CDS Regulation: Just One Simple Rule

Warning: this post will require you to be able to intelligently ponder philosophical concepts and theories, and perhaps try to forget some assumptions you may already have. I failed in my attempt to explain the concepts below in a comment thread on NakedCapitalism, so here's the full thought process:

Let's have a quick CDS tutorial: Credit Default Swaps are insurance on the credit of an underlying company. An investor who buys CDS on company XYZ will pay a fixed fee (ie, 1% of the notional he is purchasing) every year, and in exchange, the seller of the CDS will owe the buyer money if there is a default event at the company.

The biggest problem with the CDS market was that sellers of CDS - ie, sellers of insurance, wrote checks their bodies couldn't cash. They ended up with liabilities they couldn't possibly make good on, and you know the rest of the story - government bailout to avoid Armageddon.

There is another problem with CDS, though, and that's the fact that there are many more CDS outstanding on some companies than the actual underlying debt that the CDS are supposed to be insuring. Let's consider a hypothetical example: Company XYZ has $100MM in debt outstanding. JoeHedgeFund owns it all.

JoeHedgeFund goes out to the Street - the sell side broker dealers, AIG, etc, and purchases protection - CDS - for his bonds. However, JoeHedgeFund takes it one step further - he manages to buy $500MM worth of CDS - because when you buy CDS, no one asks you how much of the underlying bond you own. Why is this a problem? Because, when company XYZ runs into trouble, and goes to negotiate a restructuring, a prepackaged bankruptcy, or a reorganization, JoeHedgeFund now has no incentive to negotiate in favor of the debt he owns - in fact, he's DIS-incented from helping XYZ restructure their debt, because he's essentially overhedged by a ratio of 5-1. He doesn't care if he takes a loss on the $100MM in bonds by refusing to compromise on any sort of restructuring and forces the company into bankrutpcy, because he gets paid on $500MM of CDS.

This is what's known as "perverse incentive." Opponents of CDS sometimes say that we shouldn't allow people to buy "naked" CDS, because they don't have an "insurable interest," and thus are exposed to perverse incentives. A commonly cited example is that you can't buy insurance on your neighbor's house, because you could then burn the house down and collect on the insurance policy. You also can't buy life insurance on your neighbor, because you'd have perverse incentive to murder him to collect the payout.

Now, here's why it's fallacious logic to apply this reasoning to CDS. If I buy CDS on a company without owning any of the underlying debt, I cannot effect the health of the company. Note that I don't have an insurable interest, but it doesn't matter - the "perverse incentive" is a pipe dream, because I can't act on it.

It doesn't matter how much CDS I buy - I could own a gazillion dollars worth of insurance on the debt of a given company - but that still doesn't give me any say, any seat at the table in a restructuring negotiation scenario. There is a similar analogy with short selling stocks, and it's the reason why people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company.

Similarly, CDS levels do not effect the health of a company - they REFLECT the health of a company, or at least the market's interpretation of that health. Some companies will see the value of their CDS widen when people fear for the company's financial health. The CDS is a reflection of the fear, and not the cause of the company's problems. To suggest that panic from widening CDS levels causes companies to collapse is like saying that avoiding marking assets to market makes them worth whatever we want them to be worth - limiting CDS trading would not alter the underlying health of the company, it would only mask it.

So, since one cannot effect the health of the company by owning CDS - since one cannot murder the company (or burn it down) via a CDS position, the "burning down your neighbor's house" analogy goes up in smoke as a straw man fallacy. If you're philosophically inclined, you can imagine a world where I could buy life insurance on my neighbor's house, but the insurance company would give me a magic pill that would prevent me from being able to harm the house in any way - it would essentially eliminate the perverse incentive I had. In this scenario, obviously, there is no reason why I can't buy insurance on my neighbor's house. Similarly, with CDS, I can't effect default events by owning CDS alone, so the perverse incentive is a straw man.

However - once one DOES own some of the underlying bonds in a company, like JoeHedgeFund in our example, he certainly can effect the outcomes, and thus we need to propose some rules for how much CDS one can own. Now, these rules are theoretical - I don't have a suggestion for how to enforce them, so if you don't have the capacity for regulatory philosophy, you can click away now. Also note, that these rules address ONLY the "perverse incentive" concept - they don't cure the problem of the AIG's of the world writing too much insurance (CDS).

It's actually simple, and it's actually only one rule: SINCE a debtholder can effect the future health of a company, IF you own debt in a company, you cannot own CDS notional greater than your debt position. Following logically from that, if you own CDS in a company, you cannot buy debt in the company unless the notional value of the debt is at least at large as the notional value of the CDS.

That's it - just one rule. Note that under this rule, there is no prohibition on buying "naked" CDS in a company whose debt I don't own - because naked CDS buying does not cause the collapse of companies.

The real problem with CDS, apart from the perverse incentive effects which we've now solved with a simple rule, are not with the buyers of CDS - but with the sellers. Sellers of CDS historically underestimate the likelihood of default, and issued much more insurance than they could cover if things went sour. Regulating exposure of the sellers of CDS is a topic for another post - but one that will be covered amply in the news over the next 12 months, I'm sure.

Comments

[Tom Armistead:]

CDS levels affect the perceived creditworthiness of a company and their cost of funds. Financial companies that rely on credit can literally be put out of business by these perceptions. CDS were widely used in conjunction with naked short-selling in short and distort manipulations to take down financial firms leading up to the meltdown.

Naked CDS are gambling contracts, and contrary to your apparent belief system Wall Street is an inappropriate location for a casino operation.

Lack of insurable interest creates a motive to cause a loss - something that can be done be spreading rumors. The exemption from regulation of CDS was a primary cause of the financial crisis.

The correct "one rule" is a requirement of insurable interest: you have to own the bond in order to buy the insurance.

Nov 09 05:31 AM

[Tack:]

Tom:

Perfectly, accurately stated.

I'd even add an addendum to the "one rule:" that CDS issuance be limited to the amount of the insurable interest. That prevents even a holder of an insurable interest from "overinsuring" the potential loss, thereby creating the same incentive for failure that exists now.


On Nov 09 05:31 AM Tom Armistead wrote:

> CDS levels affect the perceived creditworthiness of a company and
> their cost of funds. Financial companies that rely on credit can
> literally be put out of business by these perceptions. CDS were widely
> used in conjunction with naked short-selling in short and distort
> manipulations to take down financial firms leading up to the meltdown.
>
>
> Naked CDS are gambling contracts, and contrary to your apparent belief
> system Wall Street is an inappropriate location for a casino operation.
>
>
> Lack of insurable interest creates a motive to cause a loss - something
> that can be done be spreading rumors. The exemption from regulation
> of CDS was a primary cause of the financial crisis.
>
> The correct "one rule" is a requirement of insurable interest: you
> have to own the bond in order to buy the insurance.

Nov 09 06:19 AM

[Kid Dynamite:]

Tom - please name one case where what you say has happened.

your views are a common misconception; they just don't reflect reality. although markets are clearly not perfectly efficient, they are efficient ENOUGH that perception does not put companies out of business - REALITY does. a nice example for my claim is what we saw during the panic last year with Buffett's bailouts of GS and GE - at the right price, for a company that has a valid business model, there will be someone who steps in.

similarly, BSC and LEH did not collapse because of either naked short selling or CDS panice. They collapsed because they were insovlent, and the market recognized that.

rising CDS levels in fragile companies are the symptom - not the problem, and banishing CDS would be like abandoning mark to market accounting - hiding the problem doesn't make it go away


On Nov 09 05:31 AM Tom Armistead wrote:

> CDS levels affect the perceived creditworthiness of a company and
> their cost of funds. Financial companies that rely on credit can
> literally be put out of business by these perceptions. CDS were
> widely used in conjunction with naked short-selling in short and
> distort manipulations to take down financial firms leading up to
> the meltdown.
>
> Naked CDS are gambling contracts, and contrary to your apparent belief
> system Wall Street is an inappropriate location for a casino operation.
>
>
> Lack of insurable interest creates a motive to cause a loss - something
> that can be done be spreading rumors. The exemption from regulation
> of CDS was a primary cause of the financial crisis.
>
> The correct "one rule" is a requirement of insurable interest: you
> have to own the bond in order to buy the insurance.

Nov 09 08:33 AM

[Kid Dynamite:]

also, "the exemption from regulation of CDS was a primary cause of the fiinancial crisis" is a partially true statement - but the regulation needs to be on the SELLERS of CDS - not the buyers. the problem, clearly, was that sellers of CDS (like AIG) issued far too much insurance for them to make good on. The problem was not investors buying CDS.

finally, Tom, there are plenty of reasons to buy "naked" CDS that have nothing to do with "gambling" - all of them are related to hedging counterparty exposure. CDS is the best way for one firm to hedge its counterparty exposure to another firm - and that exposure may have nothing to do with owning debt in the second firm.

On Nov 09 05:31 AM Tom Armistead wrote:

> CDS levels affect the perceived creditworthiness of a company and
> their cost of funds. Financial companies that rely on credit can
> literally be put out of business by these perceptions. CDS were
> widely used in conjunction with naked short-selling in short and
> distort manipulations to take down financial firms leading up to
> the meltdown.
>
> Naked CDS are gambling contracts, and contrary to your apparent belief
> system Wall Street is an inappropriate location for a casino operation.
>
>
> Lack of insurable interest creates a motive to cause a loss - something
> that can be done be spreading rumors. The exemption from regulation
> of CDS was a primary cause of the financial crisis.
>
> The correct "one rule" is a requirement of insurable interest: you
> have to own the bond in order to buy the insurance.

Nov 09 08:40 AM

[john s. gordon:]

inappropriate location or not, wall st has been a casino for at least the last 10 yrs.
i remember all the boiler room 'brokers' (it seems anyone with a telephone can call himself a broker) cold calling me on the phone saying jack you gotta buy this dot com that dot com.
i always asked does this turkey have any earnings?
the answer always was earnings don't matter jack.
at which point i hung up the phone.
> jack

Nov 09 08:50 AM

[captainccs:]

>>>Warning: this post will require you to be able to intelligently ponder philosophical concepts and theories, and perhaps try to forget some assumptions you may already have. <<<


Say there are 100 houses worth $1 million each and you expect 1% (one house) to burn down each year. To come out even, you need to collect $10,000 per house per year.

Insure one house twice, collecting an extra $10,000. If that house burns down, you have a loss of $990,000. The solution is to never pay more than the real loss which in this case would be one house, $1 million and not $2 million.

Suppose you insured every house twice thereby eliminating the loss. It would not be insurance, it would be gambling. Insurance is defined as the transfer of risk. If you don't have an insurable interest if you don't have risk to transfer.

Nov 09 09:29 AM

[candooman:]

The basic problem that caused this financial and consequently, our economic disaster is people do not understand risks. When they do understand, their greed overwhelms it - which is the basis for the 'bigger fool theory' - as in Ponzi Schemes and 'bubbles'.

In order to put a check on people's destructive behaviors, sellers of CDS' should be required to have 20% assests backing up all their risks exposures. To prevent buyers of CDS' from gaming the system (and allowing Sellers' collusion), they should be limited on how much CDS' they can buy, say 80% of their bond obligation. This is similar to a homeowner's insurance deductables - a disincentive to bad behavior. All this have to be embedded into law and with heavy penalties (mandatory jail time) for individuals and corporate management who push their employees - directly or indirectly - to violate them. Fining Corporations do not work.

This may sound harsh but look at the millions of people now out of work, having their houses foreclosed, loosing their other assets, etc. And what happened to the perpetuators? Why, they of course were rewarded with big bonuses and salaries..... a big portion of which was subsidized by who else but US, the taxpayers. I am still thinking of how to penalize our lawmakers who created laws to make this all happen. Booting them out of office is too mild a punishment ... and some do not get punished at all --- Gramm, Barney Franks, etc.

Nov 09 09:59 AM

[Kid Dynamite:]

@Captainccs - interesting analogy. I'll give you one quick example of why i hate the "insuring your neighbors home" analogy, and how it transfers to the corporate world:

it would be perfectly reasonable for me to want to protect myself against my neighbor's house burning down, right? if his house burns down and a pile of ashes is left, then it hurts the value of MY home. THUS, it's perfectly reasonable for me to want to buy fire insurance on my neighbor's home even though i don't want to burn it down - maybe the insurance company would give me the magic pill like i imagined, just to make sure i didn't burn it down.

The corporate world has a similar need for CDS that goes beyond "gambling." - the hedging of counterparty exposure - for suppliers, customers, accounts receiveable - there is no reason to prevent corporations from hedging exposure to such counterparty exposure using "naked" CDS (ie, they need not own debt in the underlying company)

it's not always about "gambling"

back to your example - there's nothing theoretically wrong with me, as an insurance company insuring every house twice, or even ten times. PROVIDED that i can make good on the insurance! your analogy is a bit odd, since we're talking about the BUYERS of insurance in this case... In the real world, the buyer cannot take out extra insurance on his house because of the exact perverse incentives i explained in this piece - but in the theoretical world where the homeowner takes the magic "can't burn down my house" pill, there's no reason why he couldn't over-insure


On Nov 09 09:29 AM captainccs wrote:

> >>>Warning: this post will require you to be able to intelligently
> ponder philosophical concepts and theories, and perhaps try to forget
> some assumptions you may already have. <<<
>
>
> Say there are 100 houses worth $1 million each and you expect 1%
> (one house) to burn down each year. To come out even, you need to
> collect $10,000 per house per year.
>
> Insure one house twice, collecting an extra $10,000. If that house
> burns down, you have a loss of $990,000. The solution is to never
> pay more than the real loss which in this case would be one house,
> $1 million and not $2 million.
>
> Suppose you insured every house twice thereby eliminating the loss.
> It would not be insurance, it would be gambling. Insurance is defined
> as the transfer of risk. If you don't have an insurable interest
> if you don't have risk to transfer.

Nov 09 10:22 AM

[Tony Petroski:]

I must confess I'm one of those nutjobs who thinks naked short selling can affect the health of a company. I watched one or two financial companies singled out for a raid in the summer and fall of 2008 with losses on stock value of 30% or more in a day. The raid would continue for a week or two (while the other financial companies had moderate or no losses). Then another company would come into the crosshairs and get shorted into oblivion.

From my nutcase perspective, I assumed it went like this: Hedgefund Joe XYZ would purchase CDS contracts at leverage of 100/1 on Bank A. Hedgefund Joe XYZ had no insurable interest at all, i.e., no debt owned on Bank A. Then Joe XYZ, along with a group of other "sharks" (Joe XYZ would openly brag that he was a shark) would anounce that he's already shorting Bank A because Bank A is insolvent and will be taken over by the government over the weekend. Hedgefund Joe covers his short position when profitable enough, and then when Bank A is declared insolvent, Hedgefund Joe collects on the CDS if the government is willing to bail out AIG.

I realize that Hedgefund Joe and his camp followers can get badly burned if his short position turns against him--I'm not saying Hegefund Joe has no risk. Only that Hedgefund Joe can certainly affect both the stock he's raiding as well as the financial community as a whole if the panic is spread skillfully.

Kid Dynamite is right: There is a legitimate use for a CDS contract. Ban CDS contract purchase with no insurable interest, regulate the CDS sellers like the insurers they are to make certain they have the capital to pay off their contracts, and then ban naked short selling. No wait. Naked short selling has already been banned.

Nov 09 10:46 AM

[Boxed Merlot:]

On Nov 09 05:31 AM Tom Armistead wrote:

> CDS levels affect the perceived creditworthiness of a company and
> their cost of funds. Financial companies that rely on credit can
> literally be put out of business by these perceptions. CDS were widely
> used in conjunction with naked short-selling in short and distort
> manipulations to take down financial firms leading up to the meltdown.
>
>
> Naked CDS are gambling contracts, and contrary to your apparent belief
> system Wall Street is an inappropriate location for a casino operation.
>
>
> Lack of insurable interest creates a motive to cause a loss - something
> that can be done be spreading rumors. The exemption from regulation
> of CDS was a primary cause of the financial crisis.
>
> The correct "one rule" is a requirement of insurable interest: you
> have to own the bond in order to buy the insurance.

The corporate world has a … need for CDS that goes beyond "gambling." - the hedging of counterparty exposure - for suppliers, customers, accounts receivable - there is no reason to prevent corporations from hedging exposure to such counterparty exposure using "naked" CDS (i.e., they need not own debt in the underlying company)

it's not always about "gambling"

back to your example - there's nothing theoretically wrong with me, as an insurance company insuring every house twice, or even ten times. PROVIDED that I can make good on the insurance!
----------------------...
Here again, I can see elements of truth in both these arguments. The problem arises when the owner of casino A places a bet on casino Bs crap table with funds belonging to taxpayer US with the sole purpose of bankrupting casino B when his loaded dice, paid off pit boss and security forces that have infiltrated the game room assure the consequence of the roll will not only prevent loss, but will guarantee B’s demise. The problem is compounded when one realizes casino B was dipping into the same till of taxpayer US to make good his ineptness of protecting his casino.

So I guess you're right, it's not about gambling, it's about gaming the system.

Nov 09 12:32 PM

[Kid Dynamite:]

@boxed merlot - obviously, i completely agree that the taxpayer should not be backstopping any of this. any CDS regulation will have to make sure that sellers of CDS can't get themselves into trouble like AIG did, where they have written insurance they can't possibly cover, and hit the taxpayer for the bill.

Nov 09 01:13 PM

[Tom Armistead:]

Kid,
BSC, LEH, AIG, MBI, ABK, MER, AIG etc. were all brought down or severely damaged by the buy CDS, naked short, and put out the word short and distort crew. Have you every looked at the threshold lists from that point in time? A situation was created where no financial instituion had any access to capital. Finally, the failure of the Federal Government to stop the carnage brought Lehman down and with it very nearly the entire economy and financial system. Panic ensued, everybody started cutting production, canceling orders, firing workers, etc. So we nearly had a Depression because of CDS and you don't see a problem?

Your argument that hedging exposure to counterparty risk shows there is a need for CDS not supported by an insurable interest doesn't hold water, for the simple reason that a counterparty exposure creates a chance of loss due to the insolvency of the counterpary which in turn creates an insurable interest.

To deny the moral hazard created by CDS in the absence of insurable interest is absolutely naive: you clearly do not understand human nature. Arson and murder for profit are a fact of life: that's how people behave; that's why fire and life insurance have requirements of insurable interest.

Obviously, some of the institutions taken down were fragile. However to justify perpetrating the financial equivalent of arson on those firms is similar to reasoning that anybody who lives in a frame dwelling has no reason to complain if someone buys eight insurance policies on his house and then burns it down. The victim of arson is not responsible for his loss becasuse he did not live in a concrete bunker.

For that matter, a person who murders for the life insurance proceeds can't justify himself by saying: "the victim had cancer, he was going to die anyway."

I am not sure why you wish to bring mark to market into a discussion of CDS. What I have observed is that many of the securities that were the issue in mark to market have recovered much of their value. Similarly, many CDS spreads have come back down into contact with reality. But the damage done to the firms involved and to their shareholders has not yet been repaired.

The whole effect of permitting the sale of naked CDS was to give an irresponsible band of financial manipulators access to a huge amount of leverage which they promptly applied to every financial instituion they could finger as a remote possiblity for take-down. Finally we had the Fed guaranteeing the credit of GE and GS, and others, with Warren Buffett putting his money on the line, for huge profits.

That was the high point of the CDS bear raids, when the spread for GE ballooned out and it looked like they were gonig to bring down the big one.

CFMA, carefully engineered as an end run around regulation for the likes of Enron, and the perpetrators of CDS, was one of the most egregious examples of our legislators selling out to financial interests who have destroyed free market capitalism as it had been established following the Depression. One by one the protections created in the wake of that horrible time in the life of this country were taken down, cumulating with CFMA which brought the curse of unregulated CDS down on the country, destroying trillions of dollars of wealth.

To summarize, CDS should be regulated as insurance, with a requirement of insurable interest for the buyer and adequate capital for the seller.

Nov 09 04:11 PM

[Tom Armistead:]

I forgot to mentin that naked CDS is the equivalent of the naked short sale of a bond. Just like naked short selling of equities, it is a tool for manipulation.

Nov 09 04:15 PM

[lower98th:]

Naked short selling can push down the market value of a company's stock, which can impact the ability of the company to get credit, meet obligations, etc. I give you exihibit one - the Fed's desperation to pump up the stock value of the financials to a level where conducting business was possible. Of course hammering company value matters.

So its your house, worth a million. You by insurance, it's prudent. I buy insurance and I broadcast that I think its on a landfill. Tom buys insurance and lets it be known he thinks there is toxic drywall. Now try to sell it, or get it refinanced.

Nov 09 05:59 PM

[Kid Dynamite:]

Tom,

first of all, thanks for taking the time to write an intelligent comment.

every firm you mentioned has something in common - the business decisions they made before the bubble collapsed resulted in them having liabilities in excess of their assets. The depression we averted was not caused by people buying CDS - I'm sure you don't really believe it was - it was caused by investors paying more for assets than they were worth. It was also caused by AIG SELLING nearly limitless amounts of CDS. The post I wrote above was about buyers of CDS - not sellers. The sellers need to be, and will be HEAVILY regulated. I'm not disputing that.

CDS buyers did not sink any of these firms. Really. It's true. Naked short sellers also did not sink any of these firms. Bad assets sunk these firms.

If CDS did not exist, every firm you mentioned would have had the same balance sheet (except AIG, of course, which had sold a metric crap-ton of CDS) - that is exactly my point, and it's why i mentioned mark to market accounting. abandoning MTM hides the reality of bank balance sheets. Abolishing CDS would be like shooting the messenger - not solving the problem, which was that balance sheets were insolvent.

i think your argument is basically that people woke up to the fact that ponzi financing was going to result in a blowup at some point in that list of toxic firms, and that CDS was a tool used to hasten that effect - bravo then. If CDS makes markets more efficient, and makes it so that INSOLVENT firms cannot continue nonviable ponzi schemes, then so be it - that's a good thing - that's how markets are supposed to work.

You note that GE and GS did not collapse - because the market is efficient ENOUGH, which is my point

Nov 09 08:34 PM

[Kid Dynamite:]

also, Tom, I don't entirely disagree with your summary: "To summarize, CDS should be regulated as insurance, with a requirement of insurable interest for the buyer and adequate capital for the seller. " the key is that just because someone doesn't own debt in Company XYZ doesn't mean they don't have an insurable interest - which you acknowledged in your post. The problem is that defining an insurable interest for supply chain components, or even competitors, is a very SUBJECTIVE task - i'd love to hear your opinions on it. In other words, a firm like GS could make the argument that they have an insurable interes in almost ANY company - as a potential client for banking, advisory capital markets business, etc... that's just one example

Nov 09 08:49 PM

[Kid Dynamite:]

@Lower89th: mehhh... I don't agree with your example at all. And it's a great example to prove my point. it doesn't matter how many people buy insurance on my house - the value of my house doesn't change. Now, you can try to make up false rumors about my house all you want, lower98th, but your rumors cannot and will never make my house worthless. At some point, Warren Buffett will come in and realize that you're full of it, and buy my house from me.

That's only because you WERE full of it, though. If my house really WAS on a landfill (MER, LEH, BSC) and my walls really WERE made of toxic waste (AIG, ABK), then buyers would realize that, and my home value would disintegrate. see?


On Nov 09 05:59 PM lower98th wrote:

> Naked short selling can push down the market value of a company's
> stock, which can impact the ability of the company to get credit,
> meet obligations, etc. I give you exihibit one - the Fed's desperation
> to pump up the stock value of the financials to a level where conducting
> business was possible. Of course hammering company value matters.
>
>
> So its your house, worth a million. You by insurance, it's prudent.
> I buy insurance and I broadcast that I think its on a landfill.
> Tom buys insurance and lets it be known he thinks there is toxic
> drywall. Now try to sell it, or get it refinanced.

Nov 09 08:52 PM

[Mike Dillon:]

On Nov 09 08:52 PM Kid Dynamite wrote:
"If my house really WAS on a landfill (MER, LEH, BSC) and my walls really WERE made of toxic waste (AIG, ABK), then buyers would realize that, and my home value would disintegrate. see?"

The problem with THIS argument (unlike the OTHER argument here: www.blogger.com/commen...), KD, is that the buyers wouldn't be any wiser as to the condition of your home as long as the environmental report came back good, the appraisal had been rigged, the assignments of mortgage fraudulently manufactured years after your note was actually lost by the note holder to preserve your chain of title, and the coat of paint was dry on your toxic waste walls during walk through.

If/when they catch on a year or three later, it's too late for them - but YOU'RE free and clear because you were able to liquidate your stealth toxic asset - as long as the buyer doesn't have the financial means to come after you for damages.

So why DO they call it ABX Index "Protection"? And why would mortgage servicers have any need for it?

Nov 10 12:03 AM

[Kid Dynamite:]

@Mike Dillon - that's a nice analogy, but it's the opposite of what we're talking about. we're not talking about companies plugging investors with crappy assets, we're talking about investors using panic destroy companies - which I am claiming is not how it works.


On Nov 10 12:03 AM Mike Dillon wrote:

> On Nov 09 08:52 PM Kid Dynamite wrote:
> "If my house really WAS on a landfill (MER, LEH, BSC) and my walls
> really WERE made of toxic waste (AIG, ABK), then buyers would realize
> that, and my home value would disintegrate. see?"
>
> The problem with THIS argument (unlike the OTHER argument here: www.blogger.com/commen...;postID=37150780999484...
> KD, is that the buyers wouldn't be any wiser as to the condition
> of your home as long as the environmental report came back good,
> the appraisal had been rigged, the assignments of mortgage fraudulently
> manufactured years after your note was actually lost by the note
> holder to preserve your chain of title, and the coat of paint was
> dry on your toxic waste walls during walk through.
>
> If/when they catch on a year or three later, it's too late for them
> - but YOU'RE free and clear because you were able to liquidate your
> stealth toxic asset - as long as the buyer doesn't have the financial
> means to come after you for damages.
>
> So why DO they call it ABX Index "Protection"? And why would mortgage
> servicers have any need for it?

Nov 10 07:26 AM

[Mike Dillon:]

Of course you're not making that claim, KD. But the larger picture is that books can - and oftentimes ARE - cooked, right down to loan level. And as long as the documentation/paperwork APPEARS to be legitimate then everything simply slogs on at it's usual pace.

The larger problem is that the assets that are being bet on with CDS are bogus from the get go and at least SOME of the investors - the ones on the inside - are aware of it. It's not a case of investors trying to create panic to drive market price - at least not with RMBS. It's a case of at least some investors knowing and/or being able to actually CONTROL what happens to the asset from the ground up thereby creating a "sure thing".

That's why you've got industry entities dealing in things like "ABX Index Protection" ... "Ocwen Announces $300M Venture to Acquire Residential MBS Lower Tranches and Mortgage Servicing" newsblaze.com/story/20...

Nov 10 09:11 AM

[Tom Armistead:]

KD, some thoughts on insurable interest. Insurance case law on the subject does not see expectations as a grounds for insurable interest, so the possiblity that GS might expect to do business with someone in the future would not create an insurable interest.

The important thing is that the insurance buyer be exposed to loss caused by default of the reference entity, and that the amount payable in the event of loss place him in the same situation he would have been in if no loss had occurred. A direct debtor/creditor relationship would be ideal, counterparty is potentially a debtor/creditor situation.

It's farily easy to construct hypothetical cases, like an auto parts supplier that had an a/r exposure to GM, if you owned the stock of the supplier you were exposed to credit risk from GM, so on and so forth. I personally would lean toward something more limited.

A very common practice that would be eliminated, and I think rightly so, would be the whole synthetic and credit linked note business. These transactions create excess supply of bonds, sometimes are less costly to assemble than acquiring the actual bonds, and have been used in dishonest ways. My favorite example I found on the Irish market was credit linked notes referencing Icelandic banks, 2 weeks before they blew up. The product is fundamentally dishonest and would be illegal if insurable interest were a requirement.

AIG's problem was that they had to post collateral. MBIA and Ambac generally did not issue CDS where they were required to do this, and they are still around in spite of having written worse business. By posting collateral, AIG placed itself in the position of guaranteeing market value, and created a situation where GS and others were able to profit by making the collateral requirement define the loss. The residue sits in Maiden Lane and is performing well and appreciating in value. The is about defining loss in such as way that the insurance buyer does not profit from loss.

That's what it's about, insurance transfers a pre-existing exposure to risk or loss: gambling creates a possiblity of gain or loss where none existed before the transaction.

Nov 10 09:41 AM

[Kid Dynamite:]

Thanks Tom. I would tend to favor a broader interpretation (than current established case law) of insurable interest when deciding who could buy CDS.

Nov 10 11:13 AM

[Wildhawk:]

Maybe I'm either a tad naive or just ill informed, but how is buying a CDS contract without any insurable interest any different than purchasing a put option on the company's equity without actually owning the equity? No one is seriously going to say we need to ban naked put buying, so why would we ban naked CDS buying? It's simply a way for a third party (whether "interested" or not) to purchase protection on the main elements of the company's capital structure- debt (CDS) and equity (put option). Just as the put option cannot drive a company out of business, neither can a CDS contract.

Nov 10 11:31 PM

[SourcingMan:]

KD is absolutely correct. No naked short seller brought down anyone. LEH is a case in point: they brought down themselves. In fact months before they went down, they knew their balance sheet was going up in smoke. With a leverage of >40:1 and undiversified exposure to the mortgage markets (as well as a massive bet on commercial RE) they had no chance. It took sometime to the market to realize that, but when it did, it brought down LEH with all its force, and large because it needed to go down as it was insolvent. Sorry for the good guys working there but their bosses ignore risk management.

True naked CDS buying selling is a bet on a house about to burn down, and it might increase the bad feelings about it. But the if the house is not rotten the market will correct (see Buffet on GE / GS etc), likely at a discount. But what really brings down the house is the house owner itself.

The rule proposed here are simple and fine. Actually, simple is fine by definition: it’s hard to game it and everybody can understand it.

The big issue is getting the CDS sellers, the insurers under control. Firstly by having themselves collateralizing the obligations they write. Not the buyer, the seller should post collateral. This will strengthen their balance sheet and inherently limit their ability to write ad infinitum CDS. Secondly, and especially if the seller is an Insurance firm, by shifting from a two man and a dog regulator to a serious one. One that can look into their positions and stop the management to take unchecked, unmanaged risks.

Nov 11 05:49 AM

[BoneYard:]

KD, You are spot on. I have been involved in situations where firms long CDS stand to profit from the failure of a firm rather than a successful restructuring (one with a chance of actually working). Although a company hedged with CDS is, essentially indifferent to the outcome. Problem is, how is the position size to be monitored?

I also agree with the use of "naked CDS" positions. The only flaw with this argument is that if firms lean on a company through CDS, it can (and does) affect the cost of debt should they need to raise it. It can also constrain the availability of new credit as higher CDS levels (wider spreads) have a higher implied default rate.

Also not addressed are those firms that buy protection without owning bonds, but having senior claims against the company.

Due to length, I wont even address those firms that use the CDS to create synthetic positions (ever try to short an illiquid corporate???) or those that use them to hedge other parts of the cap structure (preferreds - PCDS notwithstanding or sub debt).

Nov 13 09:42 AM

[BoneYard:]

Unfortunately, if a company relies on credit and it is not extended due to implied default rates of CDS, naked CDS can bring down the house - regardless of worth.


On Nov 11 05:49 AM SourcingMan wrote:

> KD is absolutely correct. No naked short seller brought down anyone.
> LEH is a case in point: they brought down themselves. In fact months
> before they went down, they knew their balance sheet was going up
> in smoke. With a leverage of >40:1 and undiversified exposure to
> the mortgage markets (as well as a massive bet on commercial RE)
> they had no chance. It took sometime to the market to realize that,
> but when it did, it brought down LEH with all its force, and large
> because it needed to go down as it was insolvent. Sorry for the good
> guys working there but their bosses ignore risk management.
>
> True naked CDS buying selling is a bet on a house about to burn down,
> and it might increase the bad feelings about it. But the if the house
> is not rotten the market will correct (see Buffet on GE / GS etc),
> likely at a discount. But what really brings down the house is the
> house owner itself.
>
> The rule proposed here are simple and fine. Actually, simple is fine
> by definition: it’s hard to game it and everybody can understand
> it.
>
> The big issue is getting the CDS sellers, the insurers under control.
> Firstly by having themselves collateralizing the obligations they
> write. Not the buyer, the seller should post collateral. This will
> strengthen their balance sheet and inherently limit their ability
> to write ad infinitum CDS. Secondly, and especially if the seller
> is an Insurance firm, by shifting from a two man and a dog regulator
> to a serious one. One that can look into their positions and stop
> the management to take unchecked, unmanaged risks.

Nov 13 09:44 AM

[a fat panda:]

"Now, here's why it's fallacious logic to apply this reasoning to CDS. If I buy CDS on a company without owning any of the underlying debt, I cannot effect the health of the company."

Rumor has it that you can affect the ability of the company to raise capital. Lowering the ability a company to raise capital in the equity markets does effect the health of the company.

I saw Ackman get on CNBC with a proposal to save the GSEs in which the equity holder would have been completely screwed. The stock opened 25% down. Here it is on SeekingAlpha.

seekingalpha.com/artic...

If the likes have Ackman had to hold the underlying securities to make money on this kind of activity, he wouldn't be so quick to destroy the underlying business.

Nov 19 09:31 PM

[a fat panda:]

Kid, Here is my primary concern with CDSs which aren't tied to an insurable asset. They are betting on failure. We are tying up a considerable amount of capital in this market, which that isn't terrible different than a horse race where people are betting on who will finish last. Is that a race you would watch?

In the same way these things are terrible for the economy when you consider the trapped capital and what it could be doing. Consider that hedge fund which borrows a dollar to fund a CDS is responsible for a dollar lost to the economy to promote a bet on failure. We then see the hedge fund do its best to destroy the company in which it has a bet. All told the economy would be better off if the dollar went to open a bar in a brothel.

Nov 19 09:39 PM