Credit Default Swaps and Financial WMDs

Gretchen Morgenson’s NYT article yesterday offered a good primer about Credit Default Swaps (CDS):

Few Americans have heard of credit default swaps, arcane financial instruments invented by Wall Street about a decade ago. But if the economy keeps slowing, credit default swaps, like subprime mortgages, may become a household term.

Credit default swaps form a large but obscure market that will be put to its first big test as a looming economic downturn strains companies’ finances. Like a homeowner’s policy that insures against a flood or fire, these instruments are intended to cover losses to banks and bondholders when companies fail to pay their debts.

As the graphics explain, counter-party risk is an ever present factor.

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click for larger graphics

17swap_1_lg
graphic courtesy of NYT

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What’s truly astonishing is the size of this market: The market for these
securities is enormous. Since 2000, it has ballooned from $900 billion
to more than $45.5 trillion — b
igger than the US equity markets, US Treasuries, and Mortgage Securities — COMBINED.
>

click for larger graphics

17swap_2_lg

graphic courtesy of NYT

>
CDS are thinly traded, have huge counter-party risk, are difficult to analyze, and are unreguylated insurance products. This leadsme to this money quote:

"As with other securities that trade privately and by appointment, assigning values to credit default swaps is highly subjective. So some on Wall Street wonder how much of the paper gains generated in these instruments by firms and hedge funds last year will turn out to be illusory when they try to cash them in."

Sounds kinda familiar . . .

>

Source: 
Arcane Market Is Next to Face Big Credit Test
GRETCHEN MORGENSON
NYT, February 17, 2008   
http://www.nytimes.com/2008/02/17/business/17swap.html

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What's been said:

Discussions found on the web:
  1. AGG commented on Feb 18

    Credit default swap is analogous to Captive insurance. Both are mostly unregulated and under capitalized. Hey Vermont lawyers, are ya covered?

  2. Bob_in_MA commented on Feb 18

    This was the first article I read that actually explained what the payouts were when Delphi defaulted on its debt and there were CDS for ten times the face value of the bonds. Those holding the CDSs, but no bonds, got about $.35 per dollar. ouch.

    Barry had a post a week or so ago, “Bear Stearns Makes $1 Billion Bet on Subprime Market Decline.” They bought already expensive CDSs assuming they would increase in value AND pay out at par. This bet is a lousy one, even if subprime does tank further, just because of the potential payouts.

  3. JustinTheSkeptic commented on Feb 18

    “Send in the clowns, there has to be clowns,” this all can’t be real… These insraments, like the cdo’s et. al., were created by intelligent people right? Or I guess intelligents is as subjective here as the prices paid for the underlying instraments…problem is no one can look at these from “both sides now, from in and out, etc”…wow!

    Would one of you truly intelligent people out there tell me how this cannot lead to another very scarry “social unrest amongst the natives,” situation??? The kind that resembles head clubing, book burning, and kill the intelligensia?

  4. Prose Before Hos commented on Feb 18

    The Power of the Bank

    I sincerely believe that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.
    – Thomas Jef…

  5. JustinTheSkeptic commented on Feb 18

    And lets just assume for a moment that the global economy can bail this situation out at present, what stops it from morphing into something even bigger several years from now? You have to guess that the greed of man will make this problem worse down the road. jmho

  6. bluestatedon commented on Feb 18

    According to Wikipedia, the intelligentsia is defined as the “social class of people engaged in complex mental and creative labor directed to the development and dissemination of culture, encompassing intellectuals and social groups close to them (e.g., artists and school teachers).”

    This group is about as far removed from Wall Street financiers as you’re going to get, and as such are among the last who will be subjected to “head clubing” by the outraged natives.

  7. Ross commented on Feb 18

    A wise old Hetman of the Cossacks once said ‘put your faith in your sword, and your sword in the Poles.’

    I suggest we do that to the counter parties except we don’t know who they are!

    The guys who wrote the insurance did so with a completely blank checkbook. There ARE no reserves. Anyone who thinks otherwise also believes their Feddiebear can save them from the boogyman.

  8. JustinTheSkeptic commented on Feb 18

    bluestatedon,

    Tell that to all the scientist, artist, and professors, who were forced to march to their deaths, in Germany, Poland, Russia, Burma, China, etc….

  9. bluestatedon commented on Feb 18

    That large numbers of the so-called intelligentsia disappeared in Germany, Poland, Russia, Burma, Cambodia, etc. is a lamentable historical fact, but it doesn’t mean there’s any chance of it happening here. Our political and social culture is so different from all of those countries in so many ways that our school teachers and artists don’t have to worry much about being placed in re-education camps as a result of a systemic economic collapse. That’s not to minimize the chaos that would attend such a collapse, but I don’t think pogroms of the intelligentsia are in the cards.

    does not mean it will happen here. We’d have to have a complete and thorough collapse of society in all ways, in combination with the institution of a radical fascist or socialist regime coming to power.

  10. SINGER commented on Feb 18

    That $45 trillion number is kind of misleading b/c that’s notional value not the Net exposure of the parties involved…Although, counter party default risk is always there…

  11. cinefoz commented on Feb 18

    There will still be a winner and a loser for each trade. Unfortunately, the gullible investor will probably be the loser. Sometimes the bad guy wins.

    I guess if you want to pick the pocket of a worldly investor, you need to use something that sounds complicated, new, and a sure thing that only a few select people can take advantage of. History abounds with stories of people who thought they were too smart by half, and gullible fools who fell for the lies of a corporate psychopath.

  12. Carmen commented on Feb 18

    The lawyers for the monolines knew how to put lipstick on a pig, like every good lawyer should.

    Hey, monolines don’t write CDS on CDOs, they write “financial guarantee insurance policies” and now the insurance regulators are on their case.

  13. rexl commented on Feb 18

    intelligentsia? what intelligentsia? inflation has been at work for decades in that realm and the roundup would be a considerable disappointment of mostly beleagured holders of large student loans; a little jail time to get out from under those obligations would probably be welcomed. god knows the product financed was vastly over-priced.

  14. larry commented on Feb 18

    So, no one knows exactly how large the actual credit default market is, nobody knows who now owns or is providing the “insurance”, there are no reserve pools to cover defaults or losses, but according to Easy Al derivatives have been a boon to the financial markets. Why would anyone say this is not a gigantic fraud. Who’s going to finally open up the storage tank and find no oil?

  15. SPECTRE of Deflation commented on Feb 18

    Barry, have we discussed Auction Rate Securities, and what they mean for thousands of businesses?

    Off the top of my head we have had issues with a drug company, 3M and Texas Instruments, but this is the tip of the iceberg. Having to mark them as investments as oppsed to a cash equivalent is gonna be a real BE-ATCH for everyone. Then again they say it’s contained so why worry?

    From CFO dated 2005. Who could of known though:

    Auction-Rate Securities: Hold That Gavel
    The securities–long-term bonds that act like short-term debt–have often helped treasurers squeeze out added return on corporate cash balances. But a bevy of woes is making it tougher to embrace the cash-management tool.
    Marie Leone, CFO.com | US
    April 25, 2005

  16. jm commented on Feb 18

    It appears that a huge fraction of the activity in the financial markets has consisted of variations on the theme of selling naked puts, an “investment” strategy which well deserves its classical description: “Picking up nickels in front of steamrollers.”

    The genius of the bankers and hedge fund managers has been to devise ways to render the steamrollers temporarily invisible and send other people out to pick up the nickels — while getting those people to pay them huge, non-refundable fees for the privilege.

  17. twistytop commented on Feb 18

    Financial WMDs? Another apt term would be the greed bomb. I can see the Laffer crowd astride this monster like Slim Pickens in Dr. Strangelove yelling Yeehaa Yeehaa!

  18. SPECTRE of Deflation commented on Feb 18

    That $45 trillion number is kind of misleading b/c that’s notional value not the Net exposure of the parties involved…Although, counter party default risk is always there…

    Posted by: SINGER | Feb 18, 2008 10:32:08 AM

    bluestatedon, agreed.

    Posted by: JustinTheSkeptic | Feb 18, 2008 10:45:46 AM

    Don’t you need a counterparty willing and able to pay on the losing bet for it to be notional? If there is no counterparty, you are royally screwed.

  19. Terminator_X commented on Feb 18

    Participants in the credit default swap market have argued against insurance-type regulation since the swaps are not technically “insurance”. While the credit default swap transfers a risk, it entitles the covered party to a defined notional amount upon occurrence of a given event; unlike insurance, which indemnifies the insured for actual losses, the credit default swap entitles the covered party to the notional amount, regardless of actual losses. And the covered party in a swap knows full well that the counter-party is not a fully capitalized regulated insurance company.

    AGG’s analogy to captive insurance is on point. Most captive insurance shifts risk in the same way that a party moves liabilities of its books by dumping them into a Cayman SPV, i.e., it’s illusory. As a tax attorney, I’ve been perplexed that Congress permits captive insurance to be treated as insurance for tax purposes.

  20. SPECTRE of Deflation commented on Feb 18

    The money is spent boys and girls. We are left with debt. Anyone who believes that this is a zero sum game will have his or her head handed to them. The bank have blown through their reserves. We are being financed through the TAF.

  21. SPECTRE of Deflation commented on Feb 18

    Watching Christine and Mike on CNBC. 53 years old and $680,000 in debt. Our grandparents are rolling in their graves. Didn’t anyone really listen to their Grandparent’s stories when they were growing up, or did the “Me” Generation just think they were smarter than everyone else who had come before them? Jackasses!

    Send us your debt confessions per CNBC. Unfrigging real.

  22. JustinTheSkeptic commented on Feb 18

    “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. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.”

    This in an article I just read relating to JP Morgan’s more than twice the exposer of citi’s derivitives…and the annoucement to do away with certain government statistics. “Oh my, what might the world do if this woven web becomes a financial death bed?

    Better hope our fighting men and women respect the judgment of our leaders? Also, who’s to say that after other countries who have had the time to wittness our quagmires in both Vietnam, and Iraq, might not find severing our world dominance appealing? Could the stability of your democracy possibly be in question? Or would the other world members see no benefit in our demise?

  23. Tom Durff commented on Feb 18

    Yes, jm, selling naked puts. And the money manager collects his 2 and 20 (or more) up front based on some pretty large nickels. And the “investors” in his hedge fund are left to be run over by the steamroller. To whom the money manager eventually says
    “sorry I f****d up” as in Friday’s power point.

  24. Günter Leitold commented on Feb 18

    A lot of talk these days about the size of the CDS market and a nice NYT chart. However, I would be more interested in a net-credit-exposure number reduced by dealer-books offset rather than looking at the number of total CDS’s contracted. Any regulator out there with an idea about this number? Guenter http://www.highyieldblog.com

  25. SPECTRE of Deflation commented on Feb 18

    JustinTheSkeptic

    You don’t get to 60 Trillion Dollars in unfunded liabilities by way of President Bush. Terrible President? Damn right, but if you think this started 7 years ago, you better look elsewhere.

  26. Estragon commented on Feb 18

    Terminator_X,

    By your definition (“unlike insurance, which indemnifies the insured for actual losses”), wouldn’t most life and accident insurance also fail the test?

  27. Movie Guy commented on Feb 18

    “Since 2000, it has ballooned from $900 billion to more than $45.5 trillion — bigger than the US equity markets, US Treasuries, and Mortgage Securities — COMBINED.”…should be in bold type.

  28. jck commented on Feb 18

    Bob_in_MA
    “Those holding the CDSs, but no bonds, got about $.35 per dollar. ouch.”
    CDS don’t pay par, they pay (par-recovery), the CDS buyers for delphi got the same payout whether they had the bonds or not.
    Otherwise pretty clueless article, you cannot transfer a CDS to another counterparty without the permission of the original counterparty.

  29. jck commented on Feb 18

    Bob_in_MA
    “Those holding the CDSs, but no bonds, got about $.35 per dollar. ouch.”
    CDS don’t pay par, they pay (par-recovery), the CDS buyers for delphi got the same payout whether they had the bonds or not.
    Otherwise pretty clueless article, you cannot transfer a CDS to another counterparty without the permission of the original counterparty.

  30. Stuart commented on Feb 18

    Fictitious Capital 101…

    Depressing thought of the day, how much of the US GDP growth over the past decade has been built on a foundation of fictitious capital and fraudulent gains in the financials…

  31. Kp commented on Feb 18

    It is a nearly-zero sum game. The world only has so much everything available for sale at any given time. All of these fake products are behaving like real ones…and causing real inflation and real scarcity as the money created by these WMDs reeks havoc on our resources. Fake or not these instruments will have real consequences.

    Everyone ask themselves why do we have laws(regulations) at all? I always thought it was to keep the unscrupulous from engaging in a mad grab for money, power, and anything else they can get there hands on with no thought as to the consequences. Can anyone claim that this is not exactly what we have seen in the financial sector for many years now?

  32. Gegner commented on Feb 18

    Nice catch Stu…given how the ‘hollow land’ consumes more than it produces, our ‘GDP’ is provably negative if we back out the ‘funny money’…

  33. Gegner commented on Feb 18

    Nice catch Stu…given how the ‘hollow land’ consumes more than it produces, our ‘GDP’ is provably negative if we back out the ‘funny money’…

  34. Steve commented on Feb 18

    >>bluestatedon

    >>doesn’t mean there’s any chance of it happening here. Our political and social culture is so different from all of those countries in so many ways …

    I guess Americans are beyond special. It’s not like the KKK killed more Americans than Al Qaeda, or that the US Army didn’t take it to the Philippines or that the Trail of Tears never occurred, or that Mexico City was sacked and half their country was taken away from them. Next you will tell me that we have reached “the end of history”. Guess what. Man is a murderous animal. There hasn’t been a day in human history that we haven’t been slaughtering each other.

  35. Tom Durff commented on Feb 18

    “Depressing thought of the day, how much of the US GDP growth over the past decade has been built on a foundation of fictitious capital and fraudulent gains in the financials…”

    Take a look at the chart in the Jeremy Grantham interview in last week’s Barron’s. Shows debt growth and gdp growth over the last 50 years. Debt line straight up since 1982. The CDS WMD’s have played a large role in that over the last 10 years.

    By the way, the point about selling naked puts from earlier: it’s that approach that keeps blowing up Niederhoffer much to the dismay of Taleb.

  36. Ross commented on Feb 18

    Winston,
    Had a secretary once who had a sign on her desk which read

    ESCHEW OBFUSCATION

    I always loved it!

  37. Winston Munn commented on Feb 18

    Can someone punch holes in this logic?

    What is the purpose of a CDS? For a bond purchaser, who has the capital to invest in the bonds, what is the point in sharing part of the yield as a payment?

    Next, what is the value to take a small token of the yield and assume the liabilities of the entire bond default – why not simply buy the bonds yourself and take on the risk + the yield?

    These are not random actions. There must be either a real benefit or a perceived benefit to both parties else the contract could not be finalized.

    What is the benefit to a buyer of bonds who has that much capital to invest? It is cheaper to self-insure if you can afford the risk.

    What is the benefit to the seller, if the seller has adequate capital to buy the bonds in the first place and get all the yield instead of a minimum insurance premium?

    The only way this makes sense to me is as an artfificial way to influence Basel I capitilization requirements, which use a risk factor in the capital determination.
    The bottom line reason is it allows more leverage from a minimum of capital reserves.

    If Lehman and Bear Stearns insured each other this way for equal amounts, they both get the benefit of a lowered risk investement and neither is actually paying a premium – they are just swapping it back and forth.

    But what happens when there is an imbalance? Here again, if the determining reason is to affect Basel I requirements, the counterparty’s solvency is not so much a question, just getting a contract is the idea.

    But who would really buy the risk for a fraction of the yield? Most likely, Billy Bob’s Hedge Fund and Insurance Shop would step in with their $12.76 of capitilization, after buying business cards and the fax machine.

    Billy Bob’s gets free money each month and Big Ass Buyer gets to show Basel I a near zero-risk insured bond purchase, freeing capital to do the whole thing again.

    Another win-win for the American financial system.

  38. Winston Munn commented on Feb 18

    Spectre,

    Sorry if that was too far of stretch off-topic, but I meant it as an addition to JustinTheSkeptic’s comments as far as killing the intelligensia, and the other comment of his about termination of certain government statistics.

    An additional bit that hints at a certain repetitive pattern of action, is all.

  39. sammy_korean_but_from_South commented on Feb 18

    Barry, the New York Times article exaggerates the risks involving CDS.

    1. The size of 45 trillion is not the net open position value but just outstanding amount.The net open position must be much smaller.

    2. They are not definitely unregulated. The banks should report swaps as a off-balance-sheet instrument in the footnotes on their balance sheet and the mark to market P&L goes directly to their current income. So they are somewhat regulated.

    Hedge funds should provide collateral to their counterparty if they are losing money in the CDS.

    So they are at least self-regulated.

    Of course, the mark to market can be distorted just like the case of AIG. But the claim that they are totally out of conrtol is not true.

    3. Delphi case, the true lenders are compensated much better than speculators. Actually they got saved 100%.

    Remember that it is the true lenders who sold the defaulted bonds at the 68% of the face value to the speculators. And they got compensated the rest of 32% in the CDS either.

    The speculators did not lose either. They just made less than they perceived. And this speculation is just zero sum game.

  40. tom a taxpayer commented on Feb 18

    I think the words of poet William Butler Yeats may be a good summary of the situation:

    Turning and turning in the widening gyre
    The falcon cannot hear the falconer;
    Things fall apart; the centre cannot hold;
    Mere anarchy is loosed upon the world,
    The blood-dimmed tide is loosed, and everywhere
    The ceremony of innocence is drowned;
    The best lack all conviction, while the worst
    Are full of passionate intensity.

  41. SPECTRE of Deflation commented on Feb 19

    Spectre,

    Sorry if that was too far of stretch off-topic, but I meant it as an addition to JustinTheSkeptic’s comments as far as killing the intelligensia, and the other comment of his about termination of certain government statistics.

    An additional bit that hints at a certain repetitive pattern of action, is all.

    Posted by: Winston Munn | Feb 18, 2008 8:23:26 PM

    WM, Got it, and agree. Anything this govt. throws our way is suspect until proven otherwise. It’s just that when we head down anything political lane, we end up talking about things so far removed from the topic that it’s hard to keep the thread on point, and it turns into finger pointing and accusations.

    We are where we are. What happened in the past won’t help us today. We on this board can hopefully navigate this mess while keeping our capital whole. It’a very tough environment to say the least.

    Let me take this op to thank you for your insights on various topics. Your comments and thoughts are always well reasoned.

  42. SPECTRE of Deflation commented on Feb 19

    I think the words of poet William Butler Yeats may be a good summary of the situation:

    Turning and turning in the widening gyre
    The falcon cannot hear the falconer;
    Things fall apart; the centre cannot hold;
    Mere anarchy is loosed upon the world,
    The blood-dimmed tide is loosed, and everywhere
    The ceremony of innocence is drowned;
    The best lack all conviction, while the worst
    Are full of passionate intensity.

    Posted by: tom a taxpayer | Feb 18, 2008 11:10:18 PM

    And then the Chorus comes in with…Fra La La La La?

  43. Nathan commented on Feb 19

    I think this article overstates the degree to which parties to a CDS contract are in the dark about who their counterparty is. The ISDA protocol for novation requires that all parties be kept in the loop and give their consent before the assignment can take place.

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  46. Lauren Bloom commented on Apr 4

    So, here we go again… a too-clever-by-half instrument developed for sale to institutional insiders in an unregulated market that grows until it looms into a potential disaster for the U.S. and maybe even world economy. My thanks to sammy_korean_but_from_South for that beautifully literate Keats quote. Personally, though, I’m reminded of a line from a 60’s song, “Blowing in the Wind”: “When will they ever learn?”

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