On Banning CDS: Sovereign Debt Isn't the Biggest Problem; Try Looking Closer to Home

by: Bruce Krasting
A lot has been written and said in the past few weeks about CDS. Almost all of it has been bad press for the poor boys who write and trade this stuff for a living. Heads of State, leading academicians and economists, the MSM and even some of the financial blogs have all been pounding the table on this issue. The message has been pretty clear. “Something has to get done, or we are really really going to blow up next time.”

The catalyst for the recent uproar has been Greece and to a lesser extent the other PIIGS. The perception has been created that somehow the existence of a CDS market for Greek Government Bonds has caused a crisis. Nothing could be farther from the truth. We now know that CDS had very little to do with the yield spike in GGBs. It was the movement by the low rent bond traders (aka global investors) that caused this hiccup. Greek CDS was the tail that got wagged. Not the other way around. But the vitriol continued. Wolfgang Munchau wrote on this topic last week. The following quote summed up his thinking:

“The case for banning CDS is about as strong for banning bank robberies.”

Some of the arguments against CDS include:
  1. They are unregulated.
  2. They create the opportunity for excessive leverage.
  3. They are used for and encourage speculation.
  4. They may be written by under-capitalized firms. Depending on the outcome this could create an excessive financial risk for the writer and thereafter cause a systemic risk. (The AIG story.)
  5. They can, by their very existence, precipitate or fuel a financial crisis.

CDS is functionally an insurance policy one can buy to protect against default of payments from a borrower. While it is different in a number of respects from payment default insurance, it really is the same thing. If you accept that CDS = MI then you have to look at what is happening in that market. Mortgage CDS is the big casino; Greece and all the others are just a sideshow by comparison.

First consider the private sector side of this. The mortgage insurance industry (MI) is represented by an outfit called MICA. The current and recent members of this group include:

S&P updated its views on the MI providers in November 2009. Does this sound like a group that is adequately capitalized? Their comments:

• The mortgage insurance industry continues to face significant challenges during 2009, to the extent that many mortgage insurers have reported losses exceeding our expectations.
• We believe that the macroeconomic environment may be having an
increasingly negative impact on the prime mortgage insurance books,
suggesting an elongation of the loss cycle beyond our prior expectations.
As a result, we are placing the ratings for several mortgage insurance
companies on CreditWatch with negative implications.

As of February 2010 this group had mortgage insurance in force totaling $850 billion. Anyone who recognizes these names and understands these ratings knows that this group is under-capitalized. The number of insolvencies of these firms and their failure to make timely payments under their insurance obligations has already strained the mortgage market. This group clearly represents a systemic risk to the system.

As insurance providers these companies are supposed to be regulated. But they functionally are not. The fact that a number of them continue to exist and write new policies ((NYSE:AIG)) proves that there is no useful regulation.

MI insurance allows a borrower to acquire a home with no or very little skin in the game. We have learned that this is bad business and leads to defaults. The D.C. mortgage agencies have learned this lesson the hard way. They have been suffering defaults on their book of “enhanced” loans at multiples of the rate of conventional mortgages.

In the heyday of mortgage silliness the MI companies were insuring up to 105% of the purchase price of a home or condo. This never should have been allowed to happen. It clearly encouraged speculation and there is no doubt that excessive leverage was the intended result.

In my opinion the MI industry has all of the negative characteristics (I-V) that the detractors of CDS point to.

The private sector side of the MI business is a joke. But it is small beer compared to what the D.C. lenders have been doing and continue to do. As of the most recent reports, Washington has the following mortgage CDS outstanding:

These numbers speak for themselves. That 50% of all mortgages outstanding are guaranteed as to their performance by the central government is the definition of a systemic problem. No one has any skin in this house of cards.

The D.C. mortgage players are regulated, but by whom? The Federal Housing Finance Agency (FHFA). The FHFA and its predecessor the Office of Federal Housing Oversight (OFHEO) have never regulated the agencies properly. The proof of that is staring us in the face. The absence of proper oversight will cost the American taxpayers at least $500 billion dollars before this mess is over. FHA will have its hand out for a federal bailout by year end.

None of the mortgage agencies have adequate capital for this type of underwriting risk. The joke is that they have no capital at all. The equity necessary to absorb the losses comes from the taxpayer. We are writing a check to cover that shortfall every quarter. That check averages $10 billion dollars a month. And every month the agencies write more CDS contracts. Nothing has changed.

The agencies have already proven that they constitute a systemic risk. They helped create the mess in we are in today. They encouraged speculation in the housing market. They have created the excessive leverage that has caused the economy to shudder. If in the next few years we find that the recovery does not hold and we slip into a protracted period of recession it will be the mortgage agencies that will be the albatross that brings us down.

The D.C. mortgage players clearly have all of the negative characteristics (1-5, above) that those opposed to CDS are worried about.

It is all well and good for the press, our political leaders and many deep thinkers to throw stones at the CDS market; no doubt some of these stones are well intended and justified. But for me it is misdirected. How can someone throw these stones while there is a $ 6.5 trillion CDS market right here in the US and it is sanctioned and encouraged by everyone one who has a say in the matter?

The reason is simple. Expedience and survival are at stake. If we woke up on Monday and there were new rules that eliminated the MI and federally sponsored guaranties on individual mortgages we would be in a depression by the end of May. Our system would simply freeze up and die if that would happen.

To a much lesser extent the same is true in the global debit insurance business or CDS market. If that were taken out of the equation it would have significant global deflationary impacts. Those that are taking up the mantle against CDS should address their concerns to where the truly big numbers lie. They also need to understand that the direction they are headed will lead us to that horrible sucking noise of deflation that everyone seems so desperate to avoid.