more like gambling than buying and selling cash equities?
The collateral effectively goes into escrow. If AIG were not supported by the government the loss of its credit rating alone would take them out due to all the collateral they would have to immediately come up with. The combination of loss of credit rating and general market covents is what is generating the ~300 billion in direct risk that the government is guaranteeing. Outright defaults of the elements being insured would amount to trillions... the government is NOT yet trying to back those (and probably won't).
The effect of this collateral shows up on the balance sheets of AIGs counter-parties. If you look at the 10-Q or the 10-K for other institutions, such as Citi or BofA, a large chunk of the document is devoted to the derivatives portfolio.
Part of the document analyzes the risks to the derivatives portfolio. Risk is not only risk of losses, but also risk of the counter-party going bust. If the counter-party goes bust the institution owning the CDS gets to keep the collateral.
Here is an example. If some bank X owns a CDS as an asset and that CDS is worth $10B, then the counter-party (AIG) has to pay out $10B if the institution being insured by the CDS defaults. However, unrelated to the default, AIG will ALSO be required to put up collateral based on various factors. AIG might be required to put up, say, $4 Billion in collateral on that CDS.
So bank X owns this CDS and puts it up as a $10B asset on its balance sheet. In the netting and risks section, the bank subtracts the collateral ($4B) and thus lists $6B of risk for that $10B asset. The direct effect of the collateral is to reduce the bank's risk.
Many banks have CDS on both the asset side and the liability side of the equation. They do NOT cancel each other out. Both sides add risk. The asset side has a risk of counter-party default (reduced by the collateral), and the liability side has a risk of insured entity default.
The counter-parties were not all idiots, they require collateral from AIG on certain credit rating and general market events. Once 2008 rolled over the collateral started being required up-front, but a lot of derivatives exist pre-2008 where the collateral was not required up-front, but is now triggered by these events.
The problem the government faces is that the collateral is like a brake on the system, preventing systemic failure. So the government is backing AIG by providing the collateral to prevent a cascading systemic failure.
I'm not saying this is necessarily good or bad. I am saying that those people who think AIG should just be allowed to roll over are not thinking very heavily about the potential consequences to thousands of entities around the world if that were to occur RIGHT NOW. As time progresses the systemic risk drops. It's a race, frankly.
-Matt
Thanks for the idiots' guide.
"This creates moral hazard because "A" has a financial incentive to undermine confidence in "C" or impair its operations in some way thereby increasing the likelihood that "C" will fail, triggering "A's" claim on "B"."
I don't see why this moral hazard is any worse than that created by put options or short-selling (you might well object to short-selling, but look how effective the ban has been at supporting the indexes......)
Has anyone yet presented evidence of investors (probably those evil hedge funds) manipulating the market via CDS? If so I would be very interested to see it.
As for reserve requirements, banks have capital ratios they have to meet which are the same thing. Were these requirements sufficient? Clearly not in hindsight! But counterparty risk is not limited to CDS, it's inherent in all OTC derivatives.
Why do you CDS 'haters' think there is greater systemic risk in the CDS market than in the (~10x larger) rates market?