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[Sep 04, 2010] Guest Post Economic consequences of speculative side bets – The case of naked CDS

September 4, 2010 | naked capitalism

By Yeon-Koo Che, Professor of Economic Theory at Columbia University, and Rajiv Sethi, Professor of Economics, Barnard College, Columbia University, cross posted from VoxEU

The role of naked credit default swaps in the global crisis is an ongoing source of controversy. This column seeks to add some formal analysis to the debate. Its model finds that speculative side bets can have significant effects on economic fundamentals, including the terms of financing, the likelihood of default, and the scale and composition of investment expenditures.

There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang Münchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes (2010) who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance. In sharp contrast, John Carney believes that any attempt to prohibit such contracts would crush credit markets, Felix Salmon thinks that they benefit distressed debtors, and Sam Jones argues that they smooth out the cost of borrowing over time, thus reducing interest rate volatility.

One reason for the continuing controversy is that arguments for and against such contracts have been expressed informally, without the benefit of a common analytical framework within which the economic consequences of their use can be carefully examined. Since naked credit default swaps necessarily have a long and a short side and the aggregate payoff nets to zero, it is not immediately apparent why their existence should have any effect at all on the availability and terms of financing or the likelihood of default. And even if such effects do exist, it is not clear what form and direction they take, or the implications they have for the allocation of a society's productive resources.

In a recent paper (Che and Sethi 2010), we have attempted to develop a framework within which such questions can be addressed and to provide some preliminary answers. We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice.

Heterogeneous beliefs and side bets

A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information. Individuals receiving the same information can come to different judgments about the meaning of the data. They can therefore agree to disagree about the likelihood of default, interpreting such disagreement as arising from different models rather than different information. As in prior work by John Geanakoplos (2010) on the leverage cycle, this allows us to speak of a range of optimism among investors, where the most optimistic do not interpret the pessimism of others as being particularly informative. We believe that this kind of disagreement is a fundamental driver of speculation in the real world.

When credit default swaps are unavailable, the investors with the most optimistic beliefs about the future revenues of a borrower are natural lenders: they are the ones who will part with their funds on terms most favourable to the borrower. The interest rate then depends on the beliefs of the threshold investor, who in turn is determined by the size of the borrowing requirement. The larger the borrowing requirement, the more pessimistic this threshold investor will be (since the size of the group of lenders has to be larger in order for the borrowing requirement to be met). Those more optimistic than this investor will lend, while the rest find other uses for their cash.

Now consider the effects of allowing for naked credit default swaps. Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it. However, pessimists also need to worry about counterparty risk – if the optimists write too many contracts, they may be unable to meet their obligations in the event that a default does occur, an event that the pessimists consider to be likely. Hence the optimists have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives. The borrowing requirement must then be met by appealing to a different class of investors, who are neither so optimistic that they wish to sell protection, nor so pessimistic that they wish to buy it. The threshold investor is now clearly more pessimistic than in the absence of derivatives, and the terms of financing are accordingly shifted against the borrower. As a result, for any given borrowing requirement, the bond issue is larger and the price of bonds accordingly lower when investors are permitted to purchase naked credit default swaps.

This effect does not arise if credit default swaps can only be purchased by holders of the underlying security. In fact, it can be shown that allowing for only "covered" credit default swaps has much the same consequences as allowing optimists to buy debt on margin: it leads to higher bond prices, a smaller issue size for any given borrowing requirement, and a lower likelihood of eventual default. While optimists take a long position in the debt by selling such contracts, they facilitate the purchase of bonds by more pessimistic investors by absorbing much of the credit risk. In contrast with the case of naked credit default swaps, therefore, the terms of lending are shifted in favour of the borrower. The difference arises because pessimists can enter directional positions on default in one case but not the other.

Naked credit default swaps and self-fulfilling pessimism

While this simple model sheds some light on the manner in which the terms of financing can be affected by the availability of credit derivatives, it does not deal with one of the major objections to such contracts: the possibility of self-fulfilling bear raids. To address this issue it is necessary to allow for a mismatch between the maturity of debt and the life of the borrower. This raises the possibility that a borrower who is unable to meet contractual obligations because of a revenue shortfall can roll over the residual debt, thereby deferring payment into the future.

As many economists have previously observed, multiple self-fulfilling paths arise naturally in this setting (see, for instance, Calvo 1988, Cole and Kehoe 2000, and Cohen and Portes 2006). If investors are confident that debt can be rolled over in the future, they will accept lower rates of interest on current lending, which in turn implies reduced future obligations and allows the debt to be rolled over with greater ease. But if investors suspect that refinancing may not be available in certain states, they demand greater interest rates on current debt, resulting in larger future obligations and an inability to refinance if the revenue shortfall is large.

A key question then is the following: how does the availability of naked credit default swaps affect the range of borrowing requirements for which pessimistic paths (with significant rollover risk) exist? And, conditional on the selection of such a path, how are the terms of borrowing affected by the presence of these credit derivatives?

For reasons that are already clear from the baseline model, we find that pessimistic paths involve more punitive terms for the borrower when naked credit default swaps are present than when they are not. Moreover, we find that there is a range of borrowing requirements for which a pessimistic path exists if and only if such contracts are allowed. That is, there exist conditions under which fears about the ability of the borrower to repay debt can be self-fulfilling only in the presence of credit derivatives. It is in this precise sense that the possibility of self-fulfilling bear raids can be said to arise when the use of such derivatives is unrestricted.

The finding that borrowers can more easily raise funds and obtain better terms when the use of credit derivatives is restricted does not necessarily imply that such restrictions are desirable from a policy perspective. A shift in terms against borrowers will generally reduce the number of projects that are funded, but some of these ought not to have been funded in the first place. Hence the efficiency effects of a ban are ambiguous. However, such a shift in terms against borrowers can also have a more subtle effect with respect to project choice: it can tilt managerial incentives towards the selection of riskier projects with lower expected returns. This happens because a larger debt obligation makes projects with greater upside potential more attractive to the firm, as more of the downside risk is absorbed by creditors.

The impact of speculative side bets

The central message of our work is that the existence of zero-sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic about the future revenues of borrowers, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic about the borrower's prospects, and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns.

James Tobin (1984) once observed that the advantages of greater "liquidity and negotiability of financial instruments" come at the cost of facilitating speculation, and that greater market completeness under such conditions could reduce the functional efficiency of the financial system, namely its ability to facilitate "the mobilisation of saving for investments in physical and human capital… and the allocation of saving to their more socially productive uses." Based on our analysis, one could make the case that naked credit default swaps are a case in point.

This conclusion, however, is subject to the caveat that there exist conditions under which the presence of such contracts can prevent the funding of inefficient projects. Furthermore, an outright ban may be infeasible in practice due to the emergence of close substitutes through financial engineering. Even so, it is important to recognise that the proliferation of speculative side bets can have significant effects on economic fundamentals such as the terms of financing, the patterns of project selection, and the incidence of corporate and sovereign default.

craazyman

You really don't know which projects are "efficient" or "inefficient" until after the fact. The financing cost is only a market signal, but one that (like all market signals) can be wrong, in hindsight.

So there's no way to judge - a priori - whether inefficient projects are being funded or not. The notion that CDS can restrain funding of inefficient projects is inherently immeasurable and therefore theoretically nonsensical.

Then there's this mind pretzel, although it's no fault of the authors:

"A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information."

How can this statement be considered unorthodox? [Well I guess in academic finance anything is possible ;) ] - it's like saying it would unorthodox to believe football betting pools can exist because it doesn't make sense that folks would have differing expectations on game outcomes, considering all bettors know who the players are and the track records of the teams. Moreover, this same unorthodox belief negates the notion that project efficiency can be objectively measured in advance of results.

It's amusing to see academic theory strain itself to explain the real world. It works in physics pretty well, and maybe in medicine to some degree, but in most other human disciplines it's pretty funny.

Oh well, far better to sit around and academicize this stuff than to go work for some Government Supported Gang of Looters and write Naked CDSs for a living and bankrupt taxpayers and savers. ha ha ha. That's for sure.

Bruce Krasting :

Of course their are consequences of financial innovation. This is like saying that the evolution of options over the last 20 years was a negative. It was not. The proliferation of ETFs is another example. It has changed trading.

I am not aware of a country that has been tipped over as a result of CDS. There have been a few corporates. Lehman comes to mind. Do you really think that LEH went down because of CDS? If so you live on the moon. They had no equity. That is why they went bust. CDS just hastened the day.

I think you have to ask yourself what would happen if you actually succeeded in turning back the clock on this. I think you would find that the global supply of credit would fall as a result. CDS in now part of that system, like it or not. Take it away and you will regret it. bk

Diogenes says:

"Furthermore, an outright ban [on naked credit default swaps] may be infeasible in practice due to the emergence of close substitutes through financial engineering."

Is it just me, or is there anyone else out there who thinks that if this statement is really true, those of us who care deeply about trying to correct the structural problems in the financial system that caused the crisis should just throw up our hands and concede that democratic capitalism is dead?

Jim the Skeptic:

Credit Default Swaps (CDSs) are insurance. If they had been called insurance then the states could have regulated them. They wanted federal regulation if any at all. In fact when Brooksley Born tried to regulate them they brought out the big guns and sank her efforts.

Naked CDSs are insurance policies bought against some other persons property. Such as, I buy a policy against your house. Insurance companies do not write such policies because I might decide to burn your house down. But even if we assume that there will be no intentional damage to other's property, we still are encouraging speculation.

IF CDSs were tightly regulated and IF naked CDSs were forbidden, and IF the federal financial regulators would refuse to bail out the the sellers or the buyers of CDSs gone bad, THEN CDSs might be more beneficial than risky. But if you believe any of that is going happen then you must be on some heavy duty drugs.

How to stop another derivatives inferno By Gary Gensler

February 24 2010 | FT.com
On October 8 1871, what started as a small fire swept across Chicago to destroy much of the city. The story goes that it was ignited when Mrs O'Leary's cow kicked over a lantern in her barn. Many buildings were made of wood, so the fire spread quickly. In the years after the fire, Chicago implemented new building and fire codes. Those rules now protect the residents of Chicago from the spread of future fires.

In the autumn of 2008, certain financial institutions kicked over the lantern that set off the financial crisis – a fire that nearly burned down the global economy. In America, more than a year later, unemployment is at nearly 10 per cent. Most of those who have lost their jobs never used the flammable financial contracts that helped create the crisis. As regulators, we have a responsibility to establish codes that will ensure the concentrated, opaque derivatives market never again brings the financial system to the brink of collapse.

Derivatives are meant to help lower risk and make it easier to discover the price of risks and assets. But unregulated derivatives heightened and concentrated risk and lessened transparency, making it harder to price risks and assets. US taxpayers bailed out AIG with $180bn when that company's ineffectively regulated $2,000bn derivatives portfolio, managed from London and cancerously interconnected to other financial institutions, nearly brought down the financial system. As we later learnt, much of the bail-out money flowed through AIG to US and European banks. The recent chill winds affecting the euro have further revealed how derivatives can be used by a sovereign country, such as Greece, to borrow from a financial institution, while obscuring the embedded loan.

Now we must rebuild the global economy, working across international borders, in a way that protects the public and market participants. Effective reform of the over-the-counter derivatives market requires three essential components that exist in the regulated securities and futures markets.

First, we must explicitly regulate the financial groups that deal in derivatives. They should be required to have sufficient capital and to post collateral on transactions so that the public does not bear the costs if they fail. Dealers should be required to meet robust standards to protect market integrity and lower risk, and should be subject to stringent record-keeping requirements.

Second, to bring transparency to market participants and the public, standard OTC derivatives should be required to be traded on exchanges or other trading platforms. The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. Transparency brings better pricing and lowers risk for all parties of a derivatives transaction. During the financial crisis, Wall Street and the US government had no price reference for particular assets – assets that we began to call "toxic". Financial reform will be incomplete if we do not achieve public transparency that will lower risk in the derivatives market.

Third, to lower risk further, standard OTC derivatives should be brought to clearing houses. Clearing houses act as middlemen between two parties to a transaction and guarantee the obligations of both parties. Transactions are moved off the books of derivatives dealers, which are part of financial institutions that may be both "too big to fail" and "too interconnected to fail", and on to those of well-regulated central counter-parties. Centralised clearing has helped to lower risk in futures markets for more than a century.

Many of the financial institutions that kicked over the lantern in 2008 now oppose critical aspects of reform. This should be expected; after all, regulatory reform would mean big changes for the biggest banks. But Wall Street's interests are not always the same as the public's. Banks have a duty to their shareholders to maximise profits. In 2008, we watched them fail to manage their risks. It is now time to enact reform so that taxpayers no longer bear the price of Wall Street's mistakes.

Chicago rebuilt itself with new rules to limit the risk of fire. We, too, should establish rules to protect the public from OTC derivatives. If we do nothing, we risk another financial fire that will cost even more jobs.

The writer is chairman of the Commodity Futures Trading Commission

Copyright The Financial Times Limited 2010. You may share using our article tools. Please don't cut articles from FT.com and redistribute by email or post to the web.

February 26

The Derivative Project


Thank you Mr. Gensler for the excellent work you are doing. We sincerely appreciate it. The Derivative Project (thederivativeproject.com) has been established to ensure:

(1) All OTC derivatives trade on a regulated exchange, there will be no customized contract exceptions.

(2) Credit default swaps will be banned.

(3) No U.S. taxpayer dollars will go towards the research and establishment of systems to monitor OTC derivatives, to effectively "babysit" the side bets of the top 5 banks in the derivative market.

We sincerely hope Congress can soon pass the above listed regulatory changes. As you are aware these are unprecedented times which call for unprecedented actions on the part of the American people to restore our economy to the values upon which our democracy was founded.

Therefore, if these regulations are not swiftly passed, we are confident, based on the response to date, that our Resolution Authority subset of The Derivative Project will be successful in changing the minds of the Boards of the five major banks to support these changes, due to their significantly decreased market share and the corresponding impact on these banks' income statements.

OTC guy

Thomas W:

I know Gensler. I know him personally in fact. He is a business student + Wharton MBA. Not the sharperst tool in the shed, just a politician.

I agree with you that there are some contracts that should not exist (CDO^2, CDO^3, all that crap that is just an exercise in being a smart-ass).

What I am saying is that the idea that moving eveything on-exchange will solve all the information asymmetries is not only naive, it is dangerous. Just look at the problems CME is having trying to clear CDS contracts.

And yes, "standard OTC derivative" IS an oxymoron. Futures are standardized by definition, and that is exactly what makes them tradeable on an exchange. A barrier option with multiple knock offs can never be standard. Face it.

M

EMH worshipping economists have to be challenged too. There was one in the FT recently supporting use of CDS prices as if these predicted the future.

That may be in some narrow cases, but it did not seem to dawn on this economist that a rising CDS price could be contributory to the failure, and not just a passive indicator. (don't take me to the other extreme -of course there are real causes). But the blindness from someone so apparently educated that it was a one directional portent to the future was mind-boggling. It could only be a religion-type attachment to EMH. Economists fawning to banking interests need to be exposed as such.

LegalTender

The Dems and their appointees are in the pay of the futures exchanges.

Tell me, did trading oil on the NYMEX (exchange traded and centrally cleared) prevent a massive oil bubble that helped kill the global consumer or did it help cause it? Does America's CFTC director not know that AIG's trades were collateralized (the problem being the size of the position and the market moves overwhelming the liquidity of the company, much as happened to Metalgesselschaft on EXCHANGE TRADED contracts).

The answer is clear. The only reason (besides campaign contributions) for the pols liking exchanges is that they can arbitrarily prevent "speculation", short selling and any other financial transaction that is not in the immediate political interest of the rulers. Look at what they tried to do to oil specs last year. If CDS were traded on exchanges only do you think anyone would be allowed to hedge against EU member default risk right now?

Here is a better idea:

Central clearing should be separated from execution by antitrust

All counterparties should disclose, mtm and stress test aggregate derivatives positions

Minimum capital/margin requirements incorporating stress tests should be established by regulators

If we do all those things it matters not whether contracts are OTC or exchange traded- except the OTC market will be better protected from politicians

dquirk:

Not only should OTC derivatives be prohibited for the most part, most exchanged traded derivatives should be prohibited. Why on earth has Obama not banned CDS (credit default swaps) yet? These stupid and dangerous casino-type securities are at the heart of the Lehman, and AIG failures. They didn't exist 10-15 years ago and serve no legitimate economic purpose other than to specualte on someone's failure, which in the process can create a self-fulfilling run-on-the-bank, if there is collusion, which there often is. While we're at it, let's ban most of the derivatives on financial products. Most people can understand the need for industrial or agricultural producers to buy derivatives (primarily futures) to lock in the price of oil or corn or whatever. Very little else is legitimate and promotes leverage and speculation. The Obama adminsitration needs to wake up.

Thomas W.:

OTC guy:

Gensler is chairman of the commodity future trading commission.

Could it be that OTC guys have never even heard of what that institution does? Just a thought.

And about complexity and bespokehood: even complex derivatives are portfolios of simpler ones, from which they are synthesized. And if they're not, and if it's indeed impossible to determine their value in any fashion where comparisons with market values of other underlyings and contingent claims can be used - what makes you think that they can exist within a market without destabilizing it?

The whole point is that the times of the innocent assumption that OTC derivatives are bilateral claims that don't affect others are over, and for good.

The whole point is the external effects of these beasts that come to the forefront in the event of insolvency of one of the parties. They are not bilateral contracts in their full economic consequences. Face it.

Furthermore, 'standard OTC derivative' isn't even an oxymoron. A handful of banks control 95% of the market for these. No wonder that everything is bespoke and complex. Don't you think?

MARK Culme-Seymour | February 25 11:12am | Permalink
| Options
As a former commodities broker I couldn't agree more. And the banks are hardly in a position at the moment to oppose reforms, whatever they may say.

OTC guy:

The fact that Gensler uses the oxymoronic expression "standard OTC derivatives" shows his lack of understanding of the subject. As a common politician, he just sees one side of the story.

OTC derivatives exist precisely because they are too complex and too bespoke to have in a clearinghouse environment.

New Jersey- State of Fiscal Emergency

some investor guy:

YLSP wrote:

The reason the financial firms are able to make a killing in derivatives is because their counterparties aren't as sophisticated as they are, right?

There are some much more frightening possibilities. One of them is that for many derivatives, different firms are booking their values using different models. People on opposite sides of the same trade sometimes both book profits. In certain cases, this can go on for a very long time.

some investor guy (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:00 am Nanoo-Nanoo wrote:

I don't think the people who currently trade them understand them.

Please elaborate. Do you mean they don't understand exactly how to price the derivative if they know what is happening with the underlying security? Do you mean they misprice or don't understand the effects of extreme events? Do they have a recency bias, assuming the future will be too much like the present? Do you think actual trading or analysis has been delegated to people with too little experience or training, and that a few people at a company know what's going on, but many people don't? Do you think they simply don't understand the why of trading, but don't mind that they get paid well?

.Nanoo-Nanoo (profile) wrote on Fri, 2/12/2010 - 5:00 am We are sooo screwed. It doesn't matter the party as they are both the same in actions, just different rhetoric.

Lobbying May Push Fiduciary Rules for Brokers Off Reform Agenda - Bloomberg.com

Feb. 12 (Bloomberg) -- Lobbying by insurers and banks including Morgan Stanley may eliminate a proposed new standard that would make retail brokers more accountable to their clients.

Tim Johnson, the South Dakota Democrat in line to become the next chairman of the Senate Banking Committee, is circulating a proposal that would drop the so-called fiduciary standard for brokers from the panel's reform package, according to a copy obtained by Bloomberg News. Johnson instead proposes that the U.S. Securities and Exchange Commission conduct an 18- month study to see if there's need for a new broker standard.

Consumer advocates have pushed for the fiduciary standard, arguing that investors are misled by the adviser title used by thousands of brokers. Investors have difficulty distinguishing between investment advisers and brokers, and most see their brokers as advisers, according to a 2008 Rand Corp. study commissioned by the SEC. Without the fiduciary requirement, brokers don't have the same accountability for their advice as investment advisers and have more leeway to sell financial products created by their own firms instead of seeking the best investment for the customer.

"Retail investors have suffered incredible losses in the recent crisis," said Barbara Roper, director of investor protection for the Washington-based Consumer Federation of America. "This provision would at least help protect investors against some of the toxic investments they were peddled by their financial advisers."

Juvenal Delinquent (profile) wrote on Fri, 2/12/2010 - 5:01 am We are all Greeks now.
.HomeGnome (homepage, profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:02 am It's all Greek to me.

some investor guy (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:03 am YLSP wrote:

The reason the financial firms are able to make a killing in derivatives is because their counterparties aren't as sophisticated as they are, right?

There are some much more frightening possibilities. One of them is that for many derivatives, different firms are booking their values using different models. People on opposite sides of the same trade sometimes both book profits. In certain cases, this can go on for a very long time.

Nanoo-Nanoo (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:06 am YES to all investor guy.

I'm sure there are some people who do, just not enough to make it any reasonable form of risk management....CLEARLY as the market is suffering from a gigantic self-inflicted poisoning with contraindicated medications taken in massive quantity We need to pump the stomach and cut out some of the narcotics.
.Sunnyside (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:08 am *You think Warren has a special place in his heart for Becky? She does have premier access. *

I have thought this for some time. It just seems a little "close".

traderwalt (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:10 am some investor guy wrote:

People on opposite sides of the same trade sometimes both book profits

For this reason they should be exchange traded and a settlement price decided upon and made public. Marked to the model is so Enron.

HomeGnome (homepage, profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:11 am Enron, you say?

"Yeah, now she wants her f------g money back for all the power you've charged right up, jammed right up her a------ for f------g $250 a megawatt hour."

---I can't wait for the Lehman tapes....

some investor guy (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:13 am traderwalt wrote:

For this reason they should be exchange traded and a settlement price decided upon and made public. Marked to the model is so Enron.

Many people and most politicians don't realize that you don't have to have exchange trading in order to get a market price. What? Anybody here who didn't know that US Treasuries are not traded on an exchange, please raise your hand. Futures and options are traded on exchanges, but not the Treasuries themselves, and you get a pretty reliable market price with a narrow spread.
.some investor guy (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:14 am HomeGnome wrote:

---I can't wait for the Lehman tapes....

Someone else's tapes might be even better. Nominations?

traderwalt (profile) wrote (in reply to...) on Fri, 2/12/2010 - 5:21 am some investor guy wrote:

Many people and most politicians don't realize that you don't have to have exchange trading in order to get a market price.

This holds for liquid markets, for illiquid markets, not so much..

shill:

Tic Tic Tic Tic.....Jersey the New Greece.

HomeGnome:

You're looking good, shill.

Most Viewed - Google Fast Flip

dum luk (profile) wrote on Fri, 2/12/2010 - 5:28 am Tic Tic Tic Tic.....Jersey the New Greece

but see: How Much Stimulus Funding is Going to Your County?

UPDATED Dec. 2009 | ProPublica Recovery Tracker

Juvenal Delinquent:

The fall from grace is going to be something to watch...

So much entitlement and so little money to pay for it~

dum luk:

Stimulus Spending Hits $272 Billion-34 Percent of Total - ProPublica

Outsider:

Synchronized drowning.

Juvenal Delinquent:

Synchronized Synching.

dum luk:

U.S. retail sales up 4.7% yr-on-yr in Jan.

Jan. retail sales ex-auto and ex-gas up 0.6%

Jan. retail sales ex-gasoline up 0.5%

Dec. retail sales revised higher to down 0.1%

Jan retail sales ex-auto up 0.6%, as expected

U.S. Jan. retail sales up 0.5% vs 0.3% expected

Einhorn: First, Let's Kill All the Credit Default Swaps

David Einhorn, who enjoys his considerable reputation for hard-fought battles against firms with shaky finances and dubious accounting (Allied Capital and Lehman), has taken aim at a new and equally deserving target: credit default swaps.

In an interesting bit of synchronicity, Einhorn's comments in a letter to investors overlap to a considerable degree with a post we wrote yesterday on why a clearinghouse for derivatives wasn't a solution to the dangers posed by credit default swaps (and note the Orwellian branding, the reforms are about "derivatives" which include benign ones, names simple interest rate and currency swaps, yet the bill has loopholes that will let many, indeed probably most, credit default swaps escape).

Credit default swaps have no redeeming social value. They are a fee machine for Wall Street and their supposed value is considerably overstated (the world pre credit default swaps functioned perfectly well) and their costs, which are considerable, are not given the attention they warrant. And I don't mean the failure of AIG, either.

Even though Einhorn gave a stinging, wide-ranging indictment, he missed one of the issues I find troubling, which is that credit default swaps result in information loss, which in turn lowers the quality of credit decisions. In other words, the product is inherently destructive.

In the world of old-fashioned fixed income investing, creditors would evaluate a borrower to make sure it had good odds of meeting its obligations. The lender could and usually did make inquiries about the borrower's income, and its other commitments. If it was a business, the bank might also want to assess information that would help it evaluate the stability of the borrowers income (for instance, learning who its main customers were to determine how diverse and solid they were).

Just as with securitiztion, credit default swaps lower the incentive to do borrower due diligence. Why bother, when the CDS spreads on the reference entity tells you what the market thinks and you can use CDS to reduce or lay off the credit risk? But the original lender is in a privileged position; he is able to gather data from the borrower that it non-public and thus will not be incorporated in a market price. Thus giving creditors an incentive not to do that work systematically lower the quality of credit decisions.

But that reason is a bit abstract, although the costs are real. Einhorn focused on more tangible types of damage wrought by CDS, as summarized by the Financial Times. First, CDS are a means of extortion:

"I think that trying to make safer credit default swaps is like trying to make safer asbestos," he writes in a recent letter to investors, adding that CDSs create "large, correlated and asymmetrical risks" having "scared the authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay".

Second, CDS speculators win if companies die. Given that the volume of CDS outstanding is a significant multiple of the amount of bonds outstanding, they are not used primarily for hedging, but for creating "synthetic" exposures. And those on the short side have compelling reasons to influence outcomes. When a company gets in trouble, the best outcome is often an out-of-court restructuring of debt before it gets even further in trouble. As much as the Chapter 11 process has certain advantages, it is also costly and risky. A CDS holder (one with a significant short position) can buy some bonds (now at a cheap price) of a struggling company to assure it has a seat at the table in negotiations so it can block a renegotiation of the debt and force a bankruptcy filing so it can assure its payoff on the CDS. From the Financial Times:

CDSs are "anti-social", he goes on, because those who buy credit insurance often have an incentive to see companies fail. Rather than merely hedging their risks, they are actively hoping to profit from the demise of a target company. This strategy became prevalent in recent years and remains so, as holders of these so-called "basis packages" buy both the debt itself and protection on that debt through CDSs, meaning they receive compensation if the company defaults or restructures. These investors "have an incentive to use their position as bondholders to force bankruptcy, triggering payments on their CDS rather than negotiate out of court restructurings or covenant amendments with their creditors"

Einhorn also agrees with our contention, that a credit default swaps clearinghouse is not a viable solution. As we said yesterday in comments:

CDS are not economic if adequately margined. Adequate allowance for jump to default risk makes it very unattractive on a ROE basis. The way around that pre-crisis was making AIG and the monolines the bagholders. That game is over, but the Street is hooked on the revenues…..

….in invoking AIG, I am saying that an undercapitalized clearinghouse is a concentrated point of failure and a very big one too, a systemic risk all of its own.

Einhorn's views:

"The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity," he notes.

That's because it is almost impossible to adequately capitalise against such developments. "There is no way a clearing house could demand enough collateral," he says. "The market can be so big and discontinuous that it is very hard to figure out the correct amount of collateral."

I think you need more people recognizing that CDS serve the interests of the financial sector at the expense of the real economy, and calling for the product to be banned. Only then might you see radical enough action taken.

However, as much as I hate CDS, I have reluctantly concluded that they cannot be taken out overnight. They have become sufficiently enmeshed in our financial infrastructure that eliminating them is like disarming a web of nuclear weapons. If you make a mistake on any one, they all go boom. One (and this is far from the only) problem is that the big banks not only have large CDS exposures, but they have other hedges related to them (such as interest rate swaps). So simply putting CDS into runoff mode could lead to dislocations in other markets.

I prefer regulating them very intrusively (like insurance, to make sure the counterparties are adequately capitalized), limiting new CDS writing to hedging existing positions (that would need to be tightly defined and monitored) and limiting CDS writing to end users (which would include proprietary trading desks) to where the investor had an insurable interest, as in owned the bonds, and only up to his exposure. That plus increasing capital requirement over, say, a three year period, to reflect the true default risk of the product should shrink the market enough to allow regulators to then ascertain whether it could then be put in runoff mode. But the intent of policy should be loud and clear: to strangle CDS, with the hope of killing them.

And for those who hope netting might do the trick, reader Richard Smith disabuses us of that notion:

Another point is about the struggle to keep up with 'financial innovation' in the OTC market. A problem for clients and regulators alike. CDS are probably the nastiest of these. They are so polymorphous – part of a basis trade, or a directional bet, or a sort-of-legit hedge, or a synthetic, depending on context; and no cap on speculation a la Gambling Act; and then vaguely like derivatives, or insurance, or short bond positions, or a prediction market.

But you couldn't rule out the possibility that equally nasty new products could be developed by some smart aleck. Maybe there should be a charge on the inventors to cover the cost of regulatory catch up. Or something equivalent to airworthiness regulations, which even libertarians accept without demur, as far as I understand. That would slow the innovators down a bit – proving the 'wings' aren't going to come off their new financial products and kill all the passengers.

Another observation I'd been meaning to make on 'CDS trade compression': the 20-40% that some commentators are so pleased about. I worked on an app like this for a large IB (recently unpopular in the guise of an mollusc) at the turn of the millennium. They had half a million daily NASDAQ trades at that time and their settlement IT guy in NY was freaking out as his mighty mainframe began to wilt under the volumes. Even with quite a conservative approach to compression (there are choices about how aggressively you net the trades – we thought we could get it down to 25,000 trades per day if we really went for it) we got 80% compression straight away, so, 100,000 netted trades per day. Of course those are highly standardized trades. The aggregation was something like stock, side, settlement date, counterparty, trade flags. NASDAQ is often characterized as an OTC market so it is really the product standardization that matters, rather than the nature of the venue perhaps. I think it went to 90% within a month or two as we got bolder but I may be confabulating; it's a while ago.

If they can only get 40% trade compression out of CDS, after a year, there must be an awful lot of detritus left over (especially when IIRC most of the counterparties are TBTFs). So things like contract clauses, reference entity, duration of cover must be all over the place in what remains. Difficult to hedge or lay off I should think. And some unconfirmed trades too no doubt. A total mess.

Ignoring all the other shortcomings of CDS the natural thing would be to standardize the product:: that's happened so many times before, but IBs hate standardization of course for the margin erosion it brings, and anyway now we get this cartel-like protection of the margins, under the guise of support for 'finanical innovation'.

The implication is that what is on the banks' books now is a bit hairier to manage than they are 'fessing up. As other experts who similarly hate the product, like Satyajit Das have observed, simply banning new protection writing would probably lead to hugely disfunctional behavior prior to the date and also lead to problems (as in big time losses, which in a worst case scenario could result in another bailout) as positions that were in runoff mode would be essentially frozen and could not be managed.

But if we can get agreement on aims, which is the product should be killed, then it becomes possible to debate the best (least painful and costly) means.

Derivatives Markets Rebound As Reform Recedes by Oxford Analytica (Guest Post )

Robust trading activity in OTC derivatives products likely to continue as reform momentum dissipates.

Research Recap

Over-the-counter (OTC) derivatives, particularly credit default swaps (CDSs), were faulted as a cause of the credit crunch, most prominently in a June 17 speech by US President Barack Obama announcing his administration's plan for financial reform. This led to calls in the United States and elsewhere to regulate the CDS market.

Regulatory outlook. Some of this pressure has been addressed indirectly by proposals such as the G20's commitment to require all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, at the latest by the end of 2012 - non-centrally cleared contracts would be subject to higher capital requirements.

The Obama administration has made a strong case for pushing to move 'standardised' OTC derivatives transactions to organised exchanges, so as to benefit both from standardisation (and the expected price decreases that will follow), and centralised clearing mechanisms (which would replace the exchange as the nominal counterparty to the transaction, thus eliminating the lion's share of counterparty risk). Unsurprisingly, the exchanges themselves support such moves and have positioned themselves to offer a broader product mix, and cross-border services

Yet different sources of opposition have arisen, even to such modest proposals. It remains uncertain whether the 2012 G20 deadline will be achieved, despite calls from such prominent officials as EU Internal Market Commissioner Charlie McCreevy for more rapid and meaningful standardisation of such markets.

Industrial companies. Within the EU, large industrial companies have emerged as an unanticipated source of opposition. The consequence of mooted changes would be to increase their costs, as they would be required to post margin to make such trades, which is currently not necessary:

Financial institutions. While some firms, such as JP Morgan Chase, have opposed changes upfront and outright, more serious debate will centre on what constitutes a 'standardised' contract, with the industry pushing for narrow interpretations so as to continue to gain high spread from structuring and offering bespoke products; and under what conditions and to what extent higher disclosure standards must be met.

Exchange default risk? Some regulators have echoed parallel concerns, for example that expanding the definition of 'standardised' transactions would put exchanges in the position of clearing illiquid products; and unexpected future systemic shocks might reveal unexpected consequences of such a policy:

This seems unlikely given past history of exchange performance, but is not impossible. Some have suggested that exchanges thus far largely have not defaulted on their commitments because they have limited themselves generally to clearing liquid products.

Congressional priorities The United States has taken the lead in pushing for exchange trading of OTC products, and the US Treasury Department has produced draft legislation. Timely US implementation of meaningful legislation could advance this issue significantly, but any such action is unlikely this year, in part because Congress first will focus on proposals to create a Consumer Financial Protection Agency, and improve regulation of credit ratings agencies.

Outlook. Robust trading activity in OTC derivatives products, including credit derivatives, is likely to continue, and signifies the broader return to 'normal' trading conditions. Yet despite the G20 commitment to move more such trading onto organised exchanges, the lack of a strong US lead to move forward quickly to this goal means major changes are unlikely before 2010 - afterward further momentum may dissipate.

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Marshall Auerback Claims of Financial Reform Victory You Can't Reform Vampires and Zombies

If nothing else, the Obama Administration has learned the virtues of Clintonian spin. The so-called "financial reform victory" claimed Friday over approved new rules for over-the-counter derivatives is, in reality, akin to using a band-aid to treat gangrene.

Any kind of bill which (in the words of the Reuters report), "strives to balance a desire to curb speculative market excess with preserving the market's useful role in helping corporations hedge against operational risks" ignores the fact that it is not the market playing a "useful role in helping corporations hedge against operational risks," but the product of a big financial subsidy to Wall Street. Lack of transparency is a hallmark of these instruments and this gives huge pricing power to the banks. More importantly, it makes them tougher to regulate. There is no public, continuous record of Credit Default Swap trades that is comparable to the data available to investors and regulators from the major cash and derivatives exchanges, and the "reforms" introduced by the House of Representatives Financial Services Committee do nothing to address this reality for Credit Default Swaps.

This is in sharp contrast to the available pricing for other OTC derivatives, which is generally good and tracks the highly visible cash basis that underlie many other derivatives markets, OTC and exchange-based. Whether you are talking about currency swaps or a commodities related product, the world of OTC derivatives excluding CDSs is largely standardized in line with the exchange-traded products. Hence, they do not generate the same volumes of profits for Wall Street, which explains why the latter have fought to retain the status quo in spite of almost blowing up the entire financial system last year.

Obama clearly believes the BS fed to him by Jamie Dimon. I guess we should not be surprised; the President taught at the University of Chicago, after all, and clearly seems to have imbibed some of the Chicago School's free market ideology, and the unspoken assumption that free, unfettered markets are the optimal state. Anything else is a distortion or a rigidity. That of course fails to address the problem of fraud, which my colleague, Bill Black, has tirelessly sought to highlight.

Dealing with fraud is not only an important moral issue, but also crucial on basic economic grounds.

If we don't know what's really going on, we can't gauge whether the government's economic policies are working or not. The advantages of living in a society governed by the rule of law require both the right laws that, with common agreement, public purpose, as well as enforcement sufficient to deter non-compliance in the first place. Laws that most agree are okay to break, and a lack of enforcement, break down the core morality of the system, and result in a dangerous degeneration into lawlessness.

Leaving aside political agendas, the truest test of any reform is: will it have any kind of positive effect? As far as the current financial regulatory reforms go, the answer is probably yes in a very limited fashion, but that is more a function of the impairment of the capital markets themselves, which is precluding additional proliferation of these horrible Frankenstein financial products. If you don't deal with a cancer fully, it comes back and spreads, even if you conduct surgery to remove some of the tumor the first time around. And, as any oncologist can tell you, it's the secondary recurrence that usually kills.

Reform of the current US financial sector is neither possible nor would it ever be sufficient. It's a bit like saying, "Well, this slavery thing has a few problems, but we can 'reform' it and make it better." As any student of horror films knows, you cannot reform vampires or zombies. They must be killed (stakes through the hearts of Wall Street's vampires, bullets to the heads of zombie banks). In other words, the financial system must be downsized.

Downsizing can begin with the following set of actions:

a) All bank assets and liabilities must be brought onto balance sheets, and made subject to reserve and capital requirements and, more importantly, to normal oversight by appropriate regulatory agencies. Any assets and liabilities that are left off balance sheet will be declared null and void, unenforceable by US courts.

b) All CDSs must be bought and sold on regulated exchanges; otherwise they will be declared unenforceable by US courts.

c) Unless specifically approved by Congress, securitization of financial products such as life insurance policies will be prohibited and thus unenforceable by US courts.

d) The FDIC will be directed to examine the books of the largest 25 insured banks to uncover all CDS contracts held. These will then be netted among these 25 banks, canceling CDS contracts held on one another. CDS contracts with foreign banks will be unwound. The FDIC will also examine derivative positions with a view to determine whether unwinding these would be in the public interest.

e) In its examination, the FDIC will determine which of these banks is insolvent based on current market values-after netting positions. Those that are insolvent will be resolved. Resolution will be accomplished with a goal of i) minimizing cost to FDIC and ii) minimizing impacts on the rest of the banking system. It will be necessary to cover some uninsured losses to other financial institutions as well as to equity holders (such as pension funds) arising due to the resolution.

These actions should substantially reduce the size of the financial sector, and would eliminate some of the riskiest assets, including assets that serve no useful public purpose. The financial system would emerge with healthier institutions and with much less market concentration.

Failing that, we should at least have the government get into the insurance business as credit insurer of last resort. Private firms can't do it, as they do not have the financial resources to meet the potential claims (see AIG). And private firms have a tendency to mis-price credit risk (again, see AIG), which creates further incentives to bad behavior. As "Credit Insurer of Last Resort" (Professor Perry Mehrling's term, not mine), the government can charge proper premiums for it, which will have the additional impact of mitigating the worst behavior of Wall Street. The government can put a floor on the value of the best collateral in the system. As Mehrling says (in a variation of the Bagehot rule - i.e. "lend freely but at a high rate during a crisis"): Insure freely but at a high premium.

We can spend more time blogging about these issues, but now is the time to do something about it. As my friend Dean Baker has already noted, those disgusted by the rapacious and highly destructive behavior of our bankers can go to Chicago on the dates of Oct. 25-27th when the American Bankers Association is having their annual meeting and make yourselves heard. If we stay quiescent, we'll get the kinds of "reforms" we deserve. To paraphrase Rahm Emanuel, it's time to ensure that this crisis does not go to waste.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator

Here comes the downsizing of finance by Martin Hutchinson

August 11, 2008
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com

A committee led by Gerald Corrigan, former vice chairman of the Federal Reserve Bank of New York, produced a report this week that promises to revolutionize finance. It proposes to place severe limits on derivatives, bringing them under the ambit of regulators and protecting retail investors from their more egregious products. His report met with a favorable reception from the major international banks; not surprising as it shuts the stable door after horses have bolted to the extent of about $500 billion of losses and counting. For investor and market protection, it doesn't go far enough. However it does represent the first institutional step towards a goal that all non-financiers should welcome: the downsizing of finance in the US and global economy.

The effect of the report, and of the changes currently under way in finance, can be seen from its treatment of the Auction-Rate Securities market, a $330 billion behemoth that melted down in February. In these transactions, investors buy long term bonds or preferred stock, the interest rate payable on which is determined by an auction process every 30 days or so. Thus investors who no longer wish to hold the securities can in theory sell them to other investors who are prepared to hold them, but only with a higher yield. In practice, in a credit crunch, they didn't work. The report proposes a prohibition on selling Auction-Rate Securities to retail investors. In addition, during the last week banks have agreed to repurchase a total of $41 billion in ARS from retail investors -- $18.6 billion by UBS (on top of a previous $3.5 billion) and $20 billion by Citigroup and Merrill Lynch. At least part of the UBS repurchases will be at par, and all repurchases will be at prices close to par.

The Auction-Rate Securities disaster is symptomatic of what went wrong in the investment banking industry following the invention of derivatives in the late 1970s, and the move towards dominance of the major Wall Street houses by traders rather than traditional corporate financiers. Traditional investor protections, devised by seasoned corporate financiers who understood the business cycle and wished to preserve the firm's good name in a downturn, were replaced by the manic bonus-hunting short term-ism of the typical trader.

Auction-Rate Securities have mostly come in two varieties: auction rate preferred stock, issued by corporations and particularly financial institutions, and auction-rate municipal bonds, issued by municipalities. There have been relatively few issues of auction rate conventional corporate debt, perhaps because a deep market already existed for corporate commercial paper at the time ARS were first issued (ARS are unlikely to be truly competitive with commercial paper backed by a bank backstop line, which for the issuer has the same characteristics of a variable interest rate and guaranteed availability over the medium or long term.)

The first auction rate preferred stock was sold by Citicorp (now Citigroup) in 1984. Within three years, the market had grown to $12 billion in outstandings, at which point disaster occurred. An issue of ARP for MCorp, a Texas bank suffering bad debt problems in real estate, suffered a liquidity crisis when there were no longer sufficient bidders for MCorp's short term paper within the price parameters set down for the issue (typically, at that stage, ARP issues prescribed a maximum as well as a minimum rate at which rates would be set.)

This was not surprising. Even the first Citigroup issue had been sold to investors as "just like short term paper" when it was no such thing. Corporate financiers with experience of the difficulties suffered by the international Floating Rate Note market in the credit crisis of 1979-82, then only a few years back, were well aware that while interest rates on floating rate paper would more or less keep up with market levels, in a period of illiquidity prices could fall arbitrarily far, as investors' liquidity preference became so strong that they were no longer ready to bid on new issues of the paper at any yield.

The ARS market thus rested fundamentally on a lie. It is extraordinary that the market lasted 24 years before blowing up, reaching total outstandings of $300 billion and spreading from the preferred stock market to municipal bonds. Retail and institutional investors were fed the market's Big Lie by salesmen, and so believed that ARS were high quality, perfectly liquid paper. The blow-up of February 2008 thus came as a great shock to the market, and it is not surprising that the banks have felt it necessary to buy back retail ARS, lest their costs of doing so be dwarfed by settlements on class action suits from lawyers representing investors – which suits would be justified, for once.

An even more dangerous derivatives-related product, also based fundamentally on a Big Lie, is the credit default swap. Here the Big Lie is that these represent hedging transactions, and hence a net reduction of risk, passing credit risk from the overstretched banks to institutions better able to bear it. Corrigan treats CDS lightly, recommending simply that all these transactions pass through a central clearing house, a recommendation that has been generally accepted, and that was made more urgent by the Bear Stearns collapse.

However a moment's thought, and examination of the principal amounts involved, will tell you that CDS are far more than a hedging instrument. The total amount of corporate debt outstanding in the United States is about $5 trillion, to which can be added $12 trillion of home mortgages to get an idea of the universe of US risks that can be transferred. With bits and pieces, say $20 trillion in total. Yet the principal amount of CDS outstanding exceeds $60 trillion, and is increasing rapidly.

In reality the CDS market moved beyond simple hedging and risk transfer many years ago, and became a sophisticated casino in which Wall Street participants could gamble, look for suckers, transfer income to more convenient years (when their bonus percentages were higher), hide mistakes and play games with the accounting. Given the spurious nature of the motivations behind CDS trading, there can be no doubt that multiple billions of losses have been accrued already in this market, only part of which losses have so far been recognized in financial statements.

When the CDS market is examined closely, it becomes clear that like ARS, it rests on a lie and has very little value to the global economy. Like much of Wall Street's activity over the past two decades, it represents pure rent seeking. Forcing trades to pass through a central clearing house reduces counterparty risk, but does not alter the fact that the CDS market creates many times as much risk as it hedges or transfers. Selling a credit risk more than once, or selling a risk that is not in one's portfolio is not hedging, it is pure speculation, increasing the overall risk in the financial system. The last year has surely demonstrated that excessive credit risks remain the principal threat to a financial system's stability; hence it is truly crazy to encourage a product that multiplies them many-fold. Given the size of the liabilities involved, CDS represent a huge and largely hidden iceberg, which could strike the shoddily designed financial system Titanic at any time.

One should give CDS the benefit of the doubt and assume that at the margin they serve a useful function in risk transfer and balancing of obligations between institutions. However, there can be no reasonable risk-management justification in selling a credit risk one does not possess, or "going short" in the credit of a third party, so that one benefits from that third party's collapse. Far more than mere short selling of stocks, short selling of credit needs to be prohibited, in order that the total volume of CDS outstanding remains a fraction of the credit risks involved and not a multiple of them, and the global financial system is protected from destabilizing games.

A third derivatives-related disaster whose full cost is not yet apparent is the collapse of Fannie Mae and Freddie Mac. Again, those institutions were based on a lie, that they were really private sector companies that could be relied upon to pursue profit in a rational fashion, without endangering the national solvency by their default. In practice, they leveraged more than would have been possible without the government's quasi-guarantee, lobbied like to crazy to ensure they were not properly regulated and collapsed thankfully into the arms of the taxpayer as soon as ill winds began to blow. The cost of the collapse will certainly be far more than the $25 billion estimated by the Congressional Budget Office, since their lending and guarantee practices were so unsound. Indeed, by their presence they turned the soundest product in financial markets, the home mortgage, into an obscene speculative casino, causing collateral damage of many times their own losses.

Finally we have the biggest lie of all, a US monetary policy pursued since 1995 that pretends the free market system works just fine when government agencies are playing games with the value of the monetary unit, inflating its outstanding volume by about 10% per annum, far more than would be justified by economic growth. That lie will cause the largest losses of all – but I have written about it many times.

Corrigan is a feeble first step in the right direction; its prohibition on the sale of auction rate securities to retail investors demonstrates as does nothing else that much of the financial services innovation of the last generation was spurious and unsound, and needs to be done away with. Rents achieved by the financial services industry will thereby become much diminished, and millions of more or less honest if overpaid toilers will be thrown out of jobs. Needless to say, stock and bond prices will suffer a meltdown when this becomes fully apparent to the trading fraternity.

For the rest of the global economy, this denouement cannot come quickly enough.

>[Feb 21, 2010] German Paper Says AIG May Have Sold CDS on Greece
... this example shows how AIG could have, and probably did, serve to channel funds from the public at large to speculators.

London investment bankers name AIG as a further CDS-seller. That company had to be nationalized during the financial crisis due to its having written insolvency insurance on American mortgages. This debt-load would have led to the collapse of the world's biggest insurer. Prior to the financial crisis AIG is said to have widely held State credit-risk. If yet-larger insurance positions on Greece exist, then the American government would have a strong interest in preventing that country's insolvency.

Even if these are mere rumors about the Greek banks and AIG, this example makes clear the weakness of CDS markets. This protection is sold by banks or insurers who themselves have access only to limited capital resources. They have as a rule clearly lesser credit-worthiness than the states for which they are selling insolvency protection. Insurance by CDS could turn out to be just a bubble.

Hugh:

"The insurance provided by CDS may prove to be a bubble"

Of course it might be more accurate to call it a Ponzi scheme. And "may prove to be"? At this late date is there any doubt?

Lyle:

CDS's are bets not insurance, insurance requires that reserves be kept against losses and the reserves be re-calculated as risks change. CDS's are just part of the Casino that Wall Street has become, with the house (Goldman et.al.) making a killing on the flow.

I have often wonders odds a Vegas bookie might charge on the various CDS's out there, or is it possible she might say I don't want to play that game?

>[Feb 20, 2010] CDS: Just Another Evanescent Bubble?

More on the Greek debt crisis from Naked Capitalism: German Paper Says AIG May Have Sold CDS on Greece. That German paper would be the excellent business-sheet Handelsblatt, and the full translation of the article into English which that blog's proprietor requests in her post follows after the jump.

UPDATE: Correction! Looking at that original German piece, it clearly comes originally from the Frankfurter Allgemeine Zeitung or FAZ – often called Germany's own New York Times. I have noticed before how the two papers clearly have an arrangement allowing Handelsblatt to reprint certain FAZ material. Credit where it is due . . .

The fever-curve of the Greek debt crisis
By Markus Frühauf
20 February 2010

Trade in the risk of Greek insolvency in the past five months has enabled fantastic earnings. That is made clear by the price-development for credit-default insurance on that financially-weak Euroland.

On 16 October 2009 a Credit Default Swap (CDS), which investors use to insure themselves against insolvency from Athens, still cost 123 basis points (1.23 percentage points). This meant a yearly premium of 12,300 euros in order to insure a claim on 1 million euros. On 4 February the insured had to pay 42,820 euros for that, a fee three times as high. Greece's risk-premium – in market jargon the CDS spread – is the fever-curve of the debt crisis.

For the growth in the expense of the insurance against non-payment reflects the reduced creditworthiness of the country. Speculation in the CDS market began after 4 October 2009, as the Greek Socialists celebrated their election victory. Two weeks later the newly-elected government informed its Euro-partners that the deficit for 2009 was going to lie at 12.7 percent of gross domestic product (GDP).

Timidly, but steadily

That was a shock, since the previous conservative government had prognosticated precisely half of that. The new estimate for the budget deficit called onto the stage the first hedge funds, reports a London CDS-dealer working for a large American bank. In view of Greece's previous history of cheating its way into the monetary union with false budget statistics, at that point a wager on Greece having payment problems was promising. This bet in the meantime has become obvious.

The rise of the Greek risk-premium at first still continued timidly, but steadily. It could be that that hedge funds had been the first to recognize Athens' exhausted budget situation but had bet in the CDS market on a fall in the value of Greek debt with little commitment of capital. But the new Greek government's commitment to transparency unleashed this speculation. The further rises in the CDS spread were accompanied by fundamental factors as well. On 8 December 2009 the Fitch rating agency downgraded Greece's credit-rating from "A-" to "BBB+". The Euroland found itself in the same category as Estonia or South Africa in its credit-worthiness. One week later Standard & Poor's followed. Here, too, the Greeks flew out of the "A-" class denoting particularly good solvency. In this period the CDS price exceeded the mark of 200 basis-points for the first time. With these rating-downgrades the fear of a possible Greek insolvency grew by leaps and bounds on the financial markets and among Europartner countries.

Unusually high interest-coupon

A first high-point was reached when the Greek finance minister issued a new five-year loan at the end of January. The offer of 8 billion euros encountered a demand among investors three times as great. This was a calming signal only at first glance. For Greece had to fit out the loan with an unusually high interest-coupon of 6.1 percent. With this the country was playing with a risk-premium in a league with Vietnam. This fed doubt on the debt market as to whether Greece under these conditions could sustain its debt-service over the long-run – in the first instance when in April and May 20 billion euros will have to be refinanced.

Besides all that, this led to a technical effect. The old loans already on the market still bore a lower interest-coupon. They were issued back when the credit-rating for Greece still lay in the "A-" range. Some investors were forced to shift into the new debt instruments with the higher interest. In the wave of selling the yield on ten-year Greek debt increased to over 7 percent. Whoever in October had bet on Greece having payment difficulties was now rewarded: the CDS spread now clearly lay over 400 basis-points. The initial investment had more than tripled when the payment-protection was sold on.

The CDS market is influenced by the same factors as the debt market. This was evident from the falling-back of the CDS premium when signs of financial support for Athens from Europartner countries multiplied. But the problem with the CDS is that this market is much more opaque. These contracts are handled over-the-counter among banks, thus in an unregulated environment. You can also speculate much more favorably aided by credit-default derivatives than on the loan market, for there is a significantly lesser commitment of capital required.

In any case, the CDS-wager has gone up because more and more true-believers in the Greek State have come to feel the need to insure their holdings. This rapidly-rising demand for insurance has been set off by the escalation of the debt crisis. But it is past Greek governments that have to answer in the first place for the exhausted budget situation. The higher demand for insolvency protection that has driven up the CDS price follows from the evidently poorer estimation of Greek credit-worthiness.

Greek banks as insurers

On the other hand, whoever expected Greece's rescue by Europartner countries would have had to position himself on the CDS market as an insurer, that is, as a seller of payment protection. The take in premiums from insurance protection sold provides increased revenue. But it's on the seller-side that the weak points of the CDS market become evident. It's still unclear who has sold insurance protection for Greece. In one study analysts from the major French bank BNP Paribas referred to market-rumors that Greek banks had insured a large sum by CDS. If this is correct, then the payment protection they have provided is worth nothing. Greek banks hold State debt of over 40 billion euros. This corresponds roughly to the entire amount of equity in the Greek credit market. A bankruptcy of the State would lead to a collapse of the banking system.

London investment bankers name AIG as a further CDS-seller. That company had to be nationalized during the financial crisis due to its having written insolvency insurance on American mortgages. This debt-load would have led to the collapse of the world's biggest insurer. Prior to the financial crisis AIG is said to have widely held State credit-risk. If yet-larger insurance positions on Greece exist, then the American government would have a strong interest in preventing that country's insolvency.

Even if these are mere rumors about the Greek banks and AIG, this example makes clear the weakness of CDS markets. This protection is sold by banks or insurers who themselves have access only to limited capital resources. They have as a rule clearly lesser credit-worthiness than the states for which they are selling insolvency protection. Insurance by CDS could turn out to be just a bubble.

>Lessons Forgotten

It occurs to me that this is more about lessons forgotten than those never learned.

1. Bankers in the 19th century were well aware that equity, through a down payment, was the way to secure your investment. They understood that when times go bad that equity is a bulwark against declining values.

2. Bankers of past years understood that last years income tax statement or a credit score was not guarantee that the borrower would not lose his job or become disabled. Last years tax return or a FICA score are not negotiable instruments - Equity is.

3. Economic times change - Markets never go up forever. You'd think they'd cover that little tidbit at Harvard Business School.

4. Credit is a lot like drugs - It turns people into junkies. The more they spend the more they want to spend. A druggie seldom figures out that the white powder up his nose doesn't produce lasting happiness or peace of mind. The credit junkie seldom figures out that a Chinese big screen in every room does not fulfill his life or that the "new car smell" eventually wears off.

5. We, the people, have forgotten that is not our right to own a home or a new car. We have to earn it.

6. And, perhaps most importantly, we have come to believe that we are all victims...No one is responsible for their circumstances; a woman is not responsible for her pregnancy, it is inconvenient and now she wants it aborted. A home owner enters into a contract thinking his home value will continue to increase forever. Now he wants a bailout. A banker thought that he could abandon the conservative principles of finance and that the FED would ride to his rescue. A criminal is in jail because of his childhood. A person is fat because of their genes and it's not fair that some students are smarter than others so let's just forget about grades. A victim always expects someone to come charging in to save them - But when we are all victims...Who do we think is coming?

> Op-Ed Contributor - The Lost Tycoons - Op-Ed - NYTimes.com By RON CHERNOW
September 28, 2008

With breathtaking speed, the world of large Wall Street investment banks has vanished. Fabled firms, some more than a century old, have been merged out of existence (Bear Stearns, Merrill Lynch), gone bankrupt (Lehman Brothers), or sought asylum as commercial bank holding companies (Goldman Sachs, Morgan Stanley). Why on earth did this happen?

The death of Wall Street has been a long-running, slow-motion crisis, barely discernible to participants who had still booked huge profits in recent years. Beneath the razzle-dazzle of trading desks and the wizardry of esoteric finance lay the inescapable fact that these firms had shed their original reason for being: providing capital to American business.

The dynastic power exercised by Wall Street tycoons in the late 19th and early 20th centuries was premised on scarce capital. Only a handful of European countries and their private bankers had surplus capital to finance overseas development. In this cash-poor world, J. Pierpont Morgan and other grandees exerted godlike powers over American railroads and manufacturers because they straddled the indispensable capital flows from Europe. With their top hats, thick cigars and gruff manners, these portly tycoons scarcely qualified as altruists. As Morgan liked to warn sentimental souls, "I am not in Wall Street for my health." Yet he and his ilk rendered America an invaluable service by reassuring European investors that they would receive an adequate return on their investments, securing an uninterrupted flow of capital.

To safeguard those returns, old-line investment bankers became all-powerful overlords of their exclusive clients. When they issued company shares, they retained a large block for themselves. Some clients chafed at these gilded shackles, while others gloried in their servitude. As the head of the New Haven railroad, a Morgan client, boasted to reporters, "I wear the Morgan collar, but I am proud of it. If Mr. Morgan were to order me tomorrow to China or Siberia in his interests, I would pack up and go."

In the sunless maze of Lower Manhattan, the old Wall Street houses were miniature temples of finance. Elite, all-male and lily-white, rife with snobbery and bigotry, they didn't bother to hang a shingle outside, and the tacit message to pedestrians was clear: keep on walking. This reflected the banks' patented formula of serving only the most creditworthy clients: industrialized nations, blue-chip corporations and wealthy individuals.

In London, these small partnerships were called "issuing houses" because they issued stocks and bonds but didn't trade or distribute them. In their risk-averse culture, J. P. Morgan and his breed considered the stock market a faintly vulgar place, better left to Jews and assorted ethnic groups outside the top ranks of investment houses. This bias would later give predominantly Jewish firms like Lehman Brothers and Goldman Sachs a marked competitive edge. Even in the 1920s, patrician Wall Street firms stayed somewhat aloof from the stock market mania.

Securities laws during the New Deal, mandating fuller disclosure of corporate accounting, eroded the Wall Street moguls' power. The new transparency reduced the need of many companies for a banker's imprimatur to certify their soundness. The Glass-Steagall Act of 1933, which forced full-service banks to choose between commercial and investment banking, further shrank the investment houses' influence.

After World War II, as capital markets revived, Wall Street investment banks remained tiny partnerships with outsize power over corporate America. Morgan Stanley demanded exclusive banking relations with the cream of corporate America: AT&T, General Motors, United States Steel, General Electric, DuPont, I.B.M. and Standard Oil of New Jersey. The essence of the business was still the traditional underwriting of stocks and bonds. The era's emblem was the solemn, rectangular "tombstone" ad in newspapers for share offerings, listing the dozens of firms involved, with Wall Street's rulers in the top tier.

Underwriting bred a sociable culture of "relationship" banking in which a smooth golf swing, Ivy League credentials, glib patter over a martini and family connections counted for more than financial ingenuity. Firms didn't advertise and paid publicists to keep them out of the press. They disdained hostile takeovers, stock trading and other activities that might threaten their coveted underwriting business. And they enforced more rules of etiquette than a debutante's ball. It was considered bad form to poach an employee or raid another firm's client. Whatever their flaws, these elite firms still played a vital role in the economy, floating stocks and bonds to create new factories and businesses.

The old Wall Street began to die a lingering death in 1979 when I.B.M. told Morgan Stanley that it wanted to have Salomon Brothers co-manage a $1 billion debt issue. Fearing that its stable of captive clients would likewise revolt, Morgan partners insisted on sole management of the issue. They were flabbergasted when I.B.M. sent back word that Salomon Brothers would be lead manager for the issue.

What accounted for this startling shift? For the first time since the heyday of J. P. Morgan, traditional corporate clients had outgrown their bankers. With Europe and Japan devastated by World War II, American companies had enjoyed unrivaled supremacy in world markets. They had grown big enough to finance expansion from retained earnings and had many more borrowing options than before. Many had developed their own financial subsidiaries with triple A credit ratings and scarcely needed Wall Street bankers to vouch for their solvency. Trading firms like Salomon Brothers and Goldman Sachs were using their prowess to cultivate relations with powerful institutional investors like pension funds and insurance companies, eating into the profits of white-shoe houses. Underwriting deteriorated into a low-margin business as traders trumped blue-blooded bankers in the Darwinian struggle.

The demise of traditional underwriting would create in the coming decades a vacuum filled by a host of volatile, risky businesses. The cozy world of relationship banking yielded to the brutal world of "transactional" banking. Stock, commodity and derivatives trading, hostile takeovers, leveraged buyouts and prime brokerage for hedge funds required ever-larger balance sheets, forcing investment houses to become huge, publicly traded companies. Firms that once remained distant from the stock market were now its storm-tossed creatures, as investors demanded ever-higher profits amid cutthroat competition, forcing bankers to take risks that would have horrified their Wall Street ancestors.

Where the old Wall Street stuck to the most prestigious clients, the new Wall Street engaged in an unseemly rush to the bottom. Investment houses that once dealt only in grade-A bonds became swept up in junk bond mania in the 1980s. Firms that once snubbed companies beyond the Fortune 500 flocked to Silicon Valley in the 1990s, eager to take fly-by-night companies public. And, in the final reductio ad absurdum, Wall Street during the past decade gorged on mortgage-backed securities, tying its fate to America's least creditworthy borrowers. Addicted to colossal amounts of leverage, the onetime arbiter of scarce capital had become the most profligate borrower.

The large investment banks that once allocated precious capital now exist in a world awash with money, crisscrossed by capital flows from many continents, with financial markets deep and liquid as never before. Once the current crisis is past, investment banking services will eventually flourish again inside diversified financial conglomerates. Stripped of excess leverage and more tightly supervised by regulators, investment bankers may even rediscover the old-fashioned virtues of corporate finance. And small boutique firms will continue to offer trusted advice as of old. But the storied investment houses of Wall Street, trailing their glorious past, have now earned tombstone ads of a very different sort.

Ron Chernow is the author of "The House of Morgan" and "Alexander Hamilton."
> Everybody Calm Down. A Government Hand In the Economy Is as Old as the Republic. - By Robert J. Shiller
September 28, 2008 | washingtonpost.com

It has become fashionable to fret that the current crisis on Wall Street marks the end of American capitalism as we know it. "This massive bailout is not the solution," Sen. Jim Bunning (R-Ky.) warned Tuesday. "It is financial socialism, and it is un-American." It is neither. The near-collapse of the U.S. financial system and Washington's sudden and massive intervention to try to shore it up certainly mark a major turning point, but a bailout would represent a thoroughly American next step for our economic system -- and one that will probably lead to better times.

Americans may assume that the basics of capitalism have been firmly established here since time immemorial, but historical cataclysms such as the Great Depression strongly suggest otherwise. Simply put, capitalism evolves. And we need to understand its trajectory if we are to bring our economic system into greater accord with the other great source of American strength: the best principles of our democracy.

No, our economy is not a shining example of pure unfettered market forces. It never has been. In his farewell address back in 1796, 20 years after the publication of Adam Smith's "The Wealth of Nations," George Washington defined the new republic's own distinctive national economic sensibility: "Our commercial policy should hold an equal and impartial hand; neither seeking nor granting exclusive favors or preferences; consulting the natural course of things; diffusing and diversifying by gentle means the streams of commerce, but forcing nothing." From the outset, Washington envisioned some government involvement in the commercial system, even as he recognized that commerce should belong to the people.

>

Capitalism is not really the best word to describe this arrangement. (The term was coined in the late 19th century as a way to describe the ideological opposite of communism.) Some decades later, people began to use a better term, "the American system," in which the government involved itself in the economy primarily to develop what we would now call infrastructure -- highways, canals, railroads -- but otherwise let economic liberty prevail. I prefer to call this spectacularly successful arrangement "financial democracy" -- a largely free system in which the U.S. government's role is to help citizens achieve their best potential, using all the economic weapons that our financial arsenal can provide.

So is the government's bailout a major departure? Hardly. Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles -- as long as the bailout promotes, rather than hinders, financial democracy.

Which, so far, it seems to. Congressional critics may be right to demand more help for homeowners and more accountability for Wall Street blunders, but the core idea of the plan is sound: to protect the financial infrastructure. Remember, Fannie Mae used to be a government entity, and by taking it over, the federal government is merely returning to the status quo ante. The measures to take toxic debts off the hands of financial and insurance firms are intended only to deal with a crisis, not to transform our financial system. The proposals do not represent any landmark change in the American way of prosperity. Everyone should take a deep breath. Changing our thinking about finance does not mean abolishing capitalism, but it does raise questions about what the changes mean.

Whenever the public endures a crisis, ordinary citizens start to wonder how -- and whether -- our institutions really work. We no longer take things for granted. It is only then that real change becomes possible.

So the current crisis got me thinking back to 1990, the year before the collapse of the Soviet Union, when I worked with two Soviet economists, Maxim Boycko and Vladimir Korobov, to try to understand the different belief systems in their country and mine. We carried out identical surveys in Moscow and New York, comparing answers about fundamental notions of capitalism, and published our results in the American Economic Review. We expected to find that the Muscovites possessed scant understanding of how capitalism really works. But we found that they actually understood free-market dynamics better than the New Yorkers. We concluded that the Muscovites had proved more savvy precisely because their system was in crisis -- something that encouraged them to rethink their most fundamental notions.

We Americans are going through a similar change right now. We no longer think that our financial future will be determined by securities brokers or inhumanly large investment banks. The most important question is not, "What form should these temporary bailouts take?" It is, "What are we really learning from all this?"

We should be learning a great deal. The current crisis offers us a singular opportunity to reevaluate fundamentally the safety and permanence of the master financial institutions that we have come to take for granted as part of the national economic landscape. Over these past few turbulent weeks, we have learned that the monolithic investment banks are mortal: They are mostly gone, or absorbed by other banks. We have learned that what we called "cash" and considered perfectly safe is not necessarily so secure.

So we are groping around for something else to trust. We should be open to thinking about a new set of financial arrangements -- a better financial democracy -- that can restore the public's faith in the economic principles espoused by Washington more than two centuries ago. Here are some key features:

1. Handle moral hazard better. The term "moral hazard" refers to the pernicious tendency some people have of failing deliberately if they think it's advantageous to do so. Moral hazard is used to justify teaching people a lesson for their failures -- the same logic that once justified "debtors' prisons." (Yes, we really did have them.) But over the course of the 19th century, Americans grew more realistic about laying blame for economic catastrophes and started eyeing other parties besides the hapless and the bankrupt. The demise of the debtors' prisons reflected Americans' changing ideas about the meaning of a contract.

By rescuing Wall Street tycoons who succumbed to the lure of an irrationally exuberant housing bubble, the bailouts today do pose something of a moral-hazard problem. But we can more than repair it by defining a new generation of financial contracts, with a continuation of our evolving thinking about moral hazard, reflecting greater enlightenment, greater understanding of human psychology and the means to deal with financial failure. For example, I have proposed replacing the conventional mortgage with what I call the "continuous-workout mortgage" -- one that would spell out in advance the conditions under which borrowers would see their debt reduced in a rocky economy. These conditions would be designed to minimize moral hazard: The borrowers would not be able to make the debt reduction happen deliberately.

2. To limit risks to the system, build better derivatives. Some of today's derivatives -- the complex bundles of toxic real estate loans that helped drag Lehman Brothers down -- turned out to be "financial weapons of mass destruction," as the legendary investor Warren E. Buffett warned back in 2003. The problem isn't derivatives per se but a certain kind -- derivatives that spun a massive web of over-the-counter contracts, relying on the solvency of countless banks and other institutions, and ultimately endangered the entire financial system when they fell apart. Some kinds of derivatives, such as those maintained by futures exchanges using procedures that effectively eliminate the risk that the other party in the agreement will default, are more useful -- and far safer -- than others. It is high time to redesign derivatives to avoid what Buffett called "mega-catastrophic" risks.

3. Trust markets, not Wall Street titans. If institutions can be said to have charisma, such giants as Lehman Brothers and Merrill Lynch certainly had it in spades. But these firms proved not to be the sole source of financial intelligence. They were merely meeting places for smart, financially savvy people -- and for some reckless folks besides. We need to learn to trust people and markets rather than institutions. This means developing better markets that will allow us to hedge against the kinds of risks that dragged us into this crisis, such as real estate gambles.

4. Ideas matter. Maybe next time, we will listen more closely to financial theorists who think in abstract, general terms. Consider the Long-Term Capital Management debacle in 1998, when the Federal Reserve leaned on financial titans to rescue a massive hedge fund and stave off global fallout. Lots of people hold that the moral of the LCTM story was the failed thinking of two of the firm's founders, Robert Merton and Myron Scholes, both of whom were Nobel Prize-winning financial theorists. In fact, the collapse of LTCM was largely due to the overconfidence of bond trader John Meriwether and some of his other LTCM colleagues, who were gambling in the markets. The disgraced Merton has been working for the last decade trying to build better risk-management systems, mostly to little avail. Maybe he will be heard now. People still seem to want to trust businessmen who have made bundles and have a huge investment bank behind them, rather than listen to experts who are thinking about the fundamentals of risk management. We would have been better off this month if we'd been ignoring the former and listening to the latter.

These and other improvements in the contemporary economy -- a better financial information infrastructure (so that people can gauge risks better), broader markets (so that people can manage big risks, such as real estate loans) and better retail products (such as continuous-workout mortgages) -- will need to be discussed, debated and delivered in the days ahead. If we move smartly, Americans can have a better, more robust financial democracy along the lines of the system envisioned by our first president. The current crisis does not mean the end of American capitalism. But if we are lucky, it will mean an important step in its evolution.

robert.shiller@yale.edu

Robert J. Shiller is a professor of economics at Yale and chief economist of MacroMarkets LLC. His books include "Irrational Exuberance" and, most recently, "The Subprime Solution: How Today's Global Financial Crisis Happened and What to Do About It."

>Asia Times Online Asian news and current affairs

Importantly, this historic credit inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the US and global economy. It was a self-sustaining bubble bolstered by ongoing credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 trillion during this year's first quarter and then sank to $1.127 trillion annualized during the second quarter. Credit growth is now in the process of collapsing.

At this point, there is clearly insufficient credit expansion to support inflated asset markets; incomes and household spending; corporate cash flows and investment; and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and municipal debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging.

As a consequence, the over-indebted household, corporate and state and local sectors now face a devastating liquidity crisis.

We are today witnessing the acute stage of bursting credit bubble dynamics. It's an absolute debacle, and there's little our well-intentioned policymakers can do about it other than try to slow the collapse. To be sure, there were momentous effects to both the economic and financial structures during the bubble period between 1994's $578 billion non-financial debt growth and 2007's $2.561 trillion. It is also worth noting that financial sector debt expanded $462 billion in 1994 compared with $1.753 trillion in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 trillion, while financial sector borrowings rose 75% to $16.0 trillion.

This credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient credit and to main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.

Importantly, this historic credit inflation inflated asset prices, incomes, corporate cashflows/earnings, government revenues, and various types of spending throughout the US and global economy. It was a self-sustaining bubble bolstered by ongoing credit excesses, asset inflation and resulting purchasing power gains. But NFD growth slowed sharply to an annualized $1.726 trillion during this year's first quarter and then sank to $1.127 trillion annualized during the second quarter. Credit growth is now in the process of collapsing.

At this point, there is clearly insufficient credit expansion to support inflated asset markets; incomes and household spending; corporate cash flows and investment; and government receipts and expenditures. Lending markets are frozen, securitization markets broken, corporate and municipal debt markets in disarray, derivatives markets in shambles, and the leveraged speculating community is engaged in panic de-leveraging.

As a consequence, the over-indebted household, corporate and state and local sectors now face a devastating liquidity crisis.

We are today witnessing the acute stage of bursting credit bubble dynamics. It's an absolute debacle, and there's little our well-intentioned policymakers can do about it other than try to slow the collapse. To be sure, there were momentous effects to both the economic and financial structures during the bubble period between 1994's $578 billion non-financial debt growth and 2007's $2.561 trillion. It is also worth noting that financial sector debt expanded $462 billion in 1994 compared with $1.753 trillion in 2007. Mortgage debt almost doubled in the six years 2002 through 2007 to $14.0 trillion, while financial sector borrowings rose 75% to $16.0 trillion.

This credit onslaught fostered huge distortions to the level and pattern of spending throughout the entire economy. It is today impossible both to generate sufficient credit and to main previous patterns of spending. Economic upheaval and adjustment are today unavoidable.

Over the years I've chronicled this historic bubble in Wall Street finance. It is worth recalling today that Wall Street assets began year 2000 at about $1.0 trillion and ended 2007 at $3.0 trillion. The ABS market surpassed $1.0 trillion in 1998 and ended 2007 at $4.5 trillion. Assets of government-sponsored enterpises, notably mortgage guarantors Feddie Mae and Freddie Mac surpassed $1.0 trillion in 1997 and ended last year at almost $3.4 trillion. Agency MBS surpassed $2.0 trillion in 1998 and closed 2007 at almost $4.5 trillion. "Fed Funds and Repos" reached $1.0 trillion in 2000 and ended 2007 at $2.1 trillion. This Bubble in Wall Street Finance was one of history's most spectacular Credit expansions. It also comprised the greatest use of speculative leverage ever.

Despite last summer's collapse in private-label MBS and related markets, the faltering Wall Street Bubble nonetheless persevered up until the Lehman Brothers collapse in mid-September this year. While it was problematic that overall system credit growth had slowed markedly, there remained key sectors of credit and risk intermediation that remained very much in expansionary mode. In particular, GSE-related obligations, bank credit, and money market fund assets had expanded rapidly in spite of the subprime collapse.

Importantly, the speculator community had maintained easy access to cheap finance. As I have noted often, despite the unfolding bust in mortgage and risk assets, market faith in "money" and the core of the system had held steadfast. This all ended abruptly three weeks ago with the Lehman filing for bankruptcy.

Today, confidence has been shattered, and Wall Street finance is a complete and unsalvageable bust. The spigot for trillions of finance - which for years fueled the asset markets and US bubble economy - has been essentially shut off and dismantled. In particular, Wall Street finance was a mechanism for intermediating higher-yielding riskier loans. This finance provided rocket fuel for both residential and commercial real estate markets - and the attendant wealth effects.

> Sellers of Lehman's Default Swaps Face Payout - NYTimes.com

In a best-case scenario, Mr. Silbert said, financial firms who sold default swap contracts would make their payouts in the coming weeks, have enough capital to cover all the positions, and take their losses and move on. In a worst-case scenario, sellers of the swaps would not have the cash to make the payments and would have to liquidate their assets to cover their positions.

"The next two weeks will be very telling," Mr. Silbert added.

The auction set the price on $4.92 billion of debt issued by now bankrupt Lehman at 8.625 cents on the dollar. Lehman bonds had been trading near that range in the past few weeks, meaning Friday's auction price further reinforces current market values for the debt and in turn the credit default swaps.

Because the auction price "was not that far off from where bonds were trading, the hope is banks and funds with CDS exposure have prepared for the cash payout," Mr. Silbert said. "There is no longer much of a debate on what the claims are worth."

Indeed, with the price set for the Lehman debt, uncertainty surrounding losses tied to those swaps should dim, providing banks more comfort with a portion of theirs and others' balance sheets.

Credit default swaps have played a prominent role in the mushrooming credit crisis that in the past month led to Lehman filing for bankruptcy protection, a government rescue plan for insurer American International Group and Merrill Lynch selling itself to Bank of America.

The government bailout of A.I.G. was necessitated in part because of the insurer's sales of default swaps. Had A.I.G. failed, it could have triggered billions of dollars in losses at many other banks and financial firms who bought swaps from A.I.G., sending them into failure as well.

> Will credit default swaps cause the next financial crisis - Sep. 30, 2008

AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.

Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)

You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.

Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.

The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.

***

ONE REASON THE MARKET TOOK OFF is that 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. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

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. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

***

THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."

>[Jul 3, 2009] Gillian Tett at LSE
May 21, 2009 | Information Processing

Highly recommended: FT journalist Gillian Tett, a PhD in social anthropology, discusses her book on the financial crisis: Fool's Gold, at an LSE public lecture.

I haven't read the book yet, but it's on my list :-) Here are two nice excerpts that appeared in the FT. She does a great job of covering the birth and development of credit derivatives, CDOs, etc.

Genesis of the debt crisis

How panic gripped the world's biggest banks

Below is a discussion of correlation from the first excerpt.

The problem with correlation

Demchak was acutely aware that modelling the risks involved in credit derivatives deals had its limits. One of the trickiest problems revolved around the issue of "correlation", or the degree to which defaults in any given pool of loans might be interconnected. Trying to predict correlation is a little like working out how many apples in a bag might go rotten. If you watch what happens to hundreds of different disconnected apples over several weeks, you might guess the chance that one apple might go rotten – or not. But what if they are sitting in a bag together? If one apple goes mouldy, will that make the others rot too? If so, how many and how fast?

Similar doubts dogged the corporate world. JP Morgan statisticians knew that company debt defaults are connected. If a car company goes into default, its suppliers may go bust, too. Conversely, if a big retailer collapses, other retail groups may benefit. Correlations could go both ways, and working out how they might develop among any basket of companies is fiendishly complex. So what the statisticians did, essentially, was to study past correlations in corporate default and equity prices and program their models to assume the same pattern in the present. This assumption wasn't deemed particularly risky, as corporate defaults were rare, at least in the pool of companies that JP Morgan was dealing with. When Moody's had done its own modelling of the basket of companies in the first Bistro deal, for example, it had predicted that just 0.82 per cent of the companies would default each year. If those defaults were uncorrelated, or just slightly correlated, then the chance of defaults occurring on 10 per cent of the pool – the amount that might eat up the $700m of capital raised to cover losses – was tiny. That was why JP Morgan could declare super-senior risk so safe, and why Moody's had rated so many of these securities triple-A.

The fact was, however, that the assumption about correlation was just that: guesswork. And Demchak and his colleagues knew perfectly well that if the correlation rate ever turned out to be appreciably higher than the statisticians had assumed, serious losses might result. What if a situation transpired in which, when a few companies defaulted, numerous others followed? The number of defaults required to set off such a chain reaction was a vexing unknown. Demchak had never seen it happen, and the odds seemed extremely long, but even if there was just a minute chance of such a scenario, he didn't want to find himself sitting on $100bn of assets that could conceivably go bust. So he decided to play it safe, and told his team to look for ways to cut their super-senior liabilities again, irrespective of what the regulators were saying.

That stance cost JP Morgan a fair amount of money, because it had to pay AIG and others to insure the super-senior risk, and those fees rose steadily as the decade wore on. In the first such deals with AIG, the fee had been just 0.02 cents for every dollar of risk insured each year. By 1999, the price was nearer 0.11 cents per dollar. But Demchak was determined that the team must be prudent.

Posted by Steve Hsu at 5:03 PM 5 comments Links to this post

Labels: cdo, cds, credit crisis, derivatives, finance

>[Jun 14, 2009] FT.com Willem Buiter's Maverecon The magical world of credit default swaps once again

To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS). But then came Amherst Holdings.

A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default. The writer of the CDS sells insurance against an event of default. The insurance premium is the price of the CDS. The buyer of the CDS buys insurance against default. If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.

An obvious problem with CDS is that you do not have to have an insurable interest to purchase the insurance it provides. You have an insurable interest, as a purchaser of insurance, if the occurrence of the contingency you are insuring against would not make you better off (even when the insurance pays out). However, the CDS market is first and foremost a betting shop. You can buy CDS written on a given class of bonds, in amounts well in excess of the total face value of the bonds you own in that class. Indeed you may not own any bonds in that class and still buy CDS that pay off in the event a default occurs on bonds in that class. That is, CDS can be used not to hedge risk you already are exposed to, but to take on additional risk. CDS can be used to place pure bets.

The morality of gambling, through CDS or any other way

Betting and gambling, including lotteries, are frowned upon by many religions and by many who do not have a religious conviction. Gambling is not explicitly forbidden in the Bible, but it is a vice that goes against many biblical principles. It sits uncomfortably with the great command "love your neighbour as yourself", it exploits the poor (gambling is regressive), it undermines the work ethic, it encourages greed and covetousness, it violates responsible stewardship of the resources one is entrusted with, it 'leads into temptation', and it can be highly addictive. It is also often associated with deception. Against that, 'casting lots' is a common way of making decisions in the Old Testament especially. The phrase 'casting lots' is used 70 times in the Old Testament and seven times in the New Testament (including the reference to the soldiers at the cross casting lots for Christ's garments).

Classical Judaism shares the views on gambling found in the Hebrew Scriptures with Christianity, but also draws on more recent traditions. As I understand it, the classical Jewish tradition says that it is forbidden to make gambling your occupation, but it does not forbid a little friendly gambling every now and then. Islam prohibits gambling. It also prohibits any game or other activity which involves betting, that is, which has an element of gambling in it. The Prophet Mohammed says, 'He who says to his friend: 'Come, let us gamble,' must give charity' (in penance).

The fact that gambling, including betting and lotteries, is both addictive and regressive in its distributional impact has not stopped governments all over the world from encouraging and promoting it. It is just too useful a source of revenue to resist. Even countries like the UK that do not tax the winnings from gambling (whence the explosion of structures, like spread betting, that turn contingent financial claims into bets), do tax the profits of the gambling industry. State lotteries are ubiquitous. Indian reservations in the US, which have a form of sovereignty or extraterritoriality in certain matters, have been allowed to open casinos in states where this is not otherwise legal. All derivatives trading is, from a mathematical point of view and in economic substance, equivalent to the creation of lotteries. Sometimes these lotteries are used to hedge risk (when the purchaser of the lottery ticket has an insurable interest; other times and, I would argue, most of the time, these derivative-mediated lotteries are designed and used to take on additional risk - to gamble - generally with other people's money. The indulgent attitude of the government towards these activities can be explained, as with conventional gambling, by the important source of government revenue that the profits from derivatives trading represent.

Moral hazard

All these religious and moral objections (including objections based on the addictive powers of gambling and its regressive distributional impact) apply even to bets or gambles where the event that is the subject of the bet or the gamble cannot be influenced by those participating in the bet or gamble. That is, in the context of betting by buying or selling CDS, it applies even if there is no moral hazard involved in the relationship established by the contract.

Traditional moral hazard occurs when the insured party (in the CDS example the purchaser of the CDS) can influence the likelihood of the insured against event occurring (in the CDS example, if the purchaser of the CDS can influence the likelihood of default on the underlying security in a way that cannot be fully reflected in the terms of the contract). There is asymmetric information in the insured-insurer relationship, and the insured party has the informational advantage - private information.

The standard economics or insurance story of moral hazard involves an informational advantage for the purchaser of the insurance. With no-fault automobile insurance and third-party coverage, I may drive less carefully. If I could take out life insurance on a third party, I might be able to expedite the demise of the insured party.

In the CDS world, the most common reported abuse of the instrument involved a party that owned both CDS and the underlying security, but had a net short position in the security. To be precise, assume I own $X worth of bonds of type j (at face value) and have purchased CDS on bond j that will pay out $Z if default occurs. If X < Z, I don't have an insurable interest in bonds of type j: I am better off if default occurs.

Now assume that, as a bond holder, I can influence the likelihood of a default occurring. A possible scenario is where the company that issued the bond is in dire straits, but has a good enough chance of recovery and survival, that, from a social or economic efficiency perspective, it is undesirable to incur the real resource costs associated with a default. Assume the issuer of the bond has asked the holders of the bond to roll over the bonds, or to voluntarily extend their maturity. All bondholders but me have agreed. I am the holdout and the veto player. By refusing to go along with the voluntary restructuring (which, by assumption, would not be an act of default), I now can trigger a default, making a gain of $(Z-X). It's socially inefficient; it may cause unnecessary human misery, but it is profitable and so, as homo economicus, I do it. Because of my hold-out position, I can drive the probability of default to unity, or 100 percent. This is the mother of moral hazard.

But now comes the mother-in-law of moral hazard. This time it is not the purchaser of the CDS (the insured party) who is afflicted by extreme moral hazard, but the writer of the CDS, the insurer. There is asymmetric information, but the informational advantage is with the insurer. Assume there is an amount $X of some bond of type j outstanding. Assume that the issuer of the bond is generally considered to be at significant risk of default. I now write (sell) CDS on that bond. Because there is no limit to the amount of CDS I can issue as long as there are willing takers, I can sell CDS to anyone who wants to have a flutter on the default of that bond. If I price my CDS aggressively (accept a low insurance premium per $ of bond j insured), I may be able to have a revenue from the sale of these CDS, $R, say, that exceeds the face value of the total stock of bond j outstanding. This would only happen if the total notional value of the CDS I sell (the total value they would pay out in the event of a default on bond j) is a multiple of the face value of bond j outstanding.

Having received revenue from the sale of CDS written on bond j well in excess of the face value of the entire stock of bond j outstanding, I then buy up, at a price above the prevailing market price (if necessary at face value or even above it!), the entire outstanding stock of bond j. As long as I can be sure I have the entire stock of bond j in my possession, I can be sure than no event of default will ever be declared for that bond. I, the writer of the CDS on bond j , and now also the owner of the entire outstanding stock of bond j , could simply forgive the debt I just acquired. The insurer has, ex-post, reduced the probability of default to zero. Those who bought the insurance (bought the CDS), wasted their money (their insurance premia).

Instead of buying up the entire outstanding stock of the bond directly and holding the bonds to maturity without calling a default, or forgiving the debt, I could instead, if the bond were some asset-backed security, purchase enough of the assets underlying the bond at prices in excess of their fair value to ensure that the issuer of the bond would have sufficient funds to pay off all the bond holders, should the bond be 'called', that is, retired prematurely. If in addition, I could make sure that the bond would indeed be called, I would again, through this financial manipulation, have reduced the probability of default on the bond to zero.

The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal.

This in essence, is what has been reported to have happened recently, when a small Austin Texas-based brokerage , Amherst Holdings, which had sold CDS (default protection insurance) on mortgage bonds, then purchased the property loans underlying these bonds at above-market prices to prevent a default that would trigger payments to buyers of the contracts.

Some mortgage bonds can be "called," or retired early, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults. The mortgage bonds targeted by Amherst fell into that category. So the mechanism through which Amherst made sure enough money would be available to the issuer of the mortgage bonds to pay the obligations due on these bonds, also caused the bonds to be called. The bonds were paid off in full, and the CDS Amherst had sold on these mortgage bonds became worthless.

Many household names in Wall Street and the City of London were at the wrong end of this transaction. Amherst has been reported as selling more than $100 million worth of CDS on $29 million of mortgage bonds outstanding - a tidy profit of at least $70 million. It certainly beats working for a living.

The problem of moral hazard on the holder's side or on the writer's side of the CDS market is not a market design problem that can be addressed by creating a central clearing facility and requiring all CDS to be traded on organised exchanges. Requiring writers of CDS to post collateral or, in the case of an organised exchange, requiring a variation margin or maintenance margin (a daily offsetting of profits and losses between the short and long positions on the exchange, made possible by mark-to-market and the fact that the number of long contracts has to equal the number of short contracts) would not solve the problem that both holders and writers of CDS can, under many circumstances, influence the likelihood of default on the asset the CDS are written on.

The first of the two real-world examples I referred to had the holder of the CDS (the purchaser of the default insurance protection) raise the probability of default on the underlying security to 1, that is, to 100 percent, because he also owned a small amount of the underlying security and was in a position to trigger an event of default. The second example had the writer of the CDS (the seller of the default insurance) reduce the probability of default to zero, by causing the bonds to be called after making sure that the issuer had enough money to pay off all the bond holders in full.

Both practices and anything like them are unethical and quite likely socially inefficient and harmful. The way to stop them is to destroy the incentive to issue CDS with a notional value in excess of the underlying securities these CDS are written on.

Conclusion

This post does not lead to a proposal for banning the writing and owning of CDS. Provided the purchasing party has an insurable interest, CDS are useful instruments for hedging risk. It is an argument for requiring that a claim for payment of $X under a CDS contract written on security j , when the default event has indeed occurred, is valid and enforceable only if the owner of the CDS can hand over $X worth of security j when he submits his CDS claim. The moral hazard that can afflict both sides of the CDS market is such that requiring a CDS owner to have an insurable interest seems the only reasonable response.

June 14, 2009 12:36pm in Culture, Economics, Ethics, Financial Markets, Monetary Policy, Politics, Religion | 31 comments

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  1. 1. True, but then not true. The whole construction of money in a capitalist society is a gamble based on trust. Buying interest rate products is a gamble, though it can be a hedge. Buying currencies is a gamble, though it can be a hedge. Buying bonds is a gamble, though it can be an investment. The whole idea about current capital markets is that is allows you to take a view on future events and profit from that view in the case you are right. Lose in the case you are wrong. Credit Default Swaps are no different to that.
    Obviously to have better laws that will help to avoid situations as with Amherst would be good, but cannot completely be avoided. However, trading CDS only when there is an insurable interest goes past the notion that CDS are also vary valuable to hedge for example counterparty risk. No need to hold a bond in order to have risk to a certain counterparty. Also the writer of a cds would then be always supposed to be short the bond, whilst that might not fit his view of the insurable interest (he might just see a temporary move in credit spread he can profit from rather than a full blown credit event).

    Posted by: M | June 14 02:17pm | Report this comment

  2. 2. Would not the requirement of the full use of an exchange (including the publishing of all details of every trade except the identities of those involved) also solve the problem? That way everybody can see when the notional value of all the CDS contracts issued is approaching the maximum (i.e. non-default) value of the underlying securities.

    Posted by: User3509011 | June 14 05:35pm | Report this comment

  3. 3. I am not sure that requiring a CDS owner to have an insurable interest is a reasonable and all the more sufficient response to reduce the moral hazard component and avoid gambling.
    I still contend that CDSs are not only what investor Warren Buffet once described derivatives as "financial weapons of mass destruction" but also financial weapons of wealth destruction. Given the skewed incentives embedded in CDSs they are more and more licenses to kill some investments and investors.

    http://mgiannini.blogspot.com/2009/03/securitisation-and-integrity-of-online.html

    Posted by: M.G. in Progress | June 14 07:13pm | Report this comment

  4. 4. I might have misunderstood, but it doesn't seem so bad to me. They were insuring against the cost default, and this company ensured there was no default. If I found out in ten years time that my house had not been burgled because the Halifax (who insure it) had somehoe ensured there would be no burglaries, would I be angry? And why?

    Posted by: User4450069 | June 14 08:15pm | Report this comment

  5. 5. This is spot on...weren't CDS originally created so that banks could exchange interests if they were overally concentrated in one sector or industry due to geographic constraints? For example if an Australian Bank heavy with miners wants to swap some of its interest in, say, BHP for an interest in Dow from a US bank heavy with chemicalsthen each bank wins by diversifying its credit exposure. So in this instance thee insurable interest may not exactly fit. But the fact that CDS have morphed into trading tools from hedging tools is the real reason for this mess. At the core and in the original iteration these are brilliant products but like most things in finance in the past 10 years or so they have been brutalised and we are all paying the price now.

    Posted by: Grizzly | June 15 02:46am | Report this comment

  6. 6. By extension Buiter must regard the entire world of derivatives as gambling - evil and insidious and something to be banned.

    And on this particular matter, the banks have lost money simply because they thought they were trading these CDS contracts to make money, but they failed to read the small print. How loudly did Buiter moan when consumers were on the other end of this?

    Very scary that this guy was on the MPC.

    Posted by: User3823616 | June 15 11:49am | Report this comment

  7. 7. Excellent summary of the issue and classical background. To me, if we cannot enforce the same collateral and margin requirements on CDS as cash spot and forward contracts, which seemingly do function as hedge instruments, then CDS must go. The infinite leverage of CDS dealer activities led to the AIG simulation of infinite insurance via same. In that light, CDS is a predatory form of gambling countenanced by governments in the same way as other lotteries.

    Posted by: rc whalen | June 15 11:56am | Report this comment

  8. 8. If proving that one has an insurable interest becomes necessary for trading in CDS "an industry" is likely to emerge that will devote itself to supplying such proof... and over time will any such regulatory prohibition meaningless.

    Would it not be better to require trading of all CDS on centralized exchanges and immediate public disclosure of the identity of the parties to the trade as well as the details of the trade?

    Wouldn't such transparency be a more powerful control mechanism than requiring proof of insurable interest? Furthermore transparency is not a rule that can be gamed over time...

    Posted by: Pawel D. | June 15 12:40pm | Report this comment

  9. 9. Re Pawel D: Trading of all CDS on centralised exchanges and immediate disclosure of the identities of the parties trading, and all details of the trade would not help mitigate the moral hazard problems I describe, because the information that is needed includes the ownership of the underlying assets (the bonds) and, in the case of the Amherst ploy, full details about the securities backing the mortgage bonds that the CDS had been written on.

    It would not be necessary to prove one has an insurable interest when trading in CDS. All that would be needed is that a party presenting a claim under a CDS contract would be required to produce proof of ownership of the same face value of defaulted bonds (of the exact type he is claiming a default protection payout for).

    Posted by: Willem Buiter | June 15 02:37pm | Report this comment

  10. 10. A couple of observations from the sell-side: first, the growth in CDS was largely a function of the terrible liquidity and lack of transparency in the corporate bond market (and the lack of an intelligent regulatory capital regime covering CDS). If the corporate bond market were efficient there would have been less need for CDS. Ten years ago one could not find bid/offer prices for coporate bonds on any pricing service. The CDS market changed that -- for the better. Much of the growth I've seen in CDS was from the investor side: why establish a portfolio of corproate bonds where the investor has to cross large bid/offer spreads with a market maker who knew whether the investor was a buyer or a seller? Hedging was next to impossible.

    Second, if we want to get biblical, we probably shouldn't be lending each other money. The abuse of CDS boils down to excessive leverage. It is no different from the LTCM meltdown. Banks got into trouble with LTCM because they assumed credit risk and market risk without collateral. Investment banks bought massive amounts of equity options from LTCM without margin, should we ban equity options (another form of betting? where if you get big enough you can control the market -- Porsche?) or should we require banks involved in these products to hold adequate collateral to protect their shareholders. The real moral hazard was a function of the banks' (and insurance companies') ability to build massive CDS portfolios and sidestep regulatory capital requirements. We should devote our intellectual energy to fixing this regulatory problem.

    Posted by: sgeo | June 15 02:39pm | Report this comment

  11. 11. Come on. This transaction doesn't fly if even ONE of the parties buying the CDSs has an insurable interest and refuses to sell. These boys were all playing naked, and things happen when you play naked. Tough.

    Since when has crying become fashionable on Wall Street?

    Posted by: Benedict@Large | June 15 02:42pm | Report this comment

  12. 12. For those who think that WB whose concern about the mroal hazard associated with CDSs should read Peter J. Wallace's defense of them - Everything You Wanted to Know about Credit Default Swaps--but Were Never Told -
    http://www.rgemonitor.com/financemarkets-monitor/255257/everything_you_wanted_to_know_about_credit_default_swaps--but_were_never_told - 25 Jan. A former lawyer, Wallace holds the Arthur F. Burns Chair in Financial Policy Studies at the American Enterprise Institute for Public Policy Research, where he codirects the Institute's program on financial market deregulation. One of their "noted" speakers recently was Dick Cheney.

    In a few days' time, they are holding a one-day conference: The Financial Crisis: Failure of Capitalism or Failure of Government Policy?, co-Sponsored by The Aspen Institute (of Aspen, Colorado [nice] on Thursday, June 18, 2009. You can find them at http://www.aei.org/home.

    As this piece is held on Roubini's web site, this renders Roubini's opinions morally hazardous in themselves.

    Posted by: the.Duke.of.URL | June 15 03:05pm | Report this comment

  13. 13. Correction: "WB whose concern about the mroal hazard associated with CDSs" should be replaced by "WB's concern with the moral hazard associated with CDSs is misplaced or excessive".

    Posted by: the.Duke.of.URL | June 15 03:09pm | Report this comment

  14. 14. @ Benedict@Large

    In the financial field, this is not quite what "naked" means. Deutsche Bank has been accused of 'naked short selling', which is not what you suggest it is. Unfortunately, naked short selling appears to be legal. The SEC has claimed that such a practice is beneficial for market liquidity. The moral hazard, indeed dangerousness, of this practice should be sufficient for it to be banned. But alas ... .

    Posted by: the.Duke.of.URL | June 15 03:16pm | Report this comment

  15. 15. Correction: @Benedict@Large, I should have said that, in WB's account, not all players were 'naked'. One implication of your comment is that boys should be allowed to play with their toys whatever the social and other costs. IAs far as I am concerned, if they don't like playing by new rules, they can take their balls and go home.

    Posted by: the.Duke.of.URL | June 15 03:21pm | Report this comment

  16. 16. I'm not sure if Willem Buiter present the requirement for an insurable interest as a means to preclude the type of transaction Amherst engaged in, but if so I don't see how it would achieve that outcome. Whether or not the buyers of insurance had an insurable interest, isn't the point that Amherst de facto engaged in market manipulation (whether it can be considered as such de jure is another matter).

    Posted by: True Blue | June 15 04:33pm | Report this comment

  17. 17. I don't see that much wrong with what Amherst did, because they essentially fleeced the gamblers without hurting those that were genuinely looking for insurance. Those who were using CDS to hedge against risk to a real insurable interest got exactly what they wanted and paid for: no default. They maybe even got it cheaper because Amherst was desperate to sell as much protection as possible. Other holders of those bonds who didn't buy protection basically got free protection when they were able to unload their bonds onto Amherst. The people who lost were the gamblers that thought they could make free money. Even their loss is useful if it serves as a warning to other would-be excessive risk-takers.

    I do like your suggestion that we require handing over the actual securities in order to claim payment on a CDS in the event of a default, though I'd like to point out that even that may not guarantee that the value of the protection sold will not exceed the value of the underlying asset. CDS purchasers could always rely on a strategy of buying the distressed assets at the last minute in order use for their claims. As long as the CDS market is not very transparent, it's still very possible that far too many bets will be placed and some of the gamblers will find themselves unable to collect their winnings. I'm not sure this is actually a bad thing, and it might in fact provide partial protection to bond-holders that didn't invest in it through the creation of a market for the assets immediately after the default.

    Posted by: Victor Galis | June 15 06:06pm | Report this comment

  18. 18. Nice post, but your comment on Amherst's profit from the trade needs clarification. Amherst's profits arose from the premia charged on the amount of loans for which they wrote protection, not the amount insured itself. Most accounts I've read indicate that Amherst sold approx. $130 million of protection at a premia of between 80 and 90 cents for every dollar of insurance. Using the lower end of that range results in revenue to Amherst of about $100 million.

    One other note on the absurdity of some aspects of the CDS market: CDS spreads on 10-yr US Treasuries have increased to 40 cents from just over 1.5 cents two years ago. This very well may be a reasonable increase in light of the state of the economy, deficits and the amount of government borrowings. However, given the dire circumstances implied by the US actually defaulting on its debt, I'm curious as to how the purchasers of CDS protection expect to collect. To me, it's quite doubtful that any protection seller will have the means to satisfy its obligations should a US government default occur.

    Posted by: User4690594 | June 15 08:26pm | Report this comment

  19. 19. I'm generally a huge fan of Buiter, but this makes no sense. If actions like Amherst's became common than only the people who actually wanted to insure their debts would buy credit default swaps, and which is exactly what Buiter wants.

    Posted by: User3436365 | June 15 10:27pm | Report this comment

  20. 20. Requiring to have an insurable interest may reduce the moral hazard but it does not reduce the systemic risk, leverage and speculative trades (crowding) produced by and with CDS contracts. If the detailed information about an existing CDS contract, other than the insurable interest, is not available to the market CDS will always be a problem. Somehow CDS are "toxic" derivatives so the market should know everything and label them accordingly. To have an insurable interest in the cds market would not have avoided or prevented the systemic and conterpart risk and excessive leverage, like the concentration of CDS in few hands. For instance did banks know that they were playing with CDS with the same counterpart? Pooling of cds contracts is dangerous.

    Posted by: M.G. in Progress | June 16 06:23am | Report this comment

  21. 21. Yet to hear a convincing argument, or indeed, any argument, from Prof. Buiter as to why it's ok to trade equity put options naked but not CDS. Willem, are you reading?

    Posted by: Anon | June 16 02:41pm | Report this comment

  22. 22. Bonds were honoured and all bond-holders got their money's worth from their purchase of CDS from Amherst. The only people damaged by Amherst manipulations were those who had no insurable interest in their purchase of CDS. Serves them right.

    Posted by: D. Mario Nuti | June 17 06:50am | Report this comment

  23. 23. @D Mario Nuti

    I understand what you are saying, but do you not think that the disbenefits of CDSs outweighs their reputed benefits? Nuclear power stations are beneficial, but the waste produced as a by-product is substantially disbeneficial, indeed incredibly dangerous.

    Posted by: the.Duke.of.URL | June 17 08:34am | Report this comment

  24. 24. @D Mario Nuti

    Also, the bonds were honored, true. But WB's point is that they were manipulated. What was done by Amherst, clever as it was, is legally but not formally different from insider trading, I would have thought.

    Posted by: the.Duke.of.URL | June 17 08:36am | Report this comment

  25. 25. When companies need concessions from bond holders something has gone wrong already.
    Maybe their business is not profitable.
    Maybe management looted the company.
    Maybe unwise acquisitions were pursued.

    Why then is it a bad thing if such a company is liquidated.

    Capitalism works well if competition and survival of the fittest drive the evolution of corporations. A necessary part of that is the death of the unfit.

    Posted by: User3467732 | June 17 10:24am | Report this comment

  26. 26. Re Anon: I would extend the requirement that you must have an insurable interest in order to buy insurance to all contracts that are, from an economic perspective, equivalent to insurance contracts. This would mean no naked equity puts. To acquire a put, you would have to own (at least) the corresponding amount of equity. The easiest way to implement this is that equity puts cannot be sold on their own but only bundled with (embedded in) equity.

    Posted by: Willem Buiter | June 17 01:00pm | Report this comment

  27. 27. Essentially in this and similar CDS transactions the seller, Amherst, was acting like a bookmaker rather than an insurance provider. There are no regulations on the size of bets a bookmaker can take, and no concept of insurable interest.

    But a bookmaker who took a large number of bets on a particular horse (in this case bankruptcy) and then nobbled the horse so that it could not possibly win would be behaving fraudulently. Real world bookmakers and casinos are regulated in ways which stop them from doing this - casinos cannot change the odds on the fruit machines, bookmakers in the UK are (I think) barred from owning or training horses. Bookmakers and casinos also have a reputational incentive to behave honestly, so that they will lose business in future if it is known that they tried to manipulate outcomes. I don't imagine smart investors will want to buy CDS from Amherst in future, but the owners may not be too concerned given the profits their behaviour has earned them.

    Incidentally, the bookmaker analogy also shows up the argument that Amherst's behaviour is a good thing, since it will discourage investors from buying naked CDS in future. Would we really argue that a cheating casino is desirable, and should not be punished, because it discourages gambling?

    Posted by: William Peterson | June 17 04:58pm | Report this comment

  28. 28. "I would extend the requirement that you must have an insurable interest in order to buy insurance to all contracts that are, from an economic perspective, equivalent to insurance contracts."

    Thank you for your reply. I take it that buying calls will be treated in a similar manner in order to avoid any asymmetry that would promote asset price bubbles. If this is correct, then what you propose is tantamount to banning any speculative options trading, which will radically reduce liquidity available to hedgers.

    Posted by: StillAnon | June 17 06:22pm | Report this comment

  29. 29. I think the idea of having to deliver a bond to get the payments from a cds is a good one. Together with some transparency about the amount of outstanding cds this would prevent this type of manipulation. Speculation and hedging for counterparty risk could still be done. If too many contracts are written prices would adjust.

    This would of course not prevent the other type of manipulation where the cds buyer holds some bonds and wants the company to default but it is a start. Another solution could be limitations for bondholders that have cds protection in bancruptcy negotiations.

    As for naked shorts and the like. There is clearly a need for some regulation in the option markets. Just look at the Porsche/VW story. Common sense says this is market manipulation but the current law does probably not allow any sanctions. Here you can also argue that the call option writers were just speculators. I do not think speculation is a bad thing. It creates information and liquidity but there should be laws to sanction clear abuses.

    There might be some changes now after this crisis but as long as the people in the regulating bodies come from the corporations they should regulate and go back there afterward (à la Goldman Sachs) it won't be effective for long.

    Posted by: Mark | June 18 10:20pm | Report this comment

  30. 30. What is the value to the market of allowing naked bets via CDS? It certainly is a good way to make a lot of money if your bets are correct, but what value does it have for the market if you don't have an insurable interest per se?

    Posted by: realestatesean | June 19 08:27pm | Report this comment

  31. 31. StillAnon,

    And "reducing liquidity available to hedgers" is a BAD thing? Seems to me that it is a VERY GOOD thing. Hedging promotes stupidity and reduces the incentive for full due diligence. The mere existence of hedging reduces the value of all personally held retirement savings because hedging such as short sales are forbidden in tax sheltered accounts.

    Generally speaking, hedging is just one more way for Wall Street professionals to shear the sheep.

    Posted by: Anandakos | June 20 04:34pm | Report this comment

>Credit Default Swaps: Problem Child of the Global Financial Crisis

Credit default swaps (CDS) are complex and powerful financial instruments that frequently have unforeseen consequences for market participants and the financial system. As former New York Federal Reserve President Gerald Corrigan told policymakers and financiers on 16 May, 2007: "Anyone who thinks they understand this stuff is living in la-la land." Recent events highlight the continuing problems.

The CDS contract is triggered by a "credit event;" broadly, this equates to default by the reference entity. CDS contracts on Federal National Mortgage Association (FNMA or Fannie Mae) and the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac") were triggered as a result of the "conservatorship."

This may seem odd given the government actions were specifically designed to allow Fannie and Freddie to continue fully honoring their obligations. However, "conservatorship" is specifically included within the definition of "bankruptcy" in the CDS contract, resulting in a "technical" triggering of the contracts. This necessitated settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion.

The triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.

The CDS market is also complicating restructuring of distressed loans as all lenders do not have the same interest in ensuring the survival of the firm. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.

Observing protocols
In recent years, practical restrictions on settling CDS contracts has forced the use of "protocols" – in which any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection-buyer based on the market price of defaulted bonds established through an "auction" system.

Recent cases highlight some of the issues in respect of the protocol and auction mechanism. The auction prices in the settlement of CDS on Fannie and Freddie (paid by sellers of protection) were as follows:

Holders of subordinated debt rank behind senior debt holders and would generally be expected to suffer larger losses in bankruptcy. The lower payout on the subordinated debt probably resulted from subordinated-protection-buyers suffering in a short squeeze, resulting in their contracts expiring virtually worthless. The differences in the payouts between the two entities are also puzzling given the fact that they are both under identical "conservatorship" arrangements and the ultimate risk in both cases is the U.S. government.

In other CDS settlements in 2008 and 2009, the payouts required from sellers of protection have been highly variable and large relative to historical default loss statistics. This may reflect poor economic conditions but are more likely driven by technical issues related to the CDS market. Skewed payouts do not assist confidence in CDS contracts as a mechanism for hedging

It's only a flesh wound!
The derivative industry's indefatigable support of the market centers on the fact that all the CDS contracts related to the high profile defaults in 2008 settled and the overall net settlement amounts were small. Strictly speaking, this is correct. Closer scrutiny suggests caution.

In practice, there are actually two settlements – the "real" settlement in which genuine hedgers and investors deliver bonds under the physical settlement rules (i.e. those who actually own bonds or loans and were hedging), and the parallel universe in which dealers and large hedge funds settle via the auction. Dealers tend to have small net positions (large sold and bought protection but overall reasonably matched).

Take the case of Lehman Brothers. Its net settlement figure of $6 billion is frequently quoted, but that refers to the second process. Real CDS losses from Lehman CDS were higher, probably around $300 billion to $400 billion. Some banks and investors that had sold protection on Lehman did not participate in the auction. They chose to take delivery of defaulted Lehman debt, resulting in losses of almost the entire face value. For example, one German Landesbank reportedly took delivery of $1 billion of Lehman bonds that were worth $30 million at current market values.

There were no failures in settlement of the CDS contracts because, in part, some sellers of protection (such as banks and some insurers) were supported by governments concerned about systemic failure of the financial system. Other sellers of protection had to bear losses, reducing the capital available to meet future claims. Whether the sellers are in a position to meet potential losses if default rates rise as expected remains unknown. As a former U.S. Sen. Everett Dirksen once noted: "A billion here, a billion there, and pretty soon you're talking about real money."

CDS contracts did, in all probability, amplify losses in the credit market in recent defaults. For example, when Lehman Brothers defaulted, the firm had around $600 billion in debt. This would have been the maximum loss to creditors in the case of default. According to market estimates, there were CDS contracts of around $400 billion to $500 billion where Lehmans was the reference entity. The outstanding volume of CDS contracts is not known with certainty, reflecting the lack of transparency about trading in the OTC market.

If used for hedging, the CDS contracts would merely have resulted in the losses to creditors being transferred to the sellers of protection leaving the total loss unchanged. Market estimates suggest that only around $150 billion of the CDS contracts were hedges. The remaining $250 billion to $350 billion of CDS contracts were not hedging underlying debt. The losses on these CDS contracts (in excess of $200 billion to $300 billion) are in addition to the $600 billion.

"I" or Innovation Dysfunction
Financial innovation can offer economic benefits. A number of major benefits of CDS contracts are often cited by acolytes and fans, generally those promoting the product.

The first is that CDS contracts help complete markets, enhancing investment and borrowing opportunities, reducing transaction costs and allowing risk transfer. CDS contracts, where used for hedging, offer these advantages. However, when CDS are not used for hedging, it is not clear how this assists in capital formation and enhancing efficiency of markets.

CDS contracts, also, are claimed to improve market liquidity. It is generally assumed that speculative interest assists in enhancing liquidity and lowering trading costs. But when the liquidity comes from leveraged investors, the additional systemic risk from the activity of these entities has to be balanced against potential benefits. The current financial crisis highlights these tradeoffs.

CDS contracts also, it is claimed, improve the efficiency of credit pricing. It is not clear whether this is actually the case in practice. Pricing of CDS contracts frequently does not accord with reasonable expected risk of default. The CDS prices, in practice, incorporate substantial liquidity premiums, compensation for volatility of credit spreads and other factors.

CDS pricing also frequently does not align with pricing of other traded credit instruments such as bonds or loans. For example, the existence of the "negative basis trade" is predicated on pricing inefficiency. In a negative basis transaction, commonly undertaken by investors including insurance companies, the investor purchases a bond issued by the reference entity and hedges the credit risk by buying protection on the issuer using a CDS contract. The transaction is designed to lock in a positive margin between the earnings on the bond and CDS fees. Negative basis trades exploit market inefficiencies in the pricing of credit risk between bond and CDS markets.

In early 2009, for example, the pricing of corporate bonds and CDS on the issuer diverged significantly. For example, the CDS fees for National Grid, a U.K. utility, were around 2% per annum compared to National Grid's credit spread to government of around 3.30%. Similarly, Tesco, the U.K. retailer, had CDS fees of around 1.40% against a credit spread to government of around 2.50%.

Another area of pricing discrepancy is the relative pricing of different firms. For example, in early 2009, bonds issued by borrowers rated "A" were trading at a higher credit spread than bonds of borrowers rated lower (say "B") in the bond market. At the same times, CDS fees for borrowers rated "A" were trading at a lower level than CDS fees of borrowers rated lower (say "B") in the credit derivatives market.

CDS contracts also are supposed to enhance information efficiency by improving availability of market prices for credit risk, thus allowing more informed decisions by market participants. But CDS contracts traded in the private OTC derivative markets provide limited dissemination of market prices, thereby limiting price discovery and any informational benefits. In reality, pricing and trading information is only available readily to large active dealers in CDS contracts – knowledge that may allow these dealers to earn economic profits.

Benefits of CDS contracts must be balanced against any additional risks to the financial system from trading in these instruments. While CDS contracts did not cause the current financial crisis (excessive reliance of debt did), they may have exacerbated the problems and complicated the process of dealing with the issues.

Risk reduction or risk creation?
The CDS market originally was predominantly a market for transferring and hedging credit risk. The contract itself has many attractive economic features and can serve useful purposes in hedging and transferring risk. Even this hedging application is dogged by some of the identified documentary issues that may reduce the effectiveness of CDS contracts as a hedge. Such problems may well be fundamental to the nature of the instrument and incapable of remedy, at least easily.

In recent years, the ability to trade credit, create different types of credit risk to trade, the ability to short credit and also take highly leveraged credit bets has become increasingly important. To some extent, the CDS market has detached from the underlying "real" credit market. If defaults rise, the high leverage, inherent complexity and potential loss of liquidity of CDS contracts and structures based on them may cause problems.

The excesses of the CDS market are evident in the recent interest in contracts protecting against the default of a sovereign (known as sovereign CDS). For example, the CDS market for sovereign debt is increasingly pricing in increased funding costs for the United States. The fee for hedging against losses on $10 million of Treasurys currently peaked at about 1% per annum or 10 years (equivalent to $100,000 annually). This is an increase from 0.01% per annum ($1,000) in 2007.

The specter of banks, some of whom have needed capital injections and liquidity support from governments to ensure their own survival, offering to insure other market participants against the risk of default of sovereign government (sometimes their own) is surreal.

The unpalatable reality that very few, self-interested industry participants are prepared to admit is that much of what passed for financial innovation was specifically designed to conceal risk, obfuscate investors and reduce transparency. The process was entirely deliberate. Efficiency and transparency are not consistent with the high profit margins that are much sought after on Wall Street. Financial products need to be opaque and priced inefficiently to produce excessive profits or economic rents.

In October 2008, former Federal Reserve Chairman Alan Greenspan acknowledged he was "partially" wrong to oppose regulation of CDS. "Credit default swaps, I think, have serious problems associated with them," he admitted to a Congressional hearing. This from the man who on July 30, 1998, stated that: "Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."

On March 6 of this year, Bloomberg News reported that Myron Scholes, the Nobel prize winning co-creator of the eponymous Black-Scholes-Merton option pricing model, observed that the derivative markets have stopped functioning and are creating problems in resolving the global financial crisis. Scholes was quoted as saying that: " [The] solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and … start over…''

As the global economy slows and the risk of corporate default increases, it remains to be seen whether CDS contracts act as instruments of risk reduction or amplify risk. Recent debates about and regulatory proposals to regulate CDS markets show a disappointing and limited awareness of these issues, most worryingly amongst people who claim to know!

Satyajit Das is a risk consultant and author of "Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives" (2006, FT-Prentice Hall).


Views are as of April 13, 2009, and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security.

Federated Equity Management Company of Pennsylvania.



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