Affordable Housing Institute : US

[Continued from yesterday's Part 2 and the previous Part 1]

 

“I bet you’re solvent.”

“I’ll take that bet.”

– The essential bargain made by a CDS buyer and seller

 

It’s just like the first time I came here, isn’t it?

We were talking about automobile insurance, only you were thinking about murder.

 

By now we’ve seen, via a useful Economist article, that Credit Default Swaps (CDSs) exploded into the public markets, as large insurers and other financial corporations used them to take large risks that they could then hide from their balance sheets.  Now that we’ve woken up, the markets are wondering who else has unmanageable notional exposure, and who will take losses from bets they cannot pay off.

 

Concern about the damage that the failure of a big swap-seller might yet do has created pressure for the CDS market to be regulated.

 

Catastrophe is a precondition to fundamnetal financial reform, and it seems inevitable – and long overdue – that CDSs should be regulated with both mandatory disclosure and higher collateral requirements.

 

New York has charitably offered to oversee “covered” swaps—those where the protection buyer holds the underlying bonds; Mr Dinallo labels uncovered CDS trades as “naked”, likening them to abusive short-selling of shares.

 

Mr. Dinallo’s right here; bets you can make without having anything to do with the assets can create unlimited exposure, and are an implicit fraud.  The Fed’s already banned naked shorts.

 

Aren’t you glad this is banned now?

 

Federal regulators, who passed up several opportunities to police the market during the credit boom, are circling too.

 

If you hold the bond, then you can mitigate your loss.  If you don’t, you have no mitigation.

 

Dealers are hoping to head them off with a series of initiatives, which have been stepped up recently at the prompting of the Federal Reserve. Chief among them is the creation of a central clearing house for credit derivatives. Several groups, including a dealer-backed venture led by Intercontinental Exchange and a tie-up between CME Group, another exchange operator, and Citadel, a hedge fund, are vying for licences. One or more is likely to be awarded in the next few weeks.

 

Among the possible new paradigms is licensing of CDS sellers.  Insurance companies have to be licensed and capitalized; shouldn’t those selling financial insurance be similarly regulated?

 

The biggest benefit would be less counterparty risk, since each member firm would face only the clearing house, not lots of partners.

 

‘Face’ is market jargon for ‘be the party opposite.’ 

 

I don’t want to face just anybody

 

By restricting the origination of CDSs to regulated entities, the market would assure that all those who are accepting the bets – being the risk bookies, as it were – are experienced and capitalized.

 

Have you got cash to cover these bets?

 

Standardised collateral arrangements would reduce the sort of payment disputes that have flared up this year, including those between AIG and buyers of its insurance. This set-up has worked well for trading of energy swaps.

 

Although it would ease one problem, it may create another by concentrating risk in the clearer—“like the military putting all its artillery shells in a single dump,” says a banker.

 

Like artillery shells, risks, once created, have to go somewhere.  Better to put them in safe hands.

 

Put the powder magazine inside the fort, away from the field of fire

 

Any clearer will need to have “tremendous creditworthiness” and iron-clad risk controls, says Craig Donohue, chief executive of CME, which is planning to back its venture with its $7 billion guarantee fund and $115 billion in collateral.

 

You think our protecting will hold  up?

 

Besides a clearing house, the market could do with more transparency. A lack of disclosure on CDS exposures has frequently led the market to overestimate risks: had it been realised that settlement payments on Lehman swaps would be only $6 billion, rather than the hundreds of billions feared, much of the turmoil in debt markets could have been avoided.

 

When it comes to risk, over-rating it is just as bad as under-rating it.

 

They’re both nasty

 

To provide more clarity, the Depository Trust & Clearing Corporation, which runs the central registry for swaps, has just begun publishing weekly data on the largest (but not broken down by counterparty).

 

It’s a start.

 

Everything begins with information

 

A streamlining of back offices, which were swamped as trading surged, is also necessary. Only now is the industry discovering the joys of “compression”, which allows offsetting swaps to be torn up. A staggering $25 trillion-worth, almost half of the total, has been binned in recent months.

 

Though this does little to cut the amount at risk, it reduces operational costs and strips away a layer of complexity that has obscured trading exposures. There are plans to extend this tidying-up exercise to other derivatives, including interest-rate swaps, whose gross value, $393 trillion at the end of 2007, dwarfs that of CDSs.

 

All this will strengthen market infrastructure. But it will also eat into the profits of big dealers, such as Goldman Sachs and JPMorgan, at a time when every dollar is precious. Estimates of their total revenue related to CDSs run as high as $30 billion a year.

 

Anybody making thirty bill a year on a business had better be reinvesting in risk-managing that business.

 

Sound advice in life, too

 

This will fall as central clearing brings more price transparency, and drop even further if the swaps end up being traded on exchanges. The dealers have long argued that bespoke swaps do not belong on bourses. But contracts, especially those tied to indices rather than single names, are steadily becoming more standardised.  Most CDSs, thinks a bank regulator, will move to exchanges “within a few years”.

 

Absolutely.  That’s what a stock market is – a legalized and collateralized flea market of finance.

 

Just add SEC and you’re a market

 

These quasi-voluntary efforts may or may not reassure those calling for more dramatic intervention. Buyers and sellers of swaps will probably be required to disclose more information.

 

Not just a good idea, it’ll soon be the rule

 

Yes.  More disclosure is overdue.

 

They will certainly have to stump up more capital to trade, making the market less attractive.

 

Yes.  That’s how you bring risky products into the financial markets: make the originator take first loss, and make the originator collateralize a large liquid equity position.

 

Indeed, since September the typical margin demanded by dealers has more than doubled. Once reshaped, the CDS market will be a bit duller and a lot less lucrative. But it will also be much safer.

 

That’s been the risk in the CDS market: not that you’d never need the protection, but that when you needed it, it wouldn’t be worth anything.

 

“Yes, I killed him. I killed him for money – and a woman – and I didn’t get the money and I didn’t get the woman. Pretty, isn’t it? I bet he croaks soon.”

– Walter Neff, Double Indemnity

 

Do I laugh now, or wait ’til it gets funny?

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