Those that are looking for a ban on CDS should consider where this takes us. The mother of all CDS providers in the US is the FDIC. Throwing stones at the evolving CDS market should be done with an eye to where the stones might fall.
The FDIC does not provide much detail on its current status. The last annual report was from 2008. From this we get the Insured Deposit number on 12/31/2008 of $4.5T. I don’t have a more recent number but I think the 4.5t is still a reasonable estimate +/-5%.
In November of 2009 the FDIC finalized a $45 billion three-year prepayment of insurance premiums. Here's the link to the FDIC for the details.
Put this together and you get an estimate on the pricing of the FDIC insurance. $4.5T divided by $45b equals 1%. Divide again by three and you have 33 Basis Points a year.
Now consider this slide on the recent pricing for CDS on BoA (click to enlarge). Note that the price to insure $10mm of Senior bonds is $116,000 (~1-1/8% per year) payable each year for the five years.
- A comparison of BoA’s CDS pricing to the FDIC average pricing produces a similar result. Yes the CDS are triple in price but there is justification for that differential. One insures deposits, the other insures so called senior debt. But in actuality the depositor’s rights are more senior (less risk). Also, the FDIC insurance is plain vanilla and limited to a maximum of 100k, while the CDS market will handle many multiples of that and provide maturity flexibility. And finally, the FDIC is not trying to make a profit. Wall Street makes nothing but profits. The difference between .33 and 1.16 is not so significant, the variance is justified.
- The FDIC does not charge a flat fee to all of the member banks. They have a rating system called CAMELS that is used in establishing an individual bank’s costs. The CDS market does the same thing. Costs for protection vary from institution to institution based on perceived or measurable risk.
- Both FDIC and CDS have annual up front costs and future pay as you go costs. Those that get the protection pay for it. In the case of the banks, they pass this onto the depositor/customer. Those that seek to protect some downside (or those who merely want to make a ‘bet’) using CDS pay the price for protection.
- If a bank defaults the FDIC pays the depositors 100% but gets the loan portfolio to offset some of the losses. The writer of CDS absorbs the losses up to the remaining value of the collateral. The settlements have similar features.
- There is no true public market or opaque disclosure on either the FDIC pricing or CDS. It would not be practical (if not impossible) to change this in any meaningful way without undermining the utility and functionality of these roles.
- Buyers of naked CDS are attempting to make a buck. Every Wall Street house has a brokered CD business. They sell $99,000 FDIC insured high yield CDs to their customers. They are gaming the system, there are big numbers involved. Everyone is out to make a buck.
- On the business of making a buck let me point out that there have to be risk takers in any functioning private market. Stocks, bonds, commodities, you name it. If you take out the risk capital these markets will not perform in a way that we need them to. Same is true for CDS. Markets create capital and share risks. Putting a plug in that process will end badly.
- An argument has been put forward that CDS creates excessive leverage that could collapse the writer and thereby trigger a systemic risk. The position is that there is not sufficient capital supporting this growth of CDS. A valid argument given that AIG is still staring at us. This may well be a fatal flaw of the CDS writers. But it is worth looking at how solid the FDIC is.
The answer is that the FDIC is as good a credit as the US Treasury. They both have full faith and credit guarantees from our Uncle Sam. They have about $40b of cash left from the “Prepay” and they have an unused, but immediately available, no strings attached, line of credit from the Federal Financing Bank (Treasury) for up to $500 billion. So it would appear that there is no comparison to the private sector providers of CDS.
Today the FDIC has no equity. They ran down their rainy day fund of $55 billion last fall. They functionally borrowed equity through the prepay. But at the end of the three-year period it is unlikely that they will have replenished any of their reserves. The FDIC is very solvent, but at the same time it is broke.
We will resolve the TBTF issue. And soon thereafter a former TBTF will fail and it will fall to the FDIC to save the system. With no money in the till they could not withstand a “Top 20” bank failure, so they would draw on Treasury to make good on their promises, but the taxpayer would once again be stuck with the tab.
The wart that both CDS and FDIC share is that there may not be enough behind them if things go upside down again. The FDIC is striving to replenish its reserve to 1.2% of deposits (from zero). That comes to ~$60billion. It will take them years to get that, and they will be lucky if they do. But even that much money is not so big anymore. Any of the current TBTFs would take out that reserve and then some. The equity behind private label CDS is equal to that percentage up front. It grows every year. For me the systemic risk that will take our breath away comes from a failure/bailout of the FDIC. Not the blow up of a top ten bank from a bad CDS book.
Without the FDIC our banks would implode. With them would go a good number of foreign financials. So the FDIC is central to the system. Without them we go “poof”. But we need to understand that their business model is pure CDS. And it is 100% leveraged. Dump this at our risk.