CDS Demonization
| Thu Nov. 6, 2008 9:19 AM PST
CDS DEMONIZATION....Are credit default swaps a major villain in the global banking meltdown? Felix Salmon, responding to a piece by Nathaniel Baker, says no:
How do we know this? Well, just look at the magnitude of the exposures that Baker is talking about. Back in January, Bernstein Research analysts totted them up, and came to the conclusion that Lehman's unsecured exposure to triple-A counterparties in general — not just the monolines — was $4 billion: large, but certainly not large enough to bring down a bank with a balance sheet of over $600 billion. Bear Stearns's exposure was smaller still, just $330 million. What fraction of that exposure eventually turned up on the banks' income statements as a mark-to-market loss? That I don't know, but it's not necessarily very large: remember that AIG's troubles only really snowballed after Lehman and Bear had gone under — and AIG was by far the largest triple-A writer of CDS.
Salmon thinks the "CDS demonization meme" is dangerous, but I'm a little confused on this score. It's a little hard to get a handle on an exact figure, but within the U.S. banking system total losses on subprime mortgages themselves probably total around half a trillion dollars. That's a helluva lot of money, but it's nowhere near enough to crash the system. That can only happen if the losses are magnified several times over via derivative losses.
Now, Salmon's point is that the CDS market is only a small portion of the total OTC derivative market. And that's a fair point. But in a previous piece, Salmon wrote this:
I had lunch yesterday with Shane Akeroyd of Markit, and he had a more sophisticated take on what we're seeing. The problem isn't CDS specifically or even derivatives in general, he said: the problem is that the world had an enormous amount of leverage, and all that leverage is now being unwound at once. Do CDS make it easier to firms to lever up? Yes — but if CDS hadn't been around, some other instrument would have been found which had the same effect.
Well — OK. Maybe bankers would have found some other way to lever up. But in the event, Akeroyd is saying, they used CDS. So why then is it unfair to say that CDS exposure was a huge driver of the financial meltdown?
Salmon's larger crusade is to defend derivatives in general, and CDS in particular, as useful devices when they aren't abused, but it's not clear to me that this is especially controversial. The question is, how should they be regulated in the future to ensure that they aren't abused? I agree that leverage itself should be the primary target of regulatory reform, but surely, under the circumstances, some reasonably strict trading rules on derivatives of all kinds will end up being part of that. Leverage is a hard thing to get at directly, after all, and we're going to need to attack it from a variety of directions. A bit of CDS demonization might not be a bad place to start from.
UPDATE: More here, including a response from Salmon.
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Comments
Certainly huge leverage was the main issue with the investment banks, but the uncertainty created by CDSs was a major problem.
So it wasn't the absolute value of Lehman's CDS position but its unknown level of exposure that created the problem.
Uncertainty creates fear, which generates a crisis.
I'm just a poor, dumb geologist...economics beyond managing my 4o3b is beyond me. Can someone explain in a relatively simple way why it is necessary to keep coming up with new and more esoteric investment vehicles? What do CDS or derivatives or anything else like that do to make the overall economy better? Do they do anything for anyone beyond a limited circle of wealthy investors? It looks to me like it's more like the lottery where the states have to keep coming up with new games to keep the gamblers interested.
orogeny: It looks to me like it's more like the lottery where the states have to keep coming up with new games to keep the gamblers interested.
I thought you said that you didn't understand economics.
Ok, one other reason: circumventing regulation. CDS's are insurance without the insurance regulation.
I am just a poor simple lawyer. Can someone explain why it is necessary to keep coming with ever larger bloatware that does stupid things like trying to guess what word I am typing and fills it in, or tries to guess what numbering system I am using and tries to insert a new number on each new paragraph, or insists on sending a dancing paperclip whenever I click "help," or that doesn't include written documentation with any new programs anymore (the documentation is on the disk that doesn't work), and so on? Then you can go back to bashing Wall Street.
I'm not sure I get it. Is the argument that derivatives need to be demonized? Everything traded these days is a derivative (writing from Chicago, home of the CBOT, commodities futures, options, etc.), meaning they derive from but are not actually the widget on which they are based.
And derivatives are necessary. The farmer relies on the futures market to hedge losses in the event of a bad crop season. The financier was supposed to rely on the financial derivative to hedge against problems with the underlying paper.
Is the argument that we need to bring THESE SPECIFIC derivattives under the purview of the SEC, CFTC or some such regulatory body? Because I agree, as a general matter, derivatives are not the issue.
So, my next question is...why can't we simply regulate such investment vehicles out of existence? I don't think I'm a commie, but I don't understand why there isn't some way to prevent this kind of garbage putting the US economy at risk.
To make my question it clearer: Is it not possible to regulate these kinds of investments in such a way as to confine the risk to those participating in the transaction...to require sufficient reserves so that the only losers are either the investor or the entity selling the investment?
Kevin,
Felix also writes in the same post:
"It's worth emphasizing that the CDS demonization meme, at least in this form, is a dangerous one -- because it implies that it wasn't really the banks' own fault that they went bust, and that the implementation of a CDS exchange could in and of itself bring the amount of systemic risk down substantially."
I think this is the point. As one of his commenters notes, demonization of CDSs turns attention away from the human element: fraud, negligence and fiduciary incompetence.
orogeny: to require sufficient reserves so that the only losers are either the investor or the entity selling the investment?
Sure. In other words regulate it the way that insurance has long been regulated, for the very reasons that you mention.
"So why then is it unfair to say that CDS exposure was a huge driver of the financial meltdown?"
Because it leads to incorrect incentive structures. If you assume that "CDS exposure" was to blame rather than, say, "improper use of derivatives," you end up banning CDS's. Then you end up with a meltdown later because they find some different derivatives to use instead.
The argument isn't that CDS's weren't (partially) to blame for the meltdown, but rather thar incorrectly characterizing them as a cause rather than an instrument will teach people the wrong lessons and thus fail to prevent a recurrence of the problem.
CDS exposure was a significant factor in these firms going under. Salmon's analysis is completely irrelevant because he is focusing on an argument nobody is making. It isn't the CDS contracts that Bear Sterns, AIG, etc. purchased from parties that apparently could not pay that was the problem. The problem was the billions of CDS contracts that they sold to others. That is the number we should be looking at. When the ratings of those companies dipped due to their problematic investments in Asset Backed Securities (including subprime MBS), their CDS contracts required them to come up with additional collateral that they did not have because they were too leveraged.
This meant they had too many obligations and too few assets to cover them. That means bankruptcy or rescue.
Sure, they had substantial losses from the subprime mess, but those losses created a snowball effect in CDS collateral requirements that led to the companies going under.
And nobody is implying that the problems with CDS contracts = the "banks" weren't at fault. If anything, it demonstrates these companies weren't just being stupid and overly optimistic about subprime mortgage investments, but about CDS exposure as well.
And it isn't just the "banks" that are at fault. Much of the current regulatory structure was premised, as Alan Greenspan testified to Congress, on the idea that the financial motivation would ensure that these businesses would properly manage risk. As Greenspan admitted, the events of the last year demonstrate that he was wrong ... really wrong.
It's the toxic assets derived from bad mortgages and the bursting housing market balloon which are the foundation of this crisis. The CDSs are a problem because they're "insurance policies" on the toxic assets which have cratered and because those who "issued" the CDSs apparently don't all have proper reserves to pay 'em off and because there's a terrific lack of transparency.
There is also some crazy assumption this wasn't all manufactured intentionally. Think about that.
Anyway, now they're saying they can't evaluate the toxic mortgages, so they don't dare lend money to firms which might not be able to pay it back. That's the credit crisis.
And, if nobody wants to sell their toxic assets, then the situation doesn't change and the question of who might have to one day pay off CDSs just hangs there like a sword of Damocles.
Finally, if that isn't enough, mortgages were apparently sliced & diced and sold here and there, so that it's hard to put this humpty dumpty back together again. This is (to my mind) more proof somebody didn't want it put back together and the problem solved.
With regard to where this crisis is headed ask, "cui bono?"
How will this thing crash down and who benefits. Or, in another way, who does it hurt and who remains standing without being destroyed (benefitting by having a future).
Could it be the Rich want to be able to hold this over the head of Obama to control him?
"Are credit default swaps a major villain in the global banking meltdown". Not really, although they have the potential to make a bad situation a lot worse.
The major villain was collaterilized debt obligations and the legal ability of financial institutions to leverage themselves all out of proportion to good business practice.
Because loan originators immediately resold the loans,and the loans were then used as collateral for other loans. They were then sliced and diced to meet the needs of the many exotic financials products out there and no one really knows what organizations are holding the bad loans or how much money any given organization is in the hole for. When the various parties started calling in the loan collateral, the house of cards fell apart.
That's why banks stopped lending to other banks; they had no way of knowing if the loan receiver was already underwater.
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