I’ve been trying to understand how these financial instruments called “Credit Default Swaps” (CDSs) got to be so big. Fortune magazine has a good article on them this week. It’s by Nicholas Varchaver and Katie Benner.
So here’s why they’re so big. A CDS is a private contract between two parties that looks and sometimes can act almost like an insurance contract. For example, if you buy a bond, you can also buy a CDS contract that gives you “insurance” in case the bond gets defaulted on. But here’s the twist. The reporters write,
- you don’t have to own a bond to buy a CDS on it– anyone can place a bet on whether a bond will fail. Indeed, the majority of CDS now consists of bets on other people’s debt.
… So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino.
… There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal [US] government has long shied away from any oversight of CDS.
Also, regular insurance is regulated by the states. But CDS contracts have always been completely unregulated…
The whole article is informative and worth reading. (see especially the para that tells you about the role Alan Greenspan, Larry Summers, and Phil Gramm played in keeping CDSs unregulated.)
It also has a couple of really helpful graphics. One is a graph showing how the total value of the CDS market soared from $919 billion in 2001 to $62.2 trillion in 2007. It came down a bit in the first two quarters of this year– to $54.6 trillion.
But then, to help you understand the scale that the problem still has, there’s a handy bar graph that shows you that the “value” of CDS contracts outstanding ($54.6 trn) is greater than the whole world’s annual GDP ($54.3 trn), and greater than the sum of the value of all stocks on the NYSE, the US’s annual GDP, and US’s national debt all added together.
The author of George Washington’s Blog has been digging around in the reports of the Office of the Comptroller of the Currency and has published some reporting on the various levels of exposure the big US banks have to CDSs, as of June 30.
Hat-tip for that to Bernhard of MoA. He’s been arguing for some time now that the only way to stop the implosion of the west’s entire financial system is to take concerted international action to declare all CDS contracts null and void.
After reading Varchaver and Benner’s article, I think I agree with that.
By the way, in this post, George Washington recalled that Business Week reported back in May 2006 that,
- “President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations.”
GW commented that Negroponte had been a key figure in the illegal Iran-Contra scheme. “Yet he and his successors – in the name of ‘national security’ – could tell companies such as AIG, Lehman, Bear Stearns, Washington Mutual, Wachovia, etc. that they could use phony accounting and keep the SEC in the dark…”
Interesting.
One is a graph showing how the total value of the CDS market soared from $919 billion in 2001 to $62.2 trillion in 2007.
This is half-informed scaremongering. notional value is not value at risk! most of these contracts are offsetting.
Vadim
Robert Peston at the BBC suggests we wait and see what is left at the end of today. Peston seems to be getting it right so far.
http://www.bbc.co.uk/blogs/thereporters/robertpeston/
Day of reckoning
Robert Peston 10 Oct 08, 07:35 AM The sharp and nerve-straining falls in share price on Wall Street last night and in Tokyo today are damaging to the wealth of many, especially those saving for a pension.
But it’s as well to remember that they are the symptom of the disease, not the disease itself.
The underlying illness remains in the financial system, as manifested in the record amounts banks were charging each other yesterday for lending to each other for three months.
One serious anxiety concerns the auction today to settle liabilities on insurance – or credit default swaps – on debt of the collapsed investment bank, Lehman Brothers.
As I noted a couple of weeks ago, there are estimates that claims under insurance contracts will total $400bn. Sandy Chen of Panmure was one of the first to highlight the scale of this looming problem.
If demands for payment are as big as $400bn, there will be pain for banks, insurers, hedge funds and other financial institutions.
Here’s why.
For every winner in a claim, there is a loser, the underwriter who has to divvy up. And if the underwriter lacks the resources to pay – which may turn out to be the case in this under-regulated market – that creates two losers: viz the bust underwriter and the claimant which doesn’t get the money on which it was counting.
And if that claimant had been calculating its own financial strength on the basis that it had insurance against its Lehman debt, well then failure to receive payment could shatter the integrity of its balance sheet. Which in turn would create potential losers among its creditors.
So this day of reckoning on Lehman credit default swaps is momentous – and it could not come at a worse time for fragile bank shares.
The fall in Morgan Stanley’s share price yesterday was a remarkable 26%, on the back of various nebulous rumours and as Moody’s said it was reviewing Morgan Stanley’s credit rating for possible downgrade.
There was also a doubling in the credit-default-swap price for insuring Morgan Stanley’s debt: there was contagion from this opaque market to the more transparent stock market.
As soon as regulators have time for breath, they surely must as a matter of urgency bring some light, order and proper regulatory oversight into the credit-default-swaps market
But probably more urgent is for the US Treasury Secretary to decide how and whether he will inject US taxpayers’ money into banks to recapitalise and strengthen them, along the lines of what the British Treasury is proposing to do.
But he “only” has $700bn to play with, which no longer looks that enormous in the context of the $400bn claims that may be enforced in just the next, anxiety-inducing few hours.
Hi Frank.
I would agree that the controls surrounding this market are weak, and that its risks are poorly understood by managers & shareholders alike. this is a good argument against holding shares in some investment banks (though I’d point out that there are many banks in perfectly good health.) It’s also an argument for everyone (especially regulators but also the general public) to learn more about them rather than spastically put out ill-informed “solutions” that compound the problem.
A perfect example of a panicky response would be to nullify *all* credit default swaps. Bernhard doesnt seem to grasp that this would amount to his own ‘worst case’ scenario (a uniform default.) It’s like saying we should eliminate nuclear weapons by detonating them.
CDS agreements have been around for almost 15 years, and are written on all kinds of traded debt, mainly on businesses far removed from the current turmoil.
@ Vadim: “the last fifteen years”… You think that’s a recommendation??
Also, its true that some portion– completely unevaluated as of now– of CDS contracts are said to “offset” each other. But no-one yet knows what portion. And, as Vachever and Benner write– and as Krugman, Calculated Risk, Roubini, and others have been writing for some time now– one of the big problems with CDS contracts is that oftentimes they’ve been bought and sold so many times that you don’t know who the counter-party is and whether indeed they have any net worth at this point.
V&B say that many of the counter-parties might turn out to have the liquidity of your average mini-mart.
To describe CDSs as “weakly” regulated is a bit misleading in the circs.
Vadim said “It’s also an argument for everyone (especially regulators but also the general public) to learn more about them rather than spastically put out ill-informed “solutions” that compound the problem.” Maybe Vadim could provide some links that will help the general public learn more about them?
My suspicion is that learning about this covert market is akin to learning about what the CIA is doing or about the causes of Alzheirmers.
This American Life (thisamericanlife.org)
has a wonderful explanation on its current show
johnh the market is already transparent: anyone with a bberg terminal can see real time quotes on thousands of CDSes. information on them –from ISDA, from books, wikipedia etc is everywhere, if you care to research read and learn.
any of these should get you going
http://www.amazon.com/s/ref=nb_ss_gw?url=search-alias%3Daps&field-keywords=credit+derivatives&x=0&y=0
still… if you know nothing about them other than what you pick up from amateur commentary on the web, you have no infor,ed basis to fear them, less still to call for their abolishment in this very silly and paranoid way.
“one of the big problems with CDS contracts is that oftentimes they’ve been bought and sold so many times that you don’t know who the counter-party is and whether indeed they have any net worth at this point.”
quite simply wrong. cdses are negotiated directly. there is never a question who your counterparty is, as its announced the second a trade occurs and a signed confirmation is exchanged within days, conditioned upon master trade agreements already being in place.
http://interfluidity.powerblogs.com/posts/1163375565.shtml
regulation is the father of structured finance. chapter one in any of those wiley books on amazon.
“Bank investors understand as well as non-bank investors that, due to model risk, CPDOs are not as safe as ordinary AAA bonds. But bank investors aren’t looking for safety. They are looking for ways to marry the appearance of safety before regulators with opportunities to enhance profits by taking on risk. One risk not included in credit ratings is credit raters’ model risk. The investment industry, constantly innovating to serve customers, has invented an instrument that exchanges credit risk (reflected in ratings) for model risk (excluded from ratings), allowing banks to have their risk and hide it too. If all goes well, banks earn more money. If all goes poorly, taxpayers cover depositor losses, while bank managers demur that they complied with regulatory requirements to the letter.
Truly, this is the golden age of finance!”
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