Are CDS a Good Thing?

Kevin Drum asks whether I’m “still as bullish about credit default swaps as I have been in the past”. It’s a good question: after all, a large part of my speech to the regional bond dealers (more of the actual speech than of the notes) comprised me explaining that I was very wrong about a lot of this stuff.

On the subject of CDS specifically, yes I think I was entranced by the shiny-new-toy aspect of them. They were so elegant, they were such efficient ways of moving risk around the markets, that they had to be a good thing, right?

I’m still no fan of the CDS demonizers, who generally have no idea what they’re talking about: if they are remotely right, they’re right for entirely the wrong reasons. But I will admit that I did rather jump in an unwarranted manner to the conclusion that because the CDS critics were so very wrong, then the CDS market must have been largely benign.

The fact is that AIG (AIG) could never have blown up if it wasn’t for CDS. UBS (UBS) and Citigroup (C) could never have suffered their billions of dollars in super-senior losses if it wasn’t for CDS. And therefore the CDS market was intimately involved in some of the most systemically-devastating events of the crisis.

That said, CDS had nothing whatsoever to do with the failure of Bear Stearns. The fact that CDS allowed you to effectively short a credit you didn’t own was not particularly harmful. The CDS market was incredibly useful in terms of price discovery, and it remained impressively liquid even as virtually all other credit markets froze up altogether. Etc etc.

So right now I’m vacillating on this one. I’ve recently finished reading Gillian Tett’s new book, and although she tells a good story, I don’t think she really succeeds in making her case that the creation of the CDS market was the proximate cause which “unleashed a catastrophe” on the world.

On the other hand, I don’t think I can really add credit default swaps to the list of undeniably positive financial innovations, like ATM cards. CDS are powerful instruments, which can be — and were — misused, most egregiously by AIG. I’m not happy about that. But I’m not remotely ready to start banning them, or to start trying to require that any buyer of protection have an “insurable interest” before being allowed to do the deal.

Comments

[William Cowie:]

Credit default swaps are good for what they are: default credit insurance. However, common sense says they should be regulated as part of the insurance industry. Think about it: if you're going to buy insurance against your $100m bonds defaulting, wouldn't you want to know the issuer will be around, with enough capital, to make a claim good?

And FOR SURE no leverage should be allowed against insurance contracts, including CDS. That would be like saying I buy a life insurance policy from insurer X, only to discover they intend to borrow come time for a claim. That's why insurance is regulated, and that's why CDS should be regulated like the insurance products they are.

Apr 25 01:30 AM

[bricki:]

Well clearly the AIG scheme (or was that scam) of selling insurance backed by no capital at all should have been illegal. And in fact there probably some laws violated, at least on the disclosure side. And how Sarbanes-Oxley doesn't get caught up in this I am not sure...

And then of course there is the little-mentioned reason these swaps came into existence - they were bought by banks as insurance on loans to reduce their own reserve requirements. So the net effect of CDS was to increase leverage to totally insane levels. The banks were complicit in this fraud - they knew AIG had no reserves, and the banks were using the CDS to avoid having reserves themselves. Clearly the banks should have some responsibility to determine the quality of the insurance they bought. Any bank that is in trouble due to this scam should have all senior executives and its board kicked to the curb immediately.

We are lucky the crash last year wasn't MUCH worse. It also explains why the government is so intent on keeping AIG afloat.

Apr 25 02:13 AM

[Tom Armistead:]

Agree with William Cowie that CDS should be regulated as insurance, with a requirement of adequate capital for sellers. There also needs to be a requirement of insurable interest for buyers, for the same reasons that an insurable interest is required in life insurance and property insurance.

Congratulations Felix for making some progress in seeing the harm that CDS did to the financial system.

Back in September last year I had deep concerns when the NY Attorney General and the SEC announced investigations of market manipulation, with a focus on CDS. Because six months have passed with no further news on this front, I am feeling safe and secure because if there were any evildoers using CDS to manipulate the market, they would have been brought to jusctice by now. So the market in naked CDS is just a bunch of generous public servants providing liquidity and price discovery...

Apr 25 04:41 AM

[jcrash:]

CDS's were treated like puts but at just a fraction of the cost. Thus, allowing someone a lever with which to fund the short sales on a security.

"The fact that CDS allowed you to effectively short a credit you didn’t own was not particularly harmful." Yeah, right. If it was not harmful, there shouldn't be a relationship precrash to the number of CDS's on a company and the eventual outcome for said company.

Apr 25 09:48 AM

[John Lounsbury:]

Felix and all commenters - - -

This article and the preceeding comment stream are getting at some of the major issues with CDSs. In addition to the valid points already discussed, I would like to add some thoughts.

Martin Hutchison (www.moneymorning.com/2.../) has argued that CDSs are agravating (and will further agravate) the spate of bankruptcies. Why should bond holders eneter negotiations for settlement work-out of insolvencies and get part of a dollar when they can just hold out for bankruptcy and get 100% from CDSs?

Yes, bricki, "We are lucky the crash last year wasn't MUCH worse." Unfortunately, we may have extended the crash into a cascade of smaller crashes. This may or may not be better than having forced the entire tangled web to be unravelled more quickly.

With regard to the question of insurable interest, I would draw a comparison to a process of buying life insurance on a bunch of strangers and then poisoning their drinking water.

All commenters have addressed the failure to regulate CDS issuers as insurers, requiring adequate capital reserves. However, that might not have avoided the problem because, while the reserves might have been sufficient for a financial Katrina, we have had the equivalent of dozens of Katrinas. This is something that was probably not considered within the realm of probability just 2-3 years ago.

Finally, I want to join Tom Armistad in recognizing that Felix has been adjusting his views on CDSs as facts have unfolded. As one who has had to change opinions when my understanding has been changed by new information, I know the process is not easy.

Apr 25 12:51 PM

[Steven Hansen:]

cds regulatory regimes need to be debated and legislated. our congress would prefer to concentrate on political issues that they understand. i see absolutely no work to examine our regulatory processes which contributed to this crisis.

Apr 25 08:28 PM

[William Cowie:]

John Lounsbury, good point about bond holders not being motivated to participate in haircut negotiations. However, one would think the CDS issuers would be interested in exploring ways to mitigate their losses. Exactly how, is not clear, but I'm surprised to see none step forward in the cases of GM and Chrysler and being proactive.

Apr 25 10:06 PM

[THofler:]

In the beginning I was in the Cowie camp. It is a straigtforward position. Then I heard a good contrary argument from a couple people including Sec. Geithner.

Suppose an auto parts supplier has a large dollar value of accounts receivable with a company like Chrysler. The supplier could hedge that liability with a CDS purchase.

My father ran a farm seed business with a relatively low profit margin. The business couldn't have worked without 100% hedges of all grain deliveries via grain futures contracts on the CBOT.

I think CDS's should be run through the CFTC. If a bond position is hedged with a CDS by more than say 80% of the bond value, then the bond holder should lose their legal rights to bankruptcy court & ancillary legal issues. (They would still participate in the monetary proceeds from a bankruptcy, but would be a passive participant.)

But, I think the predatory trading capabilities that CDS's provide are still a serious problem. Prior to the crisis, hedge funds managed perhaps a couple trillion dollars with 2 to 5X leverage, yielding massive fire power. The notion that CDS markets are always "efficient," that the trading is always "liquid," and "price discovery" is always meaningful is just silly. Short the common, buy the CDS, spread the false rumors, and kill the company. The ideal buy-to-cover price is zero.

We need a ban on a simultaneous CDS position, and a short or put position. I suppose there are clever ways (synthetic positions or other) to skirt the intent here, but it would be a start.

Apr 25 11:51 PM

[Tom Armistead:]

Steve Hansen, a good point that congress should be examing the issues and developing legislation.

After all, they're the ones that passed CFMA, without debate, as an add-on to an appropriations bill, on the day before the Christmas recess. That was the law that exempted CDS from regulation by the SEC or by the states as gambling under bucket shop laws.

They created the problem: they should fix it.

Apr 26 06:08 AM

[Nik Kondrat...:]

Tom,

The people who lobbied hard to exclude CDS regulation from the CFMA are now running the Obama economic policy experiment--Summers and Gary Gensler in particular. This is beyond financial industry capture of regulators, the American public has been sold down the river.

Apr 26 10:31 AM

[ubuy2w:]

Felix you are clearly hanging out with Mr. Weiss and his cronies a little too much they are clouding your good judgement. Take a weakened public financial institution with a lot of debt outstanding and an completely unregulated CDS market combined with naked short sellng and you have the makings for a Chernobyl like event just waiting to happen. Make a largish bet through the CDS market ,naked short a companies stock, spread a few plausibly false rumours in the financial press and you have . Of course the CDS market needs to be regulated as does the derivatives market or people will game the system for fun and profit and laugh as they steal the publics 401 ks.

Apr 26 04:11 PM

[William Cowie:]

THofler, what you're proposing seems like two different animals - a forward commodity contract (harvests, oil, things like that) and old fashioned insurance. Both have a place and a use. Both are regulated in more or less an appropriate manner. CDS are insurance policies traded as commodities, which they are not. A futures contract looks for a certainty, i.e. someone will deliver to McDonalds 100 tons of potatoes, grade A, on September 30, 2009.

An insurance contract looks for the reverse: let's hope you never need to file a claim for event X, but if you do, nice to know we're here for you and we'll pay in full. Nobody has ever argued that a credit default swap is anything but an insurance contract. All the problems we have stem from the fact that there are too many people who simply say, bollocks, let's just treat them as something else. We'll make money and we'll get someone else to pay the piper.

Can someone prove a CDS is different from a simple insurance policy?

Apr 26 07:42 PM

[levin70:]

Definately one of the best discourses i have seen on SA in a long time. Definately applaud those above me for the discourse.

currently CDS are treated by market particpants more as financial instruments. The pricing of CDS contracts tells a lot, and has been mentioned by the OP as having maintained their liquidity well during even the darkest hours of these crises. Moving to an insurance model would kill this liquidty and the flow of information from the market would end. However, the questions of empty creditor and default manipulation would hopefully end. Question - where is the happy place between the sides?

Regards

Apr 27 06:05 PM

[jcrash:]

On Apr 26 07:42 PM William Cowie wrote:


> Can someone prove a CDS is different from a simple insurance policy?


If I game the system on an insurance company it is called Fraud. If you game the system with a CDS and shorting it is ignored.
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Apr 28 07:00 PM