Tuesday, November 25, 2008

CDSes are not regulated

Contrary to the anonymous commenter a couple of posts down who insisted that Credit Default Swaps were regulated because traders responded to Federal Reserve pressure, this Bloomberg story explicitly states that CDSes are not regulated.
Geithner’s skills and limitations as a consensus-builder perhaps show up most clearly, though, in his handling of credit- default swaps, where he played a leading role in trying to make the market safer and more stable.

Trading in credit-default swaps, which were conceived to protect bondholders against default, exploded 100-fold the past decade as investors increasingly used them to speculate on creditworthiness. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should the borrowers fail to adhere to their debt agreements.

Unregulated Market

The big problem Geithner faced in trying to get a handle on the market: It was unregulated, so he lacked authority to make changes on his own and had to depend on his powers of persuasion.

The New York Fed chief began pressing banks in September 2005 to reduce trading backlogs that could prove dangerous should a crisis hit. An average 17 days’ worth of unsigned trades had piled up on dealers’ books, threatening to undermine the market if a wave of defaults hit. A lax system for unwinding and reassigning trades left dealers at times unsure of who was on the other side of their trade.

It took dealers a while to respond. A year later, they had cut the backlog of unsigned trades by 70 percent and doubled the number of deals that were electronically processed.

“It was like herding cats,” said Brad Bailey, director of business development at Jersey City, New Jersey-based brokerage Knight Capital Group and a former derivatives trader, who praised Geithner for making the effort and getting results.


Anonymous said...

While I readily agree that the CDS market is under regulated, it seems that you do not realize the importance of a regulator's “persuasion”. This tool extends a regulator’s power to address a very wide range of issues that they would like to address. For example,


The Treasury had ZERO regulatory authority to require banks to accept the Treasury’s investment. However, they all accepted in little over an hour based simply on the regulator’s “persuasion”. It would appear that a regulator persuading is a little different than the normal persuasion.

Perhaps more interesting than a discussion of the semantics of “under regulated” and “unregulated”… is your contention that the HIGHLY REGULATED mortgage market is merely a fraction of our problem as the CDS market is much larger.


While language can be open to interpretation, math is generally not. The argument that mortgages are a fraction of the problem is only valid if you have the same unit of measurement in the numerator (the value of mortgages) and the denominator (the value of CDS). However, your argument uses different units of measure… as your measure of CDS (notional value) is grossly inflated. The value of mortgages is not a fraction of the value of CDS. It is a huge multiple.

I know that passing the responsibility of our current mess to a mysterious CDS market might make people more comfortable. It is much easier for us to blame the CDS market than it is to blame ourselves. Blame ourselves, our neighbors and our mortgage bankers? The problem could not be that we were overly greedly. That we bought more of a house than we could afford. That 1 out of 5 homeowners owe more of their house than it is worth. It could not be the fault of our mortgage banker for believing the myth that housing prices always go up. “Sure they can’t afford it but if I lend them the money and they don’t pay me back, I can just seize the house, sell it and fully recover what I lent”. No, no. You are right. The problem isn’t that at all. The problem isn’t that people that are not paying their mortgage are also not paying their auto loans and their credit cards. The problem must be some mysterious CDS market. Let’s all pretend that this market which didn’t exist 10 years ago is somehow worth more than the GDP of the entire planet. I know that this makes no sense whatsoever but then at least we are not forced to confront our role in this crisis. Let’s believe the liberals who claim that this crisis would have been stopped with increased regulation of the CDS market. Or let’s believe the conservatives who claim that the crisis would not have occurred if the government wasn’t supporting homeownership through Freddie and Fannie. Just give me any excuse you can find to keep me from blaming myself, my neighbors and my friendly local banker.

Arun said...

Sorry, a regulation is a law, with a penalty for not obeying. Treasury's persuasion is not regulation.

The math is also clear. Subprime mortgates are a tiny fraction of the eleven trillion dollar mortgage market. They should not have the power to bring down large financial institutions, unless they were highly leveraged.

Finally, what you're saying is that if someone is handing out cash on the street, I ought not to take it. That is rubbish. The onus is on that someone.

You will find very few cases of people applying for mortgages having lied on their applications or having faked their credit scores. It is the folks responsible for making the loans who chose to ignore this.

In the past few days, the NYT has published articles on just how Citibank and Lehman Brothers were run; how the ratings agencies were irresponsible and so on. Sorry, your credibility and that of your industry (I assume you work there) is zero. Which is why the Fed has to bail you out, no private party with funds will risk it. Incompetents and crooks!

Anonymous said...

First, I don’t recall every stating that someone was “handing out cash on the street”. My apologies if I did. (1/3 of new home owners owe more on their house than it is worth. http://www.bloomberg.com/apps/news?pid=20601087&sid=a3uzhDOF9FXI&refer=worldwide I wonder if those millions and millions of people feel someone was “handing out cash on the street”.)

Second, I would agree that the sub prime market is only a portion of the mortgage problem and so called liar loans are an even smaller portion. Neither of these cover anywhere near 1/3 (and counting) of all homes purchased in the last 5 years. The mortgage problem is not restricted to these two relatively small aspects.

Third, I completely agree that banks were overlevered; however, you should not ignore the massive leveraging by consumers that took place. Lehman Brothers wasn’t the only one that borrowed too much money. There are millions of people (that seem blameless to you) that also borrowed money (not given free money) and now have to repay it. If you owe more on your house than it is worth (and you owe money on credit cards and a car loan), you are unlikely to make significant purchases. Consumer purchase expectations are the lowest ever recorded.
Given the importance of consumer spending in the economy, I humbly suggest that 1/3 of people owing more on their house than it is worth may impact the economy.

Fourth, I am not an apologist for the banks, the investors, the regulators or the rating agencies and have not been bailed out by anyone. I simply do not fall into the camp that suggests our crisis was caused by sub-prime mortgages or the camp (which it appears that you are in) which claims it was caused by the CDS market. It seems to me that both are driven more by political agendas than facts.

Finally, to go back to your math reference. Put in your nominator not just the sub-prime mortgage market and so called “liar loans” but all problematic mortgages (e.g. 1/3 and growing of all made in the last 5 years). Do you still think mortgages are not a problem? Now add to your nominator other problematic consumer debt (e.g. car loans that are in excess of the value of the car, credit card debt, etc…). Do you still believe that the problem is restricted to over levered banks involved in CDS?