In 2002 Warren Buffett wrote that in his view, credit derivatives were financial weapons of mass destruction ("FWMDs"). He made the comment while explaining to shareholders why he was unwinding a Berkshire Hathaway subsidiary dealing in them, and few outside of the value investor community paid much heed.
Eight years later we could be singing a different tune in both the media and Congress. After all, we've had a financial crisis, $23.7 trillion of potential government financial backstops and a "Great Recession" that were all exacerbated and partially caused by a FWMD explosion. With some notable exceptions however we haven't changed enough, and these contracts remain poorly understood even as the markets have evolved beyond the levels for which Mr. Buffett first expressed concern.
At the time of his statement, Buffett's reasoning was simply that credit derivatives were "time bombs" where parties would enter highly leveraged contracts with risks they often didn't understand or couldn't evaluate. This was effectively describing the problem AIG would later face (and he wanted Berkshire to avoid). In explaining how impossible to value some contracts were, Buffet gave the example that, if desired, he could easily purchase a speculative position on "the number of twins to be born in Nebraska in 2020." Those words should have raised red flags on how improper derivative contracts could easily simulate a massive underground gambling house.
This would not be the worst of it.
When Buffett wrote his letter, a subset of the market known as credit default swaps ("CDS") was still young. In 2000, the entire notional value of this market was just $900 billion, mostly reflecting bona fide "good faith" buyer hedging. For an individual, bona fide hedging is like buying insurance on your home; in return for a monthly premium (the contract's "spread"), you receive downside protection that pays in the event of catastrophic loss.
But in the early 2000s the CDS market started to change, and new investors whose primary purpose was to take speculative positions emerged in greater force. The reasons why are not hard to understand as potential payouts are enormous; buying $1 million of CDS protection can return as much as $200 million if the underlying company collapses. This 200X return is in contrast to the maximum 2X (ie, 100% profit) return an investor would receive using a generic equity short under the same scenario, because CDS by themselves are more inherently leveraged (ie, they simulate higher levels of debt).
By 2007 the CDS market had mushroomed to a notional value in excess of $45 trillion. At those levels, at least $20 trillion was primarily speculative -- we know this because the combined underlying markets they were based on (bonds and certain structured products) had a total value of less than $25 trillion. This would be like buying a home insurance plan worth $450,000 on the same day you acquired the house for $250,000.
That minimum of $20 trillion in contracts was therefore "naked," or at least mostly so. In finance, being naked generally means transacting in an asset without any ownership or correlated upside in that asset.
Put another way, buying a 5-year naked CDS is like buying life insurance on a stranger. The main point is that you would receive zero benefit if the stranger does well in life; in fact, you would stand to lose money (the premium) if they survived to the end of the contract. However, if they didn't do well, you would earn a fortune. This is both immoral and illegal for an individual but allowed to investors under current law.
If that were the end of it -- simple speculative insurance -- it would be problematic enough. In theory, we might even derive some benefits in the form of increased liquidity and better pricing for all insurance contracts.
However, this would only work in a world without avarice. In fact, the pure logic of buying life insurance on a stranger actually has a moral advantage to buying a naked CDS -- at least with individuals, the act itself of buying life insurance doesn't harm the stranger. It only creates financial incentive to do so.
In the case of naked CDS, buying insurance creates both incentive for harm and the circumstance for actual harm. This is similar to how a naked short works, except that naked shorts are quite rare and illegal under most instances. There are also two structural differences:
In the case of a theoretical naked short manipulation, a speculator would sell large quantities of a company's equity in order to drive the price down, but do so with shares they either don't own or that don't exist ("phantom" shares). This creates a highly concentrated burst of selling activity in excess of what would be possible using only "real" shares, shares that could either be borrowed or owned outright.
For companies that don't access the capital markets regularly, CDS pressure can be frustrating but not debilitating. However, for leveraged financial companies -- who often rely on short-term, daily funding sources -- the results of a spiraling and unknown increase in their CDS would directly affect the core business and be much more dangerous. At minimum this would hurt their cost of capital, reducing profit margins in a healthy bank or causing a weak bank to lose money more quickly. In extreme scenarios, this would even create a confidence-liquidity trap and the modern-day equivalent of a bank run. The only difference here is that we would have institutions rather than consumers lining up for their money, and they would technically not be taking money out but refusing to put money in.
I've heard it speculated that this is exactly what happened in the cases of both Bear Stearns and Lehman Brothers. The evidence -- circumstantial at best -- is that one can see a series of sharp increases in CDS spreads for both companies prior to public awareness of any issue. Sadly, forensically determining what happened is next to impossible because the players leave few traces and are exempt from oversight since the Commodity Futures Modernization Act of 2000. Whether or not CDS pressure was exerted however, what remains likely is that had a similarly weak peer institution (say, Merrill Lynch) experienced the CDS run-up instead of Lehman, their situations and timing of collapse could easily have reversed.
More recently, I have read rumors that a dispute between a TARP-receiving investment bank and the fiscal authorities of Greece escalated into the use of CDS pressure by the bank and two hedge funds to increase the government's cost of debt. This is probably not true, however it is probably also plausible; George Soros famously "broke" the Bank of England using less aggressive instruments and with far less market power than the big banks have today.
In summary:
I hope that readers and staff of the Huffington Post may join me in calling for regulators to propose a ban on abusive naked CDS that is at minimum similar to the one already in place that bans abusive naked shorts. In addition, I hope that together we can push more elected officials into doing the work needed to genuinely understand these issues beyond basic sound bytes. If they do, I am confident that more attention will be paid to smart proposals for dual-regime oversight such as the one put forward by CFTC Chairman Gary Gensler. In it, he establishes the basis for overseeing not just the markets (through exchanges, clearing houses, etc) but also the dealers themselves. Without a dual-regime approach, it is just a matter of time before smart, unregulated traders find new ways around the system because it is their financial incentive to do so.
-- The author is an independent corporate advisor at Belstone Capital and editor of the blog Polifinance.com, where this article has been co-published.
Follow Jason Paez on Twitter: www.twitter.com/polifinance
Our current situation was caused by a perfect storm AND the domino effect. The financial industry is THAT out of hand.
A lot of the same insurance, for people who really need it (i.e. users and producers of a commodity) is found in hedging and futures. Derivatives just raised the amount of leverage that can be applied.
Time was when CDS would have been picking up our children's music from all over the house while tidying up, LoL....
So glad you posted this. We enjoy learning!!
Moms in Canada
Yes, there was a very important reason why the Framers of our system of government stipulated that "all civil officers shall be removed from office for ..." both high crimes and low ones; and also that they specifically took care to list: "bribery."
We just can't deny the human nature that we all share. We can't deny that our nation cannot and will not willingly plunge into the pit that has so much historical wreckage at its lip and bottom. We may "ask" and "encourage" and even "demand" that our leaders should do what is wise and what may be best for us, but we must never expect such behavior unless we are truly willing to enforce the supreme law of our land against "all civil officers." Nothing less will do.
I fear also that the rest of the world community is about to realize some of the perils of interconnectedness. Can a corrupt Congress of the United States truly affect them, half a planet away? Definitely yes.
In principle, every financial transaction creates an asset and an equal-and-opposite liability. Whenever someone has to pay (i.e. has a liability), someone else is owed a payment (i.e. has an asset). These are equal-and-opposite in all possible scenarios: whatever is or isn't paid, the same is or isn't received. Of course, a transaction may be very complex, with many payments contingent on different criteria. But for every payment, the sum is zero. The total liabilities created in a financial transaction always equal the total assets it creates.
For accounting purposes, however, this equality does not hold. An asset holder must account for the possibility that payments will not be received, whereas a debtor facing the possibility of failure must still recognize the full value of the liability. The total of assets plus liabilities, as accounted for, is negative.
So scenarios like the following can occur: a bunch of people all own real assets; they set up a bunch of transactions; fear of default spreads; and suddenly everyone has negative wealth on paper even though no real assets have been destroyed. Then everyone has to liquidate real assets to pay off creditors in bankruptcy (or similar proceedings for firms that don't technically go bankrupt). Real wealth is destroyed for no real reason.
Leverage that poses that kind of risk must be prohibited.
I would have thought this would have been congress's first priority after the collapse. I see no point in trying to reform health care until financial reforms are first in place at a systemic level. I am so tired of being told that the abuses practiced are legal and the consumer has no recourse.
CDS IS insurance without reserve:
Fraud 101.
Just OUTLAW all derivatives,
FORCE investment back to main street..
I would caution against a blanket dismissal of the value of derivative contracts for society though, and hopefully at some point in the future I'll have the time to sit down and write a truly substantive article on why. The short version I think is that the vast majority of participants in these markets are either companies looking to hedge (no different than you or me trying to get home insurance or health insurance) or honest investors/speculators whose activity supports the efficient markets that the companies rely on. Where there is abuse, we should turn our heads to elected members of Congress -- it is their job to protect the ordinary taxpayer and provide a healthy regulatory environment.
A great way of looking at it I think is that markets are like the highway -- wonderfully efficient for travel and generally safe, as long as we have speed limits and seat belt laws.
Let's try it again for awhile.
Swing the pendulum a little too far, perhaps, but I don't think so.
Add real investment insurance, WITH reserves, and people can "hedge" their bets far more efficiently and honestly.
I think of money as the blood of the economy. The patient dies if it pools in to small an area, or if areas don't get the money they need. I will think about the Highway analogy more.
And Goldamn knew damn well what was going on:
http://www.spiegel.de/international/europe/0,1518,676634,00.html