Questioning Conventional Wisdom on Credit Default Swaps

By James Kwak

One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.

In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.

However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.

Custom derivatives would still have to be reported to regulators, so what’s the problem? The small problem is that unnecessary customization of financial products is a great way for derivatives dealers to jack up unnecessary transaction fees. The big problem is that custom derivatives are by their nature harder to oversee. Regulators want to be able to estimate a firm’s potential exposure across all its tranactions under various scenarios; the more complex those transactions, the more difficult this becomes. Regulators already had the power to demand access to banks’ books before the financial crisis; the problem was that they lacked the staff and skills to understand the complex structured products those banks were manufacturing and trading. As a result, custom products become a way for market participants to hide risks from oversight, and a potential means for systemic risks to build up out of sight.

The conventional wisdom is that some firms have unique needs and therefore there have to be customized derivatives contracts. But the real question to ask is why we need customized derivatives in the first place. For example, you can only buy U.S. Treasury bills and bonds that mature on specific dates, and in specific denominations (although perhaps there are banks that will custom-manufacture a Treasury-like security for you, and charge you a transaction fee – while throwing in counterparty risk for good measure). What’s wrong with a world where you can buy a credit default swap on any fixed-income instrument, but only for certain maturities (including the maturity of the underlying instrument) and on standard terms (such as the definition of a credit event and how the swap will be settled)?

I know the high-level answer (in fact, I already said it): firms have unique hedging needs. But I want to hear some good examples. On that same Morning Edition segment, Cory Strupp, a lobbyist at the Securities Industry and Financial Markets Association, gave this example: “If you have a company that wants to hedge a credit exposure in an odd amount of money – $156,217.25 – they can enter into a credit default swap that covers exactly that amount of credit risk, to the penny.” This is a terrible example, because if I’m a company of any size, and I have a credit exposure of $156,217.25 but I can only buy credit default swaps in multiples of $10,000, that’s perfectly fine with me. Strupp must know it’s a terrible example, but must have decided the better examples were too complicated for NPR.

And once we know what the good examples are – and I imagine there are some – the question is whether the benefits they provide to the parties involved outweigh their costs. And by costs, I don’t mean just the transaction costs; I mean the fact that customized derivatives make regulation harder and increase the risks of a costly failure. This is an externality, pure and simple, and it should be deterred or taxed.

(I’m guessing someone will point out that the Constitution limits the ability of the government to interfere in the freedom of contract. But remember, this is a regulated industry. Custom derivatives increase the cost of regulation; it would be perfectly constitutional to say that firms that trade in custom derivatives must pay a hefty tax on those products to offset the increased regulatory cost. If the tax is big enough, that would deter banks from using custom derivatives when standardized ones would do.)

There’s actually an interesting point behind this question. Someone – I think it was Felix Salmon, but now I’m not so sure – said that the real problem wasn’t that firms weren’t perfectly hedged; it’s that they believed they could be perfectly hedged. Risk never goes away; if you think you’ve eliminated it, it’s just gone someplace else to hide. Instead of a system where companies think they can hedge their risks perfectly because financial products are infinitely flexible – and therefore don’t manage their risks effectively – it would be better to have a system where companies can’t hedge their risks perfectly, and know that, and behave accordingly.

Comments

[indeolie:]

While you're at it, also ban naked longs - if everybody had a flat position none of this would've happened. Oh and also ban stocks please, since they're nothing more than call options on a company's value.

Jun 26 08:47 AM

[indeolie:]

...and if only miners and farmers (sellers) were to be allowed to use futures how would they ever find a buyer?

Jun 26 08:52 AM

[John Lounsbury:]

James - - -

This is a good article. You wrote, "Risk never goes away; if you think you’ve eliminated it, it’s just gone someplace else to hide." Actually, it only hides for a little while if risk is realixed. Recently the hiding place was found to be the public coffers.

By "diversifying" risk you are not controlling it, merely transferring risk. Ultimately, if carried to the leveraged extreme, risk is transferred from individual firms to the financial system as a whole and multiplied. We have been there, done that.

The risk of default is not diminished by all the financial engineering in the world. Looking at mortgages, for example, it could be argued that the risk of default is increased. I'll give two arguments for that:
1. Collateralizing mortgages makes it easier for marginal loans to be made because the originator is not going to be held responsible for collecting the repayment.
2. Once the mortgage is sliced and diced, the relationship between the lender and borrower is no longer straightforward and workouts of distressed situations that might have been feasible are not pursued.

So the risk of defaults occurring has been increased by financial engineering, and the cost has been amplified by leverage.

James, you have touched on these ideas, so I am merely restating some of your points in a way that makes sense to me. Your article is addressing issues that need to be understood by a broad audience and are not, although many SA readers probably do understand.

Jun 26 09:35 AM

[morph366:]

JohnL

You make a good point about risk transfer and the fundamental fallacy of the originate and distribute model that underpins CDO's. Risk has to be borne somewhere in the system - it cannot be traded away - it simply passes eventually to the greater fool (s) e.g. AIG, BSC, LEH etc
And when they fall over it passes to all of us.

Jun 26 09:47 AM

[Jeff Nielson:]

There is growing evidence that the entire CDS market was nothing more than fraudulent, "pretend insurance" that was never meant to be relied upon (complete with "side letters" repudiating any responsibility for CDS pay-outs).

This article lacks relevance by not discussing that the inherently fraudulent nature of this market.

Secondly, the debate about "regulation" is totally moot. There were regulators (and regulations) in place BEFORE the U.S. financial crime syndicate created the largest Ponzi-scheme in global history (i.e. the U.S. economy).

Everyone of these corrupt regulators turned out to be blind/deaf/dumb. All the regulation/regulators in the world won't prevent these career-criminals from engaging in more scams in the future if they remain thoroughly corrupt.

Look at Citigroup, they just had to shut-down their mortgage securitization unit because it had NEVER STOPPED buying and packaging fraudulent mortgages.

Jun 26 10:36 AM

[mrwizard:]

i especially agree that only the owner of an instrument should be able to purchase swap protection. otherwise they can become pure wagers, not insurance of some kind. not to mention subject to manipulation.

picture GM or chrysler bond holders that are protected by swaps. think any of them would agree to anything except something that triggers payment?

Jun 26 10:49 AM

[Swashbuckler:]

Agreed indeolie---Speculators play a VITAL function in the futures markets. They assume the risks that others won't. If a farmer needs to lock in a future guaranteed price for the crop he is planting today, to guard his investment from drought or inclement weather, the speculator is always there to assume the risk the farmer doesn't want or can't afford. Ditto for DOZENS of industries,( oil, cereal, timber, etc.etc). You know this, but others on this board don't.


On Jun 26 08:52 AM indeolie wrote:

> ...and if only miners and farmers (sellers) were to be allowed to
> use futures how would they ever find a buyer?

Jun 26 10:50 AM

[PlanetHead:]

Sure someone has to take the other side of the bet. But the question I think we all ask. To what size until it starts to look so lopsided that it crashes the whole system ...That's where the regulators need see the whole picture that's why you can't have custom Derv. They need to be on a exchange.

Jun 26 11:40 AM

[Larrysyr:]

It's pretty clear that AIG engaged in fraudulent activity in selling insurance (CDS) it couldn't cover. Fraud is already illegal. Some of the other practices mentioned in the comments, such as naked shorting, are also already illegal.

So the counterparties to AIG were victims of a massive fraud. Well, so were the investors who lost money with Bernie Madoff.

Derivatives, in and of themselves, are not the problem. Fraud and other criminality is the problem.

Jun 26 12:18 PM

[RTF 360:]

JUNE 26, 2009 Gensler Says Derivatives-Dealer Oversight 'Critical' to Obama Plan


Mr. Gensler worked with Sen. Phil Gramm and Alan Greenspan to exempt credit default swaps from regulation, which led to the collapse of A.I.G. and has resulted in the largest taxpayer bailout in U.S. history. He supported Gramm-Leach-Bliley, which allowed banks like Citigroup to become “too big to fail.” He worked to deregulate electronic energy trading, which led to the downfall of Enron and the spike in energy prices.


CDS & Systemic Risk
"While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These markets subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.

Seen in this context, AIG was the most visible "sucker" identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.

Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers" David Fuller

Jun 26 01:25 PM

[Josh Kupers...:]

James,

You highlight some very important ideas and raise some intriguing questions about regulating and/or abolishing custom derivatives. Your point that "customized derivatives make regulation harder and increase the risks of a costly failure ... should be deterred or taxed" is right on the money.

I would like to address your question "why we need customized derivatives in the first place". It is generally acknowledged that at least the *easily understood*, non-highly-customized derivatives such as shorts with uniform expiration dates add liquidity to the market and are an important source of market information. Even Christopher Cox acknowledged the 2009 short ban was a "mistake".

As far as customized derivatives, along with their added counterparty risk, higher transaction fees, and lack of regulatory oversight, I think it's definitely questionable whether such securities are beneficial to the market as a whole. As a "little guy" with little access to such exotic fare, I'm probably not in the best position to judge them.

However, as we've seen from the sheer scale of the recent meltdown these customized derivatives are extremely popular with hedge funds and other large investors -- even in the aftermath of the financial crisis. PIMCO even has a page up specifically extolling the virtues of CDS: www.pimco.com/LeftNav/...

I do agree that the supposed benefit of CDS quoted from Cory Strupp was borderline nonsense, but presumably he was just trying to keep things simple.

Jun 26 02:22 PM

[Gtarras:]

"I know the high-level answer (in fact, I already said it): firms have unique hedging needs."

Not sure why this is not good enough explanation. Most of this noise is because it is hard to customize securitized products, having worked with them for 15 years, i will testify to that. Securitization, meanwhile accounted for two-thirds of money flow in the US. If securitization is not restored, the economy will not recover. Think about it. CP and auction paper funding programs are DEAD. And they were huge. We need to bring back to life ABS, CDOS etc. They will be critical, especially now that the reserve requirements for the banks will be increased.

So why not introduce this solution: Allow OTC trading for only certain types of credit products (for instance, customized tranches). In addition, allow purchase of a CDS contract only if the asset is already on purchaser's books.

Jun 26 02:40 PM

[TinyTim:]

Bottom line- there wasn't enough backing the CDS's so that when they were needed, they were worth something

Jun 26 02:44 PM

[Living4Divi...:]

Here's how CDS is supposed to work:
X borrows 1,000 from Y. X sells credit default swap to investor Z. If Y defaults, Z pays X. Let's name this specific CDS and name it be CDSofY. This is perfectly fine.

Nowadays, not only does X sell CDSofY to Z, but two unrelated parties also gamble on the outcome. In which A sells CDSofY to B. In fact, banks were crashed when momentum shorting was being performed using CDSes.

Jun 26 03:14 PM

[Gtarras:]

one more thing to add to that: increase funding reuirements for protection seller to avoid AIG type of fiasco


On Jun 26 02:40 PM Gtarras wrote:

> "I know the high-level answer (in fact, I already said it): firms
> have unique hedging needs."
>
> Not sure why this is not good enough explanation. Most of this noise
> is because it is hard to customize securitized products, having worked
> with them for 15 years, i will testify to that. Securitization, meanwhile
> accounted for two-thirds of money flow in the US. If securitization
> is not restored, the economy will not recover. Think about it. CP
> and auction paper funding programs are DEAD. And they were huge.
> We need to bring back to life ABS, CDOS etc. They will be critical,
> especially now that the reserve requirements for the banks will be
> increased.
>
> So why not introduce this solution: Allow OTC trading for only certain
> types of credit products (for instance, customized tranches). In
> addition, allow purchase of a CDS contract only if the asset is already
> on purchaser's books.

Jun 26 03:16 PM

[dw57:]

maybe require any cds seller to treat like its insurance. have to have a license. have to have a reserve large enough to cover the contract. and make it illegal to have a cds/cdo for some thing you don't own. and you loose the payout if you actively cause a lose or its found out you don't have it. and if some one really just needs a cds/cdo thats custom they pay a heavy tax to do so. and are subject to even more onerous (both seller and buyer have to report on the wmd).

Jun 26 03:52 PM

[User 187943:]

Cove, your comment below is absolute stupidity!

"The system has to remove the gambling instinct from markets...mere bets on short term price movements. This means banning options, futures, shorts etc unless you're a farmer or miner. If you fear for debt, put in a stop loss or sell the bond, or move to a safer security."

I participate in the futures markets daily. If you are invested in any type of fund (i.e. mutual, etf, etc...) your portfolio manager is also participating in the futures markets. he/she has to hedge the portfolio exposure to smooth out returns. Simply eliminating futures and options markets would be the final death of a free market system, which is apparently what you are asking for. I see how well our government manages their finances! If you eliminate price discovery and speculation then you don't have a market.

What is troubling to me is that everyone wants to eliminate derivatives, but those same people who want them eliminated don't even understand or want to understand how they benefit businesses and people. Futures are derivatives, and I made more money last year when the stock market was down over 37% using futures markets. You see, with futures I don't have to borrow money on margin and pay interest on it to short a stock. Nor do I have to find the stock to short before I can short it. With futures I simply pay my margin for a contract(s), which is merely a performance bond or good faith payment, and I play both sides of the market (i.e. short/long). I ask you, what is wrong with making money when a market is going down or up? There is nothing wrong with it, that is called free market capitalism! It is called price discovery! You make reference to gambling, the stock market is gambling, the options market is gambling, the futures market is gambling, the bond market is gambling. Hell, it is all gambling! If you want a guaranteed return, then put your money in a bank. Sure, you will earn .25% - 2% interest and your money will be FDIC insured. However, you will never keep up with inflation and your dollar will buy less and less. In the meantime, I will keep "gambling" in the futures and options on futures markets. Yes, I lose money too, but that is what trading is all about. You do lose money and you do make money. All that I would simply ask is that people strive to educate themselves on the purpose of free markets and the benefits they provide. Somewhere in this financial crisis the people of this country have forgotten that.

On Jun 26 08:09 AM cove3 wrote:

> It's appalling that there's no mention of ELIMINATING credit default
> swaps altogether, or at least restricting them to only those actually
> owning the underlying debt. Not owning the underlying debt gives
> you incentive to burn the house down.
>
> The system has to remove the gambling instinct from markets...mere
> bets on short term price movements. This means banning options, futures,
> shorts etc unless you're a farmer or miner. If you fear for debt,
> put in a stop loss or sell the bond, or move to a safer security.
>
>
> Ron

Jun 27 08:51 AM

[dcb:]

> Subject: How fading political will..... (forward to Mr. Plender)
> To: [e-mail]

> Date: Saturday, June 27, 2009, 10:06 AM
>
> Please forward to Mr. Plender
>
> Dear Mr. Plender,
> It is with great dismay that each and every day I read in
> multiple sources about how the efforts of reform of the
> financial system are getting bogged down because of a lack
> of political will in the United States. Perhaps it is time
> that columnists around the world start to look beyond the
> traditional excuses for "the lack of will". If one ignores
> the rhetoric with which Mr. Obama used to get elected, but
> instead looked only at his appointments, his policy choices,
> and his support for change (in summary a real black box
> analysis of the reform effort) one would conclude that in
> fact no real reform was intended from the start.
>
> President Obama's appointment of Mr. Geitner, Summers, and
> multiple other insiders suggests that change was not high on
> the agenda to begin with. The decision to hand to congress
> the details of policies allows for greater influence by
> special interests groups. By beginning the debate with very
> mild reform efforts Mr. Obama ensured the final reforms,
> after compromise, would be even further diluted.
>
> At a certain point the evidence pointing towards one
> direction becomes overwhelming. At what point does
> politeness get put aside and the clear and obvious
> conclusion get mentioned in the press. From the start Mr.
> Obama never intended for any significant financial reform to
> occur.
>
>
>
>
>
>

Jun 27 10:19 AM

[dcb:]

From all the BS from the bankers one would assume that the world didn't exist before all these derivative contracts. It did and we didn't have a nuclear weapon strapped to our backs at all times. So you have the answer there as simple as can be.

Any discussion of regulation with the industry being regulated is just stupid. they always use a variant of the same argument (it will hurt the consumer or the economy), and they are always against regulation. think cars and fuel milage, food safety, pollution, capital requirements, etc. Each and every regulation is always the "end of the world as we know it".

the market loves not having to post capital, and having to worry about risking the world economy, and loves profits. If the market applauds a pundit or a solution I can assure you it is a shitty answer to the problem. The market is heaping praise on Bernanke right now. all he has done is give it an unlimited cheap funds at tax payer expense with the fed taking a great deal of risk off their hands and transferring it to the taxpayer. Of course the market loves him. Market loved Greenspan and we know how that turned out.

I am going to tell you one real problem. Goldman bundles together shit they know will fail and then buy insurance on it before anyone realizes they have bundled together shit. they get the upside, and the downside and the economy and public get screwed.

They also pervert the system so you want to drive a company into the ground because the CDS pays off the most instead of finding the best solution,

I don't settle my claims because the CDS contract pays off more. These are not the market incentives we want in place



Morph and John as usual very good insightful points

Jun 27 10:41 AM

[dcb:]

False, securitizing was the final straw that led to over leverage and collapse. What you mean is that the false log returns of the stock market (and therefore bonus structure) will only be able to expand that their natural linear rate. We will recover, it will be painful, we will have a much more stable system when it is done with. I for one do not want to recover with such high degrees of leverage and walk around with an economy that is the same thing as having a gun pointed at my head that could go off at any time

what you don't understand is that the average (great majority) of people desire stability. Wall street, CEO's with their perverse compensation structure want booms and busts.


On Jun 26 02:40 PM Gtarras wrote:

> "I know the high-level answer (in fact, I already said it): firms
> have unique hedging needs."
>
> Not sure why this is not good enough explanation. Most of this noise
> is because it is hard to customize securitized products, having worked
> with them for 15 years, i will testify to that. Securitization, meanwhile
> accounted for two-thirds of money flow in the US. If securitization
> is not restored, the economy will not recover. Think about it. CP
> and auction paper funding programs are DEAD. And they were huge.
> We need to bring back to life ABS, CDOS etc. They will be critical,
> especially now that the reserve requirements for the banks will be
> increased.
>
> So why not introduce this solution: Allow OTC trading for only certain
> types of credit products (for instance, customized tranches). In
> addition, allow purchase of a CDS contract only if the asset is already
> on purchaser's books.

Jun 27 10:49 AM