Defending and Fixing Wall Street, Part II Credit Default Swaps
In the first article of this series I discussed how to reform the mortgage underwriting market. This article will focus on credit default swaps, or CDS'.
The most common argument against CDS' is to quote Warren Buffet's statement from the Berkshire Hathaway 2002 annual report where he called derivatives "time bombs." This is a particularly interesting statement considering the latest Berkshire Hathaway 10-Q states:
Berkshire utilizes derivative contracts in order to manage certain economic business risks as well as to assume specified amounts of market risk from others. The contracts summarized in the following table, with limited exceptions, are not designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across other contracts with that counterparty.
In other words, Buffet's investment firm uses derivatives to manage risks - just like every other investment manager on the planet. That makes the 2002 annual report's statement moot.
First - what is a credit default swap?
The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
Let's flesh out this definition with an illustration that compares two situations. First, suppose an investment manager buys 100 shares of a company. He is doing this because he is convinced the stock price will go up. But he wants some insurance in case the price goes down below a certain level. To mitigate downside risk he can sell an option - a contract where he agrees to sell his stock to somebody at a certain price. He will sell the contract at a price below the level where he purchased the stock. This is one of the primary ways options are used and is standard practice with all investment managers. If you invest in a mutual fund your fund will use this strategy (look at the prospectus). This type of trading has occurred on a formal market since 1973.
Now, let's suppose an investment manager buys bonds instead of stock. He also wants protection in case the price of the bond drops below a certain level. Can't he just sell an option as well? No - at least not until 1997 when the first credit default swaps came into existence. The manager was simply out of luck. Now with a credit default swap the manager makes periodic payments to the insurer; and the insurer guarantees the manager will get his entire principal back in case the bond defaults. In other words - credit default swaps are simply options on bonds that allow bond managers the same degree of flexibility as equity managers.
So - why all of the terror talk about "financial weapons of mass destruction?" The central reason is there is no formal market where CDS' are traded. Instead they exist in what some people have called the shadow world of finance. As a result it is difficult to get a handle on the exact size of the CDS market. A Time magazine article in March 2008 placed the market at $45 trillion which is almost three times the size of the US economy. That total also assumes there is a CDS contract on literally every bond ever issued by a US financial entity - a fact which seems incredibly difficult to fathom.
And therein lies the central problem with CDS: there is no formal market. As a result, individual players are allowed to participate in the market to any degree they deem appropriate. This theory hasn't worked out very well as the failure of AIG demonstrates. They were heavily involved with the CDS market and it cost them - and the US taxpayer - big time. AIG loved the premiums they were getting from underwriting CDS but they were unable to pay in the event a large number of the bonds they wrote policies on might go belly-up.
CDS are very beneficial investments to the right player -- specifically large institutional bond managers. For these investors CDS offer the same protection long afforded to equity managers -- the ability to mitigate downside risk. CDS are also helpful to all investors because the provide information: when the premium on a bond increases we know that investors are concerned about the underlying credit.
As a result, the logical step to take is to form a formal CDS market. This would require a combination of options and futures knowledge. The key would be to write the underwriting rules in such a way as to insure people/companies that wrote the contracts would have the ability to pay for the underlying contract if the buyer wanted to exercise the contract. That is the central problem we've been dealing with lately thanks to an unregulated, shadow market.
So -- keep CDS just put them on a formal market. It's really that simple.
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you forget the key point of CDS's.... if I insure my house worth $500k for
$500k, that is prudent risk insurance, but if everyone in the whole state
buys and sells insurance on that same house....i
game with mega millions bet on... if or if not ...my house burns down !!!!!
and all the more a weapon of "mass financial destruction" if the bettors
haven't the means to pay off a single bet.....Bu
kool-aid perfectly while Greenspan extolled the virtues of this as another
example of how unregulated markets perfectly regulate themselves
Credit-default swaps function as insurance. When people buy that kind of protection they call it insurance in plain English. Right now the public is completely lost by the term "credit-default swap". We need to somehow get the media to use a phrase such as "a type of insurance" when they discuss credit-default swaps.
An insurance company without sufficient reserves is about the same as a Ponzi scheme.
A great idea:
Start a hurricane insurance company with just a few dollars and get $500 from everybody in Florida. That is half the going rate. You can sell on price. Until there is a storm you will make out like a bandit. It worked for AIG. Until..... oops.
Wallstreet is and always was nothing more than a casino, only with worse odds. The wheels, decks and slots are rigged and you almost always lose what you play unless you're on the inside ("House")
....worst of all, Wallstreet doesn't even serve free drinks.
I got some free hats and a golf jacket. NO drinks though.
Give us a TRULY FREE MARKET (Libertarian version) or give us SOCIALISM.
This supply-side, banker-controlled Capitalism is nothing but slavery and anyone who plays in this system who is not a banker or already a billionaire is an idiot.
The whole allure of CDS's and most other derivative products is their unregulated nature. Heaven forbid that business transactions which have the ability to bring down the financial system should be transparent.
Many years ago someone said "Isn't it strange? The same people who laugh at gypsy fortune-tellers take economists seriously.
Wall Street wasn't 'Making Money', it was Faking Money!
Hales' analogy of "CDS = Equity option for Bond" is very flawed. CDS are quite different from equity options. They are more like insurance in that they guard against Default - a total Loss of principal. It's an all or nothing situation.
Equity options respond to price fluctuations of the underlying equity and there is no principal w\stocks.
"To mitigate downside risk he can sell an option - a contract where he agrees to sell his stock to somebody at a certain price. He will sell the contract at a price below the level where he purchased the stock. This is one of the primary ways options are used and is standard practice with all investment managers"
1) I do not believe this "standard practice with ALL Investment managers". Common, yes, but not something that's always done.
2) This is also not guarding against default, it's price protection of an asset that doesn't have principal. A subtle, but important difference.
CDS should be regulated for the same reasons Insurance in general is regulated.
So -- keep CDS just put them on a formal market. It's really that simple....
that's what I say about drugs... or at least marijuana.
BUSH LET EVERYONE RUN WILD FOR 8YRS , NO ONE WAS COMPLAING EVERYONE WAS MAKING MONEY HOWEVER NOW WE HAVE TO GIVE BACK ALL THE MONEY WE MADE IN THE LAST 8 YRS AND MORE
IT SEEMED GOOD AT THE TIME LESS REGULATION LESS GOVERMENT
BUT YOU ALWAYS NEED A POLICE MAN OR EVERYONE WILL DRIVE 90 IN A 65
HuffPost's Pick
Not having one iota of knowledge in how the financial sector operates, I must still offer a comment. When I read explanations and interpretations of how the players of Wall Street work these magical formulations of finance I am reminded of those Russian nesting dolls. Boxes within boxes within boxes ... It comes out sounding as if all these great financial intellects were all busy scheming ways to get rich while trying to hide the fact that hardly any of it had any value at all.
What does buying insurance protection against the value of your assets have to do with "scheming ways to get rich' or "Russians putting boxes within boxes"?
Why were people allowed to buy "protection" against assets they didn't even own with these CDS? I can understand if people wanted to insure their own investments, but this unregulated market allowed people buy insurance against other peoples investments.
In addition to the comment below, one could definitely argue that selling insurance protection far in excess of one's ability to pay is a get rich quick scheme. As for the buyers, it's remarkable that the investors who bought CDS are getting bailed out for hundreds of billions while the Katrina victims who bought homeowners insurance got lectured on how the insurance companies can't be expected to pay for such massive calamities.
Think "deal flow" or transactions per unit time. In other words, you gotta keep selling. Once the first doll has been sold you make a likeness, as if to insure that it is not lost, and then you may sell it, and the next layer and so on.Each sale generates revenue even though of dubious value. Sounds a lot like a Ponzi scheme doesn't it?
One of the biggest and almost ignored issues are the credit ratings agencies and their dishonest evaluation of various derivatives (AAA or AA when they did not understand the derivative product being evaluated). They were one of the possible "brakes" on the system if they had only done the job correctly. Too late now.
Bonddad I love ya man but part one and two of this series is WAY out there my friend. Wall Street has become a casino craps table and that's all it is. In ever financial transaction someone has to lose for another to make money and there is no way around this. The only insurance is not betting all of your money to start with. It's insanity to think that one can conduct business and not lose anything, or pay a few hundred thousand to insure billions of dollars and truly expect to be paid. The derivatives market by some estimates ranges between 600 - 900 TRILLION dollars while world GDP checks in around 45 trillion. It's not insurance, it's gambling and the entire system needs to be flushed down the toilet... along with fractional reserve banking.
Bingo...
HAAAAAA - Bonddad is just another Wall St apologist. These economists would rather climb a greased pole than tell the truth.
For example, the Boskin Commission gave us "imputations," "hedonics," "weighting," and "substitut
I wish Bonddad and his ilk would just fade away, like the sooth-sayers of old.
Ya, economists are all part of a big conspiracy theory.. LOL
They call economics a "science" but no one can replicate the research of another. nor does it have predictive validity: oftern times even the so-called "experts" don't agree with each other.
When was the last you heard two professors of mathmatics disagree as to the sum of two plus two? Yet, you accept that PHD Economists from the "best" universities can't even agree on whether or not the country is in recession.
LOL at YOU !! Give me a BAAAAAAAAAAAAAAA
You know you're talking to a Republican when they try to escape a debate they're losing by yelling "Conspiracy Theory!" It's like arguing Middle East peace with a right-wing Isreali or Bush advisor ("Anti-Semite!")
BondDad is not an economist. He is a lawyer. Check out his web site.
You're 0 for 2 with me on your defensive solutions for Wall Street. You think that using debt securitization and credit default swaps to spread risk across financial markets eases the flow of capital, but in reality all it does is redirect the flow of capital toward investments that are otherwise too risky to consider. They are instruments of malinvestment.
You talk about parallels between stock and bond markets. As you know, investors in stocks use the P/E ratio to evaluate how the current price compares to the fundamental value of the stock. This is market capitalization over annual income, and it relates to the expected rate of growth. Stock investors hardly look at assets compared to their intense focus on profits.
But in the bond market, it's mostly about assets. Investors don't care as much about the ratio of debt to income as they do with stocks, even though it's clear that income is the best predictor of ability to repay debt. There's not even close to enough income to justify the level of outstanding debt. If the bond market tracked P/E ratios, they would put late-90s dot-com stocks to shame.
Financial "innovation" has made it easy for investors not to care that there's no income backing the debt that backs the securities held by a managed fund. But income is the one true basis for debt, and no amount of innovation will sustain a financial environment of too much debt chasing too little income.
I don't have a problem with putting them in a formal market, but let's call them what they are insurance. It's what you buy in Vegas. What needs to happen to companies who sell CDSs is to follow rules similar if not identical to those in the insurance industry.
CDSs are a time bomb because they aren't regulated and I suspect because there was no legal requirement to have a certain percentage of cash reserves on hand should a bond default. If all these investment houses had sufficient cash reserves it wouldn't be the disaster it is today because of the housing meltdown.
Can you imagine if we buy insurance only to find out it's worthless because there is no requirement for a company to have money to pay for our loss?
I still don't see a legitimate need for CDSs. If you are buying a bond that pays 5% and you buy a CDS as insurance, now you are only earning maybe 4%. So, why not just buy less of the bond if you can't handle the risk, and put the rest of your money somewhere safer? (its like self-insurance which most big companies do in many ways anyway) Or, why not just buy a safer bond that pays 4% in the first place?
Because if you have no confidence in your investments without some insurance, then you have to look at the risk that whoever insured your CDS might default, so would you buy another CDS to insure against the default of your insurer. Now, you are down to a 2-3% return. Then you can buy another to insure against the default of the insurer of your insurer... etc; etc;
Virtually all funds that handle money use some kind of hedging instruments to protect themselves from risk.
Yes, but to protect yourself from risk, you would buy insurance from someone who may not have the money to pay in case of a default??? If you want to hedge your bets, buying something real like an asset, not an insurance contract where you are essentially paying money out and may never get anything for it.
I worked at a major hedge fund for 2 years, and I agree with you that there is no legit need for CDSs. They should be made illegal along with other types of swap agreements. There are plenty of ways for banks to hedge risk using publically traded and regulated securities such as futures and options without using CDSs.
The real purpose of CDSs is to enable parties to to hide their investments from markets, regulators, and competitors. The seller of a CDS gets the benefit of owning a security (regular payments from the buyer) without legal ownership and disclosure requirements. It is a private deal between two parties that is hidden from regulators but can have enormous impacts on markets as we have seen. Large investers basically don't want anyone to know what they are buying and selling and CDSs serve this purpose.
"So -- keep CDS just put them on a formal market. It's really that simple." Not so simple. CDS contracts are very complicated, usually over a hundred pages of payment schedules and endless conditions. Each one is unique. More importantly, Wall St. doesn't want a formal market in CDS because they don't want to be regulated.
Ban 'em now.
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