Unlicensed insurance: Credit Default Swaps (CDS’s): Part 2, no sympathy for the devils?
[Continued from yesterday’s Part 1.]
“I bet he croaks soon.”
“We bet he won’t.”
– The essential bargain in Credit Default Swaps
I think he’s very ill – lead poisoning?
As we saw yesterday, even as a Credit Default Swap has something in common with a life-insurance policy on a third party, it’s also a risk concentrate and risk shifter. As reported in a useful Economist article, so much new technology being introduced, with limitless utility, led to an explosion of risk-taking and runaway growth, leading to problems:
[2] Another is the rickety state of back-office plumbing, which was neglected as the market boomed.
We’ve got our top ducks and frogs on it
Private investment usually outruns public infrastructure, so when a private market’s booming, underinvestment in infrastructure is par for the course. That’s as true for tight recordkeeping on Wall Street as it is for proper sanitation in Mumbai.
[3] A third is that swaps can be used to hide credit risk from markets, since positions do not have to be accounted for on balance-sheets. They make it beguilingly easy to concentrate risk. AIG could have taken the same gamble in other ways, for instance by borrowing heavily to buy mortgages. But the CDS route was quicker and less visible.
Ahhh … here’s a real problem of technology outracing regulation.
The regulatory light goes on?
It isn’t that the new financial technology is risky; risk is what makes capitalism go. Rather, it’s introducing high-risk products into a low-risk regulated environment.
In complex civilized society, markets exist on a symbiosis between government and private entities. Government offers to act as a neutral referee because in doing so, it creates economic growth from which government and citizens benefit. Companies accept restrictions, regulation, and ongoing obligations (like full and fair disclosure) because they want to avail themselves of the public market’s money store. The price of that access, however, is compliance – and when regulated entities can start chasing large unregulated risks, and keep anybody from knowing what risks they’re taking with publicly raised money, then you have a horrible mismatch: people making what they think are low-risk deposits or investments, only to discover later that those entrusted with their money put it on the default roulette wheel.
We’ve invested your money conservatively
Being AAA-rated, AIG was able to post modest margin requirements—the deposit it had to pay against the risk of the contract being triggered.
Although I’ve previously criticized the rating agencies’ lassitude, they’re blameless if in fact the companies like AIG were hiding risks (through the sophist distinction of ‘non-required disclosure’).
When its credit rating was cut, a lot more margin was suddenly demanded and it had to turn to the public purse.
“We sent out a signal that the stronger you were, the crazier you could be,” says Mr Dinallo: highly rated companies were allowed to write reckless volumes of swaps.
Nothing wrong with that: being strong should allow entities to take crazy risks. Strong companies are the ones who can absorb such large losses – but if the market can’t see the crazy risks, then you are arbitraging the risk curve in ways that constitute something akin to a fraud upon the public.
You can’t repot what you can’t see, can you?
Like a murder-for-insurance plot, it’ll usually catch up with you.
Originally conceived as a means for banks to reduce their credit exposure to large corporate clients, CDSs quickly became instruments of speculation for pension funds, insurers, companies and (especially) hedge funds. And with no fixed supply of raw material, unlike stocks or bonds, bets could be almost limitless.
Anything with zero cost can experience runaway growth (see email spam).
Kind of derivative, and free for the sender, isn’t it?
The industry is scrambling to limit the damage. Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), says he is determined to combat “misconceptions” about CDSs. The true amount at risk, after cancelling out offsetting exposures, is only about 3% of their notional value (that is $1.6 trillion, even so).
Pickel: When you cancel out the misconceptions, it’s only $1,600,000,000,000!
Bookies live by balancing their risks; they modulate the money odds so that roughly equal amounts are bet on each side of any proposition; that way, whoever wins or beats the spread, the house never goes bankrupt.
This type of reasoning reminds me of the Sixties’ nuclear deterrence arguments: why worry that the Russkies can nuke us twenty times over, we’ll be dead after the first three times!
It takes only one!
Opaque as CDSs may be, they are less complex than CDOs. In essence, they unbundle the interest on a debt from the risk that it is not paid back. Selling credit protection is similar to writing certain kinds of common options on shares.
The root cause of the crisis, Mr Pickel argues, is bad mortgage lending, not derivatives: swaps on subprime mortgages grew unstable because the loans themselves were dodgy.
True enough, but an industry that wrote thousands of ‘double indemnity’ policies can’t very well blame those who cashed in:
Never should have let her write that policy on me
Still, there has been “more fear than facts” around the CDS market, says Brian Yelvington of CreditSights, a research firm. Essentially, it provides fixed-income investors with “a liquid way to do what equity and futures participants have been doing for years: to take a negative as well as constructive view on credit.”
Furthermore, the market has held up better than many expected. The process for settling claims after Lehman’s default and the government’s seizure of Fannie Mae and Freddie Mac “performed as designed”, says Darrell Duffie of
In other posts, I’ve pointed out the destructive effects of marking to market for publicly traded companies. Here mark-to-market unquestionably helped mitigate damage, since entities suffering losses from risky bets they made were forced to collateralize their losses bit by bit.
That’s collateralize, not cauterize
In all, $21 billion had been theoretically at risk. Margin payments are widely thought to cover two-thirds of total CDS exposure.
The CDS market has remained fairly liquid throughout the crisis, even as cash markets dried up.
As long as money is moving between parties according to bargains they previously struck, the market is functioning.
At the moment, derivatives spreads reflect fundamental values more accurately than those in corporate-bond markets, reckons Tim Backshall of Credit Derivatives Research (CDR). Swap spreads have become a key barometer of financial health. They provided an early indicator of trouble at investment banks, although they became distorted as more and more firms scrambled to hedge or speculate.
But if credit swaps were not a primary cause of the past year’s conflagrations, they were, in certain respects, an accelerant.
I’ve previously described them as risk moonshine or balance sheet turbochargers.
Charging up financial particles
Financial eggheads used them as building blocks in “synthetic” CDO-type structures, which are based on CDSs rather than actual bonds. The market value of some tranches has slumped to less than ten cents on the dollar. And CDSs share some problems with securitisation. A paper last year by economists at the Federal Reserve Bank of
There’s the rub: opacity.
For opacity implies unstated mendacity, and mendacity has an obnoxious odor.
I smell the obnoxious odor of opacity!
Some fear that worse may be yet to come. The failure of another big actor in the market would send dealers and other counterparties scurrying to replace trades, almost certainly at a higher cost. Replacing those struck with Lehman, as spreads widened after its bankruptcy filing, is thought to have cost some dealers upwards of $200m each.
That’ll teach you not to question your counterparty’s fiscal soundness.
That risk remains, judging by CDR’s counterparty-risk index, which measures the health of CDS dealers (see chart 1).
As the Economist’s chart shows, the market is repricing risk, and probably over-pricing risk.
The next shock could be the failure of a hedge fund with a big swap book, given the spike in redemptions and margin calls many funds face, thinks Pierre Pourquery of the Boston Consulting Group. Hedge funds wrote almost a third of all credit protection last year (see chart 2).
Selling CDSs would be like hedge funds, who are the latest generation of the ’smartest guys in the room’ – big bets, no assets required, just enormous risk tolerance and confidence.
Winning a Nobel Prize was no guarantee that Scholes would succeed
As rising defaults trigger CDS payments, the effect on other markets is likely to grow. Credit insurers are increasingly having to find money to pay claims that once seemed merely notional.
For folks like this I have no sympathy.
You were happy enough to take the premiums, what did you expect?
[Concluded tomorrow in Part 3.]
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