Sunday, November 16, 2008

On Credit Default Swaps

Borrowers who took out subprime mortgages are **NOT** the cause of the current financial mess. It bears repeating, because so much propaganda to the contrary is out there.

Devilstower, on dailykos endeavors to explain
.
Subprime mortgages (and all mortgages, really) are a fraction of the current problem. The bailout would have been enough to buy out every subprime mortgage in foreclosure across the country. In fact, it was enough to do that several times over. So why not do that?

The reason is that the purpose of the bailout (at least as Treasury Secretary Paulson sees it) isn't to stop mortgage foreclosures, but to save the banks. And the banks have some self-inflicted problems that make those mortgages an afterthought.

For example, the wonderful credit default swap. In essence, credit default swaps are (or were) nothing but insurance policies for loans. And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.

How is that possible? Come with me back to the primitive world of 1999, when SUVs ruled the roads and cell phones did not yet shoot video, and let's see how this clumsy bit of fiscal jargon conquered the planet.


and a bit later:

Stage 4 (Fatum casus)
I have a swap. I really, really want someone to take my swap. Only even with every incentive I can offer, not enough people are loaning. Sure, there's a record amount of hypothetical money sloshing around the system thanks to me and my swaps, but it's still not enough. So what can I...

Wait a second. Swaps are unregulated. No one says I have to have enough resources to cover the swap, and even better, no one says I have to offer the swap to the person who actually made the loan! Hey buddy, see that loan over there? You may think it's iffy, but I think it'll hold up. In fact, I'm so sure it will, I'll sell you a credit default swap on it that pays off if it fails. You don't make the loan, you don't have to pay off on the loan, you don't have anything to do with the loan. You just pay me the fee. And if that guy loses his money, you collect. How sweet is that!

This mutation is enormous (see how the genera changed up there?). At this point, credit default swaps have become completely divorced from the original function. A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.

16 comments:

Anonymous said...

Article filled with inaccuracies!

The author has misstated the size of the CDS market, you have made false claims about the assets of the participants, and you have falsely claimed that the market lacks any regulation. I apologize if the explanation of how this article is inaccurate is too technical; however, I felt it was important to support my claims of inaccuracies with supporting evidence.
Size of the Market:
Fact 1: Contrary to many reports, the CDS market is much smaller than the bond market and nowhere near $70 trillion. The CDS market related to mortgages is even smaller.
The author stated “And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.”
Evidence 1: The $70 trillion that you are quoting the gross size of the amount insured of the global CDS market. The net amount is much, much smaller and the value of that net amount is a fraction of that. The net amount of CDS is much lower because the same investor both buys and sells CDS. Under pressure from the Fed (note: a regulator), over $25 trillion of needless CDS trades have been torn up in the last several months without a penny change in the actual value (www.isda.org).
Evidence 2: When there is a default, up 95% of CDS contracts cancel each other out. Why? Every 3 months, the CDS changes the standard maturity that is traded. Currently, the liquid CDS contacts that are traded will expire on December 20, 2013. On December 21st of this year, the CDS market will trade contracts that expire March 20, 2014. If you bought insurance the expires December 20, 2013 and sold an equal amount of insurance that expires on March 20, 2014, you have two very different instruments that you do not cancel each other out today as a default could occur after December 20, 2013 but before March 20, 2014. If there is a default, the only question is “Do you have valid insurance?”. It doesn’t matter if you insurance expires the next day or 100 years later. If there is a default before December 20, 2013, the CDS in our example completely cancel each other out. Pre-default you can only cancel out CDS with the same maturity date (e.g. the $25 trillion reference above.)
Evidence 3: The amount covered by a CDS contract is nowhere near its value. If you buy $100,000 in insurance on your home, the insurance policy isn’t worth anything near $100,000. Its value is close to zero as the premiums that you pay for the insurance is roughly equal to the value of the protection (plus some incentive for the insurance company). By comparing the gross amount of what is insured in the CDS market (which is nowhere where near the value) to the GDP of the planet, the author is comparing apples to oranges. One is value. The other is not.
Evidence 4: The amount of money lost (and gained) in CDS is a very small fraction of the amount lost on bonds. The amount lost (and gained) on Lehman CDS ($5.2 billion) was less than 1/20th of the amount of CDS lost on Lehman Brother bonds (www.dtcc.com). At the insistence of the Fed (note: a regulator), a central database was set up at DTCC to administer the cash payments in CDS. The amount of CDS on the top 1,000 entities is available free to the public at www.dtcc.com. You can compare for yourself the amount of net CDS to the bonds of the companies.
Evidence 5: You will notice on the DTCC website the significant amount of CDS that is not related to mortgages (e.g. State of Italy, General Motors). Most CDS has nothing to do with the mortgage market. If the author is going to reference to overall gross amount of the CDS market in an article related to mortgages, they should at least note that only a very small fraction of that amount is related to the mortgage market.

Fact 2: You do need assets to be in the CDS market.
The author claims that “You don't have to have any assets to issue a swap. The investment bank of First Me and The Change I Found In the Couch Cushions can offer swaps for all the debt at Morgan Stanley, and that's okay.”
There are zero retail investors investing in the CDS market. By suggesting that anyone can buy and sell CDS, the author is doing a major disservice to their readers. The market is entirely an institutional market.
While there may be a concern that your CDS counterparty does not have enough assets to cover their obligations when they are due (e.g. AIG), that does not mean that they did not have any assets when the contracts that were first made. If the assets that your counterparty has when you initially make the trade are mortgages back by subprime mortgages, you may have a problem. The problem with counterparty risk is precisely why central clearing agencies are being set up (at the demand of regulators). The central counterparty in CDS will not make bets in risky assets like subprime mortgages. It will simply offset risks… and demand collateral. The concerns with the ability of participants to honor their obligations are legitimate; however, the contention that no assets are needed to participate in the CDS market is completely inaccurately. It is time the CDS discussion had reasonable and informed voices.
Fact 3: Swaps are not unregulated
While most would agree that the CDS market needs additional regulation, regulators that claim it is unregulated are trying to expand their regulatory authority at the expense of other regulators. (How many comments do you see from the Fed and from the Treasury that the CDS market is unregulated?) While the CDS market may not be covered by state gambling laws, that does not mean that it completely lacks regulation. To claim it is unregulated does disservice to some regulators but (more importantly) masks the problem. Regulation doesn’t keep investors from making bad investment decisions. When additional regulation comes, the ability for AIG (or the likes of Lehman Brothers or Bear Stearns) to make poor investment decisions will not disappear.
Fact 4: CDS is no more gambling than buying a bond or stock is gambling.
The author claims “A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.”
Anyone that thinks investing in CDS is gambling must think that investing in bonds is gambling. Selling CDS on General Motors is in many respects the same as buying a General Motors bond.
You buy the bond to make a return. You sell the CDS to make a return.
If GM defaults, you can loose the same amount in the bond as you did in selling the CDS.
While more regulation is needed in the CDS market, it seems that those that claim there is a problem with selling insurance on an asset that you don’t own are people that haven’t considered why people invest.
Unlike a house or a car, you don’t buy a bond or stock to use it. You buy it for the return for a given amount of risk. If you can do that in a more efficient way (e.g. CDS), you do.
You may lose money but that is a reflection more of your investment decisions that the tool itself.
When all the investors that bought General Motors bonds/stocks loose when GM defaults, will we call for a ban on bonds and stocks?

Arun said...

Let's go point by point.

1. The size of the CDS market

"The CDS market exploded over the past decade to more than $45 trillion in mid-2007, according to the International Swaps and Derivatives Association. This is roughly twice the size of the U.S. stock market (which is valued at about $22 trillion and falling) and far exceeds the $7.1 trillion mortgage market and $4.4 trillion U.S. treasuries market, notes Harvey Miller, senior partner at Weil, Gotshal & Manges."

Source of the above

"According to Bill Gross, a fixed income market guru, the size of the credit default swap market is "$43 trillion, more that half the size of the entire asset base of the global banking system." If that is not scary enough he goes on to tell is that "total derivatives amount to over $500 trillion, many of them finding their way"......................well, everywhere."

Source of the above

"The market for these securities is enormous. Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — roughly twice the size of the entire United States stock market.

No one knows how troubled the credit swaps market is, because, like the now-distressed market for subprime mortgage securities, it is unregulated."

Source of the above

So maybe off by a factor of two.

Arun said...

I assume you are talking about this ISDA press release

1. I don't see the hand of any regulatory agency here.

2. "According to ISDA's semi-annual survey to mid-year 2008, the notional amount outstanding of credit default swaps (CDS) decreased by 12 percent in the first six months of the year to $54.6 trillion from $62.2 trillion. For the same period, Trioptima reported $17.4 trillion in completed CDS tear-ups. Subsequent notional reductions would bring CDS notional outstandings to $46.95 trillion before accounting for new trades since July 1, 2008.

The notional principal, or notional amount, of a derivative contract is a hypothetical underlying quantity upon which interest rate or other payment obligations are calculated. Notional amounts are an approximate measure of derivatives activity and reflect the size of the field of existing transactions. For CDS this represents the face value of bonds and loans on which participants have written protection. "

This notional value - the face value of what is insured - is what I understood to be the $70 trillion.

And it is irrelevant that a lot of it has nothing to do with mortgages. The reason being that if an institution is highly leveraged, its mortgage related portfolio will be enough to drive it to default. Take AIG for instance, which was healthy in all other parts of its business.

Arun said...

Evidence 2 doesn't make any sense to me.

I'm not sure what you're trying to say in evidence 3. If I insure my house for $100,000 then I may make a claim upto $100,000, and the insurer may have to pay.

Depending on the CDS, it doesn't matter if the defaulter is able to pony up 99% of the amount. It is still a default. Just like the poor subprime borrower cannot restructure his loan I expect it is pretty much the same, the insurer has to pay out.

Arun said...

Even though CDS is entirely an institutional market, the institution did not need assets to insure credit defaults as opposed to insurers of autos, houses, etc., which need to have assets to back insurance. Being an institution does not equate to having assets. So I fail to see the point.

Anonymous said...

Arun,
All of your references of the “size” of the CDS market compare something that is not value to something that is value. The comparisons are about as valid as comparing the count of grains of sands to the count of dollar value of the stock market. If you would like more inaccurate comparisons, you do not have to stop with the ones you mentioned. 60 Minutes claimed (inaccurately) that the CDS market was “worth” $60 trillion.
Why does notional value not equal value? You can instantly create a $100 trillion notional market. I can bet you $100 trillion notional value that the sub will rise in the east. If I am wrong, I agree to pay you 1/100 trillionth of the notional value… or $1. While the example is by purpose extreme, it demonstrates that notional value is not value. We can instantly make a market that has a “size” greater than the US economy… and a maximum value of $1. Notional value is simply part of the formula that determines cash flows. Notional value is not value and it never has been.
In terms of Evidence 2, I understand the point is a bit technical. Imagine that you bought $100k of 4 year insurance on your house and sold $100k of 5 year insurance. In this example, the market notional size is $200k. If your house burns down in 4.5 years, you have a real problem as your 4 year insurance (that you bought) has expired but the 5 year insurance (that you sold) has not. If your house burns down today, the market net notional size is $0, Why? The $100k insurance that you bought completely offsets the $100k insurance that you sold.
In the CDS market, the same people that buy insurance also sell insurance. After a default, the vast majority of these contracts cancel each other out.
In terms of Evidence 3, I agree that you may make a future claim up to the amount insured. However, the fact that you may make a claim at some point in the future does not mean that today’s value is equal to your potential future claim. In our example, the value of $100k insurance policy is $100k only if the house was completely destroyed today.

Regarding your statement…“I don't see the hand of any regulatory agency here.”
http://marketpipeline.blogspot.com/2008/07/credit-default-swap-tear-ups-may-shrink.html
In terms of a central CDS counterparty
http://www.bloomberg.com/apps/news?pid=20601009&refer=bond&sid=aGFOJDk3S2rg
Search for CDS and letters to the Fed. You will see several letters to the Fed with specific commitments by CDS market participants.

Regarding your statement…“Depending on the CDS, it doesn't matter if the defaulter is able to pony up 99% of the amount. It is still a default. Just like the poor subprime borrower cannot restructure his loan I expect it is pretty much the same, the insurer has to pay out.” I did not follow. Can you explain?

Regarding your statement…“Even though CDS is entirely an institutional market, the institution did not need assets to insure credit defaults as opposed to insurers of autos, houses, etc., which need to have assets to back insurance. Being an institution does not equate to having assets. So I fail to see the point.” People don’t buy insurance on their house from an insurance company with no assets. Banks don’t buy insurance on bonds from companies with no assets.

Arun said...

Let's get this straight - you're saying that when say Merrill Lynch wrote a CDS covering bonds worth $1 billion, the amount it agreed to pay in case of default by the bond issuer might have been much smaller, say 10% of the notional value?

If I insured my $1 million house for $100K, then only in the la-la land of derivative securities would the transaction be labelled by its notional value of $1 million seems to be what you're claiming. Every sane person would say that is insurance of $100K, not insurance of $1 million; yet in the CDS world you claim that this would be counted as a $1 million transaction.

This is an extraordinary claim. Maybe this is one of the roots of the problems with CDS, if you are correct. But I'm yet to be convinced that you are correct.

Anonymous said...

“Let's get this straight - you're saying that when say Merrill Lynch wrote a CDS covering bonds worth $1 billion, the amount it agreed to pay in case of default by the bond issuer might have been much smaller, say 10% of the notional value?”

I am saying that if Merrill Lynch has $1 billion notional value in CDS on General Motors, it is highly unlikely that they have purely bought $1 billion notional value or purely sold $1 billion in notional value of CDS on General Motors. What is likely is that they have both bought and sold CDS on General Motors and that the total notional value of all of these positions is $1 billion. For example, it is far more likely that they have bought $550 million notional in CDS on General Motors and sold $450 million notional in CDS. While the total notional amount of all of their CDS contracts is $1 billion, the net amount is Merrill Lynch has bought $100 million notional value in CDS on General Motors (with a value less than $100 million even with General Motors appearing to be on the verge of default).
Why is there $1 billion of notional value CDS for General Motors on the books of Merrill Lynch if there net exposure is only $100 million notional value? There are two reasons for this. 1.) Merrill Lynch in this example has not aggressively worked with its trading partners to cancel unnecessary trades. More recently there has been focus on this and that is why $25 trillion of notional value in CDS has been torn up with zero impact on value. 2.) Trades can only cancel each other out if they have the same maturity date. Buying 4 year protection and selling 5 year protection is not that same. They will not cancel each other out… unless there is a default before the 4 year insurance expires. For example, if there is a default today, both the 4 year contract and the 5 year contract are valid and cancel each other out. Why? At the time you get in a car wreck, the only question is if you have valid insurance on the date that you got in the wreck. It does not matter if the insurance expires a day later or 10 years later.
You don’t have to take my word for it.
http://www.dtcc.com/news/press/releases/2008/dtcc_processes_lehman_cds.php
As stated in the press release, there was $72 billion in notional value of Lehman Brothers CDS outstanding at the time of default. The payout to the buyers of Lehman Brothers CDS was 91.375 cents for every dollar of notional value in Lehman CDS. This can be found at http://www.creditfixings.com/information/affiliations/fixings/auctions/current.html
. (100- the auction Final Price of 8.625). If you did not account for the netting of offsetting positions (i.e. the same investor that has both bought and sold CDS) then you would have assumed that the amount lost (and gained) in Lehman CDS was $65.8 billion (or $72 billion multiplied by 91.375%), However, the amount lost (and gained) in Lehman CDS was $5.2 billion (in the same press release). How is this possible? Because the vast majority of the CDS contracts cancelled each other out.

“This is an extraordinary claim. Maybe this is one of the roots of the problems with CDS, if you are correct. But I'm yet to be convinced that you are correct.”
All I can do is provide supporting evidence to my argument. It is up to you to decide what you should believe.

I posted my original comment on Daily Kos and look forward to any debunk that has actual supporting evidence.

Arun said...

Sorry, I don't believe a word of what you write.
http://arunsmusings.blogspot.com/2008/11/cdses-are-not-regulated.html

Anonymous said...

Then you choose to believe those that have no evidence to support their claims.
I will let you go your merry, uninformed way.

Arun said...

Your so-called evidence does not stand up to examination.

Anonymous said...

Really?
Where is your evidence that the CDS market is worth "$70 trillion dollars, which puts it above the gross domestic product of the entire planet"? Or (as no such evidence exists) are you ready to admit that the value of CDS is nowhere near the GDP of the planet and never has been?
It seems unlikely that you would as your false claim that the CDS market is worth $70 trillion is the very cornerstone of your argument. Take it away and your argument crumbles to dust.
I will take any credible source whatsoever that the CDS market is worth $70 trillion. I eagerly await your producing someone of standing that will claim a few thousand people actually created something worth more than the GDP of the Earth. (Also, it is impossible for someone to both be on Earth and also to create more value than everyone on Earth… as they would be included in the “everyone on Earth”. As such, please identify the planetary location of these CDS individuals that out produced everyone on Earth).

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