One Easy CDS Fix

I've had my share of disagreements with Arnold Kling on the subject of credit default swaps in the past, but he has a good idea today:

Regulators and accountants could require firms that are net sellers of credit default swaps to translate those positions into bond holdings and put these synthetic bonds on their balance sheets. My guess is that had such a policy been in place in 2000, the CDS market would not have taken off.

My guess is that Kling's guess is wrong: there were actually very few net sellers of CDS, and in any case for most of this decade the stock market seemed to think that ever-expanding financial balance sheets were a good thing, not a bad thing. But yes, definitely: if you're a net seller of protection, then the notional amount of credit that you're exposed to should be considered an asset on your balance sheet, just as it would be if you owned that credit in bond form.

It is conceivable that the monolines -- which were by far the largest publicly-listed net sellers of protection -- might have thought twice about continuing their escapades in the CDS market if there would have been such an enormous effect on their balance sheet. Doing so would have brought them more into line with the buyers of synthetic CDOs, who were the other large net sellers of protection, and who invested up front all the money that they could possibly lose.

Kling's other point is that it's hard to buy long-dated derivatives on the big exchanges in Chicago: if you want something with a maturity of three years or longer, you need to buy it in the OTC markets. That's true, but he's wrong that "it is quite difficult to take a position of any size" in long-dated options: those OTC markets are huge, and in many cases substantially larger than the exchange-traded markets. And they seem to work pretty well, in the absence of massive players like AIG taking large net positions (on the order of hundreds of billions of dollars) in the market.

Comments

[Alex Filonov:]

You are right that there are few net sellers of CDS. Unfortunately, AIG is one of them.

Mar 30 11:50 AM

[Ishortyou:]

that means an oligopoly in CDS markets, it needs to be supervised anyways, many tried to make easy money on it till they got burned.

Mar 30 11:58 AM

[Mad Hedge F...:]

How about this idea? There is an easier, cheaper, and faster way to solve the banking crisis which no one is talking about on Capitol Hill. If collateralized debt obligations (CDO’s) are the problem, just get rid of them! Desecuritize them! Just convert them back into the underlying loans. There are $1.4 trillion in CDO’s outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations of perhaps 3.7 million loans. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50%-80% discounts. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks’ balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments or in default can be discounted to maybe 70% because they are still secured by the value of the homes. This would boost the value of the entire asset class from the current 20-50 cents up to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. Of course it would be a massive admin job unwinding the rats’ nests behind some of these securities, but Heaven knows there is abundant subprime and Alt-A expertise available for hire these days. Just sift through the ashes of Lehman Brothers and Bear Stearns. It is a workable plan, and therefore is unlikely to ever see the light of day.

Mar 30 12:16 PM

[Tom Armistead:]

You're missing the point on the monolines: the provided credit insurance in two froms, traditional insurance policies and CDS.

Unfortunately the effects of mark to market accounting, which was not in place when the CDS were written, creates grotesque distortions on their financial statements, which have been further twisted by the negative hype from the short and distort crew.

Both Liddy and the OTS testified earlier this month that the assets insured by AIG's CDS on super senior CDOs were performing 100% through that date.

Translating their CDS into synthetic bonds is exactly the solution that was imposed on AIG - the insured bonds were bought and placed in the Maiden Lane facility.

The only fix for the CDS problem is to regulate them as insurance, with a requirement of insurable interest on the part of the buyer and adequate capitaql on the part of the seller.

The fix for the synthetic bond problem is to outlaw the practice because it puts the investor into the insurance business. Amazingly, there were synthetic bonds registered with the Irish Financial Regulatroy Authority, linked to the credit of the Icelandic banks, weeks before they failed. That is the klind of cynical fraudulent behavior created by the synthetic bond business.

Mar 30 12:40 PM

[market ace:]

Why is everyone only talking about CDS's when the derivative market in interest rate swaps dwarfs it about 10-1 and giant problems will arise here when interest rates rise.

Until the third quarter of last year, the banks' losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

Now, with potential new losses in interest rate derivatives, this problem has the potential to cause a collapse in a whopping 82 percent of the derivatives market.

Thus, considering this far larger volume, any threat to interest rate derivatives could be far more serious than anything we've seen so far.

Today U.S. banks alone control $200.4 trillion in derivatives; and it's precisely in this dangerous sector of IRS's that the megabanks dominate the most.
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According to the Office of the Comptroller of Currency's Q4 2008 report, America's top five commercial banks control 96 percent of the industry's total derivatives, while the top 25 control 99.78 percent. In other words, for every $100 dollar of derivatives, the big banks have $99.78 ... while the rest of the nation's 7,000-plus banking institutions control a meager 22 cents!3 This is a massively dangerous concentration of risk.

The large banks are exposed to the danger that buyers will vanish, markets will suddenly become illiquid, and they'll be unable to unload their positions without accepting wipe-out losses. The large banks are exposed to the danger that, with exploding federal deficits and new fears of inflation, interest rates will suddenly surge, delivering a whole new round of even bigger losses in the months ahead.

Worst of all, the five biggest banks are exposed to breathtaking default risk — the danger that their trading partners could fail to make good on their gambling debts, transforming even the best winning trades into some of the worst losers.

Here's a chart on these risks, updated to reflect the new data just released on Friday for the year-end 2008,

Bank of America's total credit exposure to derivatives was 179 percent of its risk-based capital;

Citibank's was 278 percent;

JPMorgan Chase's, 382 percent

HSBC America's, 550 percent, and

Goldman Sachs' total credit exposure at year-end was 1,056 percent, or over ten times more than its capital.

Get ready for some big fireworks in the banking industry that even Bernanke's giant printing press cannot possibly handle and all of the proposed accounting changes cannot mask or cure this massive problem..

Mar 30 01:06 PM

[Mark Bern:]

Since the OTC market is so large relative to the exchange-traded derivatives market it might seem logical to create an exchange for such investments, on the one hand.

On the other hand, that may require too much conformity to accomodate the needs of the marketplace. So, I have to side with Mr. Armistead. The sheer size of this market begs for regulation and adequate capital standards. Considering the obvious consequences of having no regulatory oversight, it appears necessary.

It is becoming obvious now that there are many pieces to this economic problem puzzle. Regulations could forestall future repeats of our malaise but the solution for today still seems to have Wall Street and the Beltway befuddled.

Mar 30 01:17 PM

[helplessobs...:]

Wow, GS has liabilities that exceed its ability to pay by 1056%. It had better not return the TARP equity injection. Such lunacy demands correction.

Mar 30 03:25 PM

[Poor Dude:]

Maybe we just need to outlaw all derivatives period? And most certainly, all naked ones or third-party ones where anyone other than a party with direct exposure is allowed to participate (and where anyone WITH direct exposure is allowed to participate only to their limit of exposure). Buying insurance on an asset or hedging a future liability is one thing. But placing bets on the future value of something you don't own is just gambling anyways, and really has nothing to do with investing.

And I'm no lawyer, but I thought gambling was already illegal in most places and that any contract based on (or requiring) illegal conduct was automatically null and void by operation of law. Am I wrong?

Mar 30 03:40 PM

[Tom Armistead:]

At one time state "bucket shop" laws, in particular NY State's General Business Law Section 351, prohibited gambling transactions in the equity markets. Your Congress saw fit to specically exempt CDS from these types of legislation, with the results we have seen. Write your congressman.




On Mar 30 03:40 PM Poor Dude wrote:

> Maybe we just need to outlaw all derivatives period? And most certainly,
> all naked ones or third-party ones where anyone other than a party
> with direct exposure is allowed to participate (and where anyone
> WITH direct exposure is allowed to participate only to their limit
> of exposure). Buying insurance on an asset or hedging a future liability
> is one thing. But placing bets on the future value of something you
> don't own is just gambling anyways, and really has nothing to do
> with investing.
>
> And I'm no lawyer, but I thought gambling was already illegal in
> most places and that any contract based on (or requiring) illegal
> conduct was automatically null and void by operation of law. Am I
> wrong?

Mar 30 03:48 PM

[Blackeyebart:]

Most of these good ideas are analogous to rounding up the herd before fixing the fence.

We need new regulations that limit or ban CDS and MBS. Immediately we have this the problem will start to shrink. At the moment it's still growing.

Mar 30 11:46 PM

[wakeup call:]

While we are at it short selling should be eliminated. It creates a death spiral provided the short seller has sufficient resources to take a major short position. This at the very least is market manipulation. It was outlawed for a brief period last year for financial stocks. Once the successful test period ended it was not renewed. Taking out short selling and elimninating mark to market would go a long way towards fixing out busted economy and put some light at the end of the tunnel. Light at the end of the tunnel in my opinion is the only way to restore consumer optimism whihc will help prime the pump. The are two fixes that can be put in place with the stroke of a pen. Why is there no movement?

Mar 31 08:58 AM

[Ishortyou:]

A Lot of those bets on derivatives have been done by financial instiutions with money that they dont have, borrow money, margin money and when things went down there you go down the tubes. The bets on housing related derivatives brought the banks down when the housing bubble popped, it is imperative now to correct the oversupply in housing to prevent further damage on those bets specially the ones in the banks books.

Mar 31 09:54 AM