Credit derivatives were originally hyped as hedging tools to protect the value of a portfolio. For example, if you own a bond, you can buy protection against the possibility of default by paying a protection premium, similar to the premium you pay on an insurance policy. The difference between insurance and the credit derivatives known as credit default swaps (CDS) is that you don't actually have to own the bond in order to "buy protection." But like an insurance policy, you have to negotiate the terms of the contract.
Leverage and Language
Since I wrote the first edition of my book, Credit Derivatives and Synthetic Structures in 1998, (John Wiley & Sons, second edition 2001), nothing has changed for the better in the credit derivatives market. It is the first trade book about credit derivatives and stresses that these products are primarily used for leverage. The overwhelming problems are pricing and the risk of misinterpretation of the meaning of the contract language.
Language "Arbitrage"
Sometimes contracts are maliciously written to disadvantage the unwary; this is also called "language arbitrage," because manipulating the language makes a risk-free gain for the perpetrator. In April 2005, I explained to the International Monetary Fund (IMF) that no one in the credit default swap market should trust ISDA "standard" documentation. One has to rewrite the contract language to protect one's own interests. The beginning of this clip illustrates that point:
Janet Tavakoli at the IMF conference, "Asset Securitization and Structured Financde: Benefits, Risks and Regulatory Implications," April 19, 2005 (requires Windows Media Player).
The following is from my March 12, 2010 post, "Washington Must Bank U.S. Credit Derivatives: Games and Gold," on problems with U.S. credit derivatives, but it applies to the problems with credit default swaps on Greece today.
Sovereign Credit Default Swap Contracts: Tower of BabbleThe credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.
J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.
The problem today is that some owners of credit default protection on Greece think they should be able to declare a credit event, but the ISDA cartel has issued an opinion that according to its interpretation of the documents, there has been no default. The problem has always been that contract language is subject to both abuse and "interpretation."
Greece and the ISDA Cartel: Language Games
There are a variety of problems that arise with credit default swap language. The two biggest are disputes about the definition of a credit event and disputes when it's time to settle up after everyone finally agrees a credit event has occurred. Settlement disputes arise over the value of the physical instrument delivered (for physical settlement) or with the calculation of the cash settlement amount (for cash settlement).
Recently the ISDA committee, which is stacked with the large financial institutions that dominate the trading of these products, ruled that no credit event has yet occurred for holders of credit default protection on Greece, if one used "standard" ISDA documentation.
The committee is controlled by the largest banks and financial institutions that trade these products. You can view the list here. For the Americas, the committee includes Voting Dealers: Bank of America / Merrill Lynch, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase Bank, N.A., Morgan Stanley, Societe Generale, UBS, and Voting Non-dealers: BlueMountain Capital, Citadel LLC, D.E. Shaw Group, Elliott Management Corporation, and Pacific Investment Management Co., LLC.
Credit Default Swaps: A Speculators Dream of Leverage
Given all the problems for hedgers, why has the credit derivatives market grown like crazy to notional amounts in the tens of trillions of dollars?
Speculators poured into the CDS market because of its tremendous leverage. If you think a bond might go down in value, or if the bond is downgraded, the credit default swap will gain in value, even if no default occurs. A speculator who gets in early enough can exit the trade at a huge profit and is out only the amount of the premiums paid in the meantime.
It's as if you bought a life insurance policy on your sovereign neighbor, known to those paying attention to be a reckless-driver, and then made a killing when your neighbor had a fatal accident. Obviously, you know it wouldn't be fair play to tamper with your neighbor's brakes, but others who stand to make a huge gain might be tempted.
Speculators look for huge swings in value. Some speculators aren't too fussy about how those swings in value occur and sometimes try to help it along by say, stoking a rumor mill or other market machinations.
Since credit derivatives often allow speculators to get the benefit of high leverage for very little initial outlay, credit derivatives, which were once touted as hedging tools, have become dominated by speculators.
Pricing is Always an Issue: You Can't Trade With a Screen
If a speculator bought credit default protection on Greece a couple of years ago, the speculator wouldn't have paid much in premiums and today can make many times the initial outlay. For example, during the past couple of years (depending on when one entered and exited) a few hundred thousand dollars could net a gain of several million on a $10 million trade.
But the trade is for people with deep pockets, because the pricing is controlled by a handful of traders, and when you ask for a price, the screen price becomes irrelevant and all of the "market makers" suddenly offer you the same lousy price. In one recent example, a speculator with a $10 million notional CDS claimed that he was being ripped off for $500 thousand after being low-balled in a bid for the protection he had purchased long ago. That $500 thousand isn't merely 5 percent of the notional amount, since it represents a much larger percentage of the gains to which he believed he was entitled. This sort of thing happens all the time, since pricing is controlled by a small group of market makers who often have a buyer lined up on the other side. Any money the "market maker" middleman squeezes out of buyers and sellers becomes profit.
Speculators aren't as fussy about language, because unlike hedgers, they aren't trying to match off risk. Often the interests of speculators and hedgers are misaligned, since hedgers often prefer that the underlying bonds (or other risk) recovers -- the risk is rarely completely hedged, because hedges are expensive. But speculators often make a naked bet. If a speculator is long credit default protection, the worse things get, the more the speculator makes.
Protect Yourself
There are so many issues in the credit derivatives market, that it's impossible to cover them all in a post. The Dodd Frank Act won't resolve the problems in the credit derivatives market, and bank lobbyists were successful in neutering effective change.
The disputes over credit default swaps on Greece highlight the fact that most participants in the credit derivatives market are at the mercy of ISDA when it comes to interpretation of ISDA's language. The only solution to that is to exercise one's rights, and insist on a custom-made over-the-counter contract that protects one's interests. As the past few years have shown, "regulators" won't protect investors either before or after the fact. You have to protect yourself.
Credit Dervatives and Systemic Risk
In earlier commentaries, I discussed how credit derivatives foster systemic risk in the global financial system. One example is "Goldman's Undisclosed Role in AIG's Distress," Nov. 10, 2009.
Endnote: My new e-book, The New Robber Barons, is now available in the U.S., UK, Germany, France, Italy, and Spain.
Everything is set-up to break the way of the banking oligarchy. Our political "leadership" has betrayed the people by letting the banks have their way after accepting bribes from the oligarchy. No one blinks even when the bankers are back to paying themselves multiple million bonuses after having raped the public of trillions of dollars due to the bankers' own greed and stupidity. The system is completely broken and will soon self destruct. Within a decade, wall street will burn. Buy gold and Support the only presidential candidate who understands this issue and is not on the take: DR. RON PAUL!
Keep up the good work Janet and continue to shed light on the organized crime syndicate that is the global banking system. The people have power too. They can stop doing business with the global banks and use local credit unions for there financial intermediation needs.
If I'm a trader in the Credit Markets, what does a CDS do for me? It's potentially 70% of a haircut of worthless. Where do i reflect the risk of the bond,,. in the price of the bond?? In the CDS spread?
Here's the common sense Credit Market move, I ain't gonna be in line to buy Spain and Italy debt when they try to issue new or roll a maturity in the coming months. The ECB better make room on their Balance Sheet.
My second most unfavorite trade is going to be the EU Banks' debt. Although the whole point of this thing looks a lot more like bailouts for the EU Banks
The conflicts of interest at the ISDA are insane, too. If people can't see the by-nature conflicts in self-regulation, they better get their eyes and head checked. You wait, these guys will turn out to have been making a buck, knowing what the outcome was going to be.
But here's the irony, if this had happened in early Oct/11, MF Global wouldn't be bankrupt and Corzine would be rich on the deals, and still using his clients' capital..
If being buried in debt, and not being able pay for it, isn't a default.. then what is?
[If the market considers CDS's to be "a fire insurance policy against your neighbor's house burning down", then it is the responsibility of politicians and regulators to protect the public and ensure such products are not irresponsibly created and abused. Instead, these two groups sold out the American people to the bankers.] Literally.
If the ability to write CDS policies were held to the same standards and regulations as insurance underwriters, the world not be facing the financial crisis it is today, period.
Now those of you who want to buy the BS of the regulators and politicians who say "well we didn't have the legal authority or charter to regulate those products".... REALLY? How often do we witness regulators and politicians make power reaches and grabs? How many times? And you're going to buy that line of BS?
Without the unregulated, non-capitalized underwriting of the CDS's, the "web of cross liabilities" would not have become so complex nor would the gross exposure been able to have grown to be systemically dangerous." - Centurion9.41
http://www.zerohedge.com/contributed/2012-09-03/greek-cds-and-new-house-rules-get-over-it#comment-2219669
They just rake it in. When it hits the fan, the taxpayers own the policies. The unemployed should be building giant prisons for the Financializers.
I see no way out. Someone please tell me that there is. Greece will most certainly default at some point when the smoke and mirrors run out. What then? What if a classic "financial contagion" then starts to spread across Europe and reach our shores like the Vienna Credit-Anstalt Bank event of May 13, 1931? It was the event that eventually enabled the comeback of Fascism in Europe. But this time there cannot be a World War II to save the banking interests of the United States via financing industrial scale war. The weaponry is just too great now.
http://www.businessweek.com/magazine/content/11_18/b4226012481756.htm
Your typical Fox News viewer will sermonize to high heaven about poor people causing the financial crisis, but in truth the damage from defaulting home loans would've been contained within the mortgage industry were it not for the $30 trillion CDS bubble which acted as the dry brush and heavy winds which allowed the fire to spread throughout the global markets. In fact, the total abandonment of lending standards would not have happened in the first place if banks and investment brokers alike were not incentivized by the comparatively larger returns from CDS trading -- trading which was blocked from being regulated by a Republican-sponsored bill in 2000 (i.e., CFMA of 2000). The Republican-controlled congress practically forced his hand to sign the dotted line, spelling inevitable doom for the US economy in years to come.
Toxic assets were an invention of Wall St. because it was the only way to sustain their $30 trillion derivatives bubble. Had Republicans not used the Modernization Act of 2000 to block regulation of CDS trading, it's unlikely that the mortgage meltdown would've been the catastrophe that it was.
http://fcic.law.stanford.edu/report
However, with the advent of exotic investment vehicles created by Wall St., it was then possible to lend to virtually anyone and still make a profit. It was that type of lending which caused the financial crisis. Government did not create that kind of lending.
I understand your dislike for government. I don't care much for our government either. But, in order to understand what really happened to cause the financial crisis, it really takes being able to see the bigger picture while at the same time taking note of the details. Try reading that link I posted. It's a valid source and it supports everything I've said so far.
http://www.cnbc.com/id/46592127
The nagging question is what credibility does a Credit Default Swap have if all types of maneuvers are being used in Greece's case in order to avoid the adverse impact of them? It seems the CDS as a valid instrument is itself at risk, because of this issue in Greece.
So, the usefulness of investing in "negative views" can be likened to the need for observance of tragic events for the purpose of learning from those events and subsequently creating greater societal stability. On the one hand there are bar-b-cues and parades on Memorial Day, and on the other hand there is a morbid inner desire to relive those events by creating more wars. A balance between those two must be maintained, but unfortunately that balance is not one that Wall St. has been able to achieve.
Or if you want some leverage, then buy puts.
I couldn't agree more regarding the fundamental problems with credit default swaps.
Especially the observation that the markets for them are inefficient, illiquid, and thin. Therefore the 'invisible hand' is more or less useless in curbing excesses.
If they were totally hived off from systemically important financial institutions, then OK, I suppose. But we all know how that worked out last time.
As far as still flogging the AIG/Hidden bailout meme, your supporters might want to revisit the financial costs. Maiden Lane II is winding down with a $2.8 billion profit. Maiden Lane III is on track to do the same. And with the stock price over $29, the government's stake is now in the black.
But back to your central point. The potential for abuse and catastrophic concentrations of risk far outweigh the benefits of their use as bona fide hedges.
Keep speaking out.
We have seen some weird things happen in vanilla markets -- the May, 2011 flash crash.
Greece, within her present borders, will never recover.
Funny how liberals invent all these complicated constructs to mask a very basic issue.
Have a great day!
Unfortunately if they were restricted to having the equivalent of an insurable interest in the underlying debt obligation, they would be very likely regulated under insurance regulations. (The interested parties fought hard to make sure this didn't happen) Remember, regulations are bad, greed and shifting wealth around to generate profits is good!
The underwriter of the CDS should be required by statute to reserve for each one written. This of course would end the game for the uber wealthy speculating in financial time bombs that provide absolutely 0/Zero/Nil real economic purpose.
There's are important roles for financial regulation but one that presumes to outlaw bad investments is not one of them. Caveat emptor works just fine...when government LETS it!