Plumbing of CDS becoming clearer
November 5, 2008 – 2:25 pm
A great deal of important information regarding the credit-default-swap (CDS) market has come out over the last week. Many of us who have tried to keep abreast of this unregulated insurance market have been proven in some ways to be quite the Cassandras. The systemic threat posed by CDS may have more to do with how the contracts work than with how they are used. But that doesn’t mean there isn’t a problem. In fact the problem is pretty big.
First, the DTCC released some great information today. According to them, the CDS market is not as big and bad as estimated. The proportion of contracts to debt size is relatively even, so negative economic incentives—using CDS to speculate against debt you don’t hold, rather than as insurance against debt you do hold—doesn’t seem to be such a big problem. This is good in that it means the heart of the market seems to be in the right place. Sure, there are operators out there using the CDS market in unsavory ways. But as with most things, most of those using the system seem to be using it the way in which it was intended. (Update: already CDS cognoscenti are casting doubt on the DTCC’s figures for outstanding derivative contracts. They say DTCC completely ignores CDO-related CDS, perhaps 40% of the market.)
Second, news about AIG reveals that the current problem with CDS has very little to do with the nature of the market and negative economic incentives, but with how the contracts work. As Martin Mayer says, it’s the plumbing, not the principals, that matters most. AIG does not seem to have lost all that much money, or I should say does not seem to have handed it over to counterparties. Rather, as the nature of the bad bets AIG made became clear the insurance giant has been forced to post larger and larger amounts of cash in collateral accounts to prove that it can pay its CDS obligations if in fact the underlying companies do default.
The money is not gone, it’s just stuck waiting for things to get better or get worse. Sure eventual payouts might be needed and that would be bad for those who have to pay, but then at least the money could be put back to work by those on the receiving end. Right now CDS seems to be working as a big liquidity sponge, sucking up cash into collateral accounts and keeping it from greasing the economy. This is likely happening to everyone, though on a scale smaller than AIG.
What’s interesting about all this is that the collateral positing requirements of a CDS contract are basically self-imposed capital adequacy requirements between parties to a CDS trade (great book on regulating capital here). Capital adequacy requirements have long been considered the brakes on the global economic locomotive. They keep banks from betting too big when times are good. And, if managed properly, they are reduced during bad times so banks can pull the cork out and lend, lend, lend. One of the big fears with CDS is that there really were no capital adequacy requirements. To a certain extent this is true, because nobody checks to make sure a counterparty can post the collateral when it’s due. The collateral requirements of CDS contracts, however, act like capital adequacy requirements. As it becomes likely that a CDS contract will have to be paid out, collateral requirements, er, require that protection sellers have more cash on hand.
If collateral posting is forcing cash into collateral accounts that otherwise could be used to make loans, we have a problem. And that problem is likely to get worse as more debtors become unable to pay their bills, CDS spreads rise, and more cash needs to be posted as collateral. The CDS market seems basically to be a liquidity easting machine and if that’s true then all the lowering of rates and injection of dollars into banks won’t do much unless something is done to either a) reduce collateral requirements on CDS trades (what would that do to the CDS market?) b) improve the credit of all debtors, which would reduce CDS spreads and let money out of collateral accounts.
The CDS market seems to be set up to make things worse when they look bad by sucking cash out of a cash starved system. Not smart.
So, the good news is that the real problem has been identified. The bad news is that it’s unclear what to do about it. Does Uncle Sam have to guarantee everything? I don’t think it can. In fact I’m certain it can’t.
…..
On a different note, I’ve been doing GOTV/poll watching work for the last few days and have to say it was very rewarding. I never fully caught the Obama bug. I just thought he was better than the rest and hope he is up to the task (great onion joke about it all). But, I love that so many people are so happy and so hopeful about yesterday’s results. I watched hundreds of people walk out of the polls with such enormous smiles on their faces that I couldn’t help but be happy with them. Animal spirits are so much more important than most people realize and with luck this guy Obama will make us all feel ready to take on the challenges ahead (CDS clearinghouse, massive fiscal outlays to rebuild national infrastructure and create jobs, and serious commitment to reduce US energy consumption in real population adjusted terms going forward). I find myself humming…
Posted in credit default swaps |
21 Responses to “Plumbing of CDS becoming clearer”
You are such a mouthpiece patsy Kimball. That’s not at all how the CDS markets work and you damn well know it brother. What is it you’re trying to do exactely?
“Self-imposed” capital adequacy requirements huh?!?! If the CDS market didn’t work exactely the way we KNOW it does, then why the hell have we been living through the greatest bank, brokerage, and hedge fund metldown ever witnessed?? Let me guess….lack of confidence right??
Since when has it been policy of any CEO, CFO, COO et al to drive their company straight into the dirt over, as you incinuate, such a tame widdle ol’ CDS market that couldn’t hurt a widdle fly?
Who’s paying you to spew this BS Kimball??
By RGT on Nov 5, 2008
So ignoring the rude bits, I thought I’d respond to this comment with one of my own.
1) What else would you a requirement to post money in reserve? It’s basically asking one party to a trade to prove it can pay. Capital adequacy requirements do very much the same thing, except they are imposed by regulators and not counterparties. I thought I discussed why this is a problem. A liquidity sponge can be as bad as a bank blow up.
2) The CDS market, in my opinion, led to the collapse at Bear Stearns and the troubles at AIG. In both cases the contracts created liquidity crises at the firms, which ended in calamity. That doesn’t seem to have been the case at Lehman. What worried me about the CDS market is that it gave speculators incentive to see firms collapse in order to have their bets pay off: negative economic incentive. The information released by DTCC seems to show that the extent to which the market is net negative is very small. That is a good thing because it means there is little negative economic incentive out there. Why do I trust DTCC? Because people I trust and who I’ve learned a great deal from think DTCC is a good outfit. They are not the ISDA.
3) Sadly, nobody pays me. But if you guys would be more inclined to leave tips in the jar if we shouted that the sky was falling I will shout away. But, I hope that readers are more interested in exchanging ideas than they are in affirming their own beliefs.
4) If I’m missing something about the CDS market, something specific, please let me know. The biggest reason I post this stuff is to be told I’m wrong and to find out why. If you think I’m wrong please point me in the right direction.
By Arthur Kimball on Nov 5, 2008
The DTCC has a minority of the total derivatives market. I believe it was 7% in the case of Lehman CDS. How in the world are their data authoritative?
By Aaron Krowne on Nov 5, 2008
lack of confidence right?
Wrong, lack of liquidity which makes this post spot on!
By michaelh on Nov 5, 2008
Correction to the above; the DTCC had $72B nominally out of about $400B in Lehman CDS; that would be 18% of the market.
Where’d the rest go? I hear anecdotally that much of the recent dollar demand is due to foreign banks quietly paying out on Lehman CDS contracts.
michaelh:
If the problem was just “lack of liquidity” wouldn’t the Fed’s $3.8T helicopter drop orgy of the past year have solved it?
By Aaron Krowne on Nov 5, 2008
The CDS market would fail if the Fed. hadn’t printed money to present the illusion of a balance of payments.
Your “sponge” is filled with monopoly money.
By eolltz on Nov 5, 2008
RGT….
Work on the word EXACTLY…Improve your spelling and education.
By Snobbypit on Nov 5, 2008
snip
“I love that so many people are so happy and so hopeful about yesterday’s results. I watched hundreds of people walk out of the polls with such enormous smiles on their faces that I couldn’t help but be happy with them. Animal spirits are so much more important than most people realize and with luck this guy Obama will make us all feel ready to take on the challenges ahead (CDS clearinghouse, massive fiscal outlays to rebuild national infrastructure and create jobs, and serious commitment to reduce US energy consumption in real population adjusted terms going forward). I find myself humming…”
quoting Saul Bellow:
“A great deal of intelligence can be invested in ignorance when the need for illusion is deep.”
By Lisa on Nov 6, 2008
On your different note:
Whether Obama does it right or not isn’t the big issue. Yes, there’s a lot of Obamania. For me it’s more: after the disasters of 8 years Bush, the GOP didn’t deserve to deliver “more of the same, but with a slight tweak”. Shame on America that after: a terrorist attack on Bush’ watch, an invasion of a sovereign country, the deaths of hundreds of thousands of people, torture, locking people away without trials, evesdropping, alienating the rest of the world, and handling of the economic crisis (protect Wall Street without much regard to Main Street), shame on America that McCain still came relatively close to become president.
By Manok on Nov 6, 2008
I totally agree and i don’t understand what’s the deal with the other posters rude comments.
Suzi
http://www.homepricetrend.com
By Suzi on Nov 6, 2008
Questions - The CDS’s are off balance sheet. Why do you make the assumption that they need to hold cash on their balance sheet for balance? Seems faulty in judgement!
By bob on Nov 6, 2008
bob: the CDS collateral requirements are bilateral, they have nothing to do with general (regulatory) balance sheet requirements.
Bloomberg just came out with this story pointing out the ways (and giving some numbers) on derivatives exposure the DTCC is missing: Credit Swap Disclosure Obscures True Financial Risk
By Aaron Krowne on Nov 6, 2008
Look, everyone, it doesn’t take a brain surgeon to see the US has been headed for big time trouble for years. Even Alan Greenspan knew that.
I’ve seen several speeches of his admonishing people to do something about our entitlement programs. He stated in one I saw on Bloomberg many years ago that things were going to start in 2010 and we’d start feeling the effects of it in 2008.
This housing and derivatives problem has also not been a secret. It’s not like now that Obama is president that he gets to go into a secret room and learn what’s really happening in American economics. He’s BEEN in the senate and he should already know what’s going on. Practically none of what he states in his platform will be able to be implemented. We simply don’t have the money for it, or it can’t be done or it won’t work.
This blind–anything but Bush or Clinton–rhetoric and cult behavior is not going to help us. We need to look at this problem squarely. We need to face as Americans what we stand for, what we want as a society and how we can get there from where we stand. Despite this housing debacle there are many domino tippers. Then, there’s the monolith–Medicare.
Obama should already have known what we are facing. He doesn’t have solutions. Americans are so ridiculously naive.
I couldn’t stand either Bush and Since Reagan started the trend of crazy spending–we haven’t seen good fiscal management since Clinton. Too bad we didn’t get Hillary.
Like I said before, there’s nothing to party about. I’m pretty disgusted about the multi millions that have been spent on this campaign–when I look around my city and see all the things that could have been done with that money–food and shelter for the homeless, infrastructure investment, etc–it makes me depressed.
“A great deal of intelligence can be invested in ignorance when the need for illusion is deep.”
By Lisa on Nov 6, 2008
There is a solution but no one’s going to implement it. What the solution involves is a directive science and engineering superstate, not a welfare one. And the so-called free market won’t invest in it because it’s not an iPod-Phone/mp3 player. GE was once a tech company; the free market had turned it into a corporate “loan shark” financial firm.
In a sense, the American century was about US dominance in technology, its creation and proliferation. This had started with the Cotton Gin, it had taken off with Edison-Tesla and peaked with the Apollo landing. Today, real R&D is not being done stateside.
What needs to happen is that R&D needs to happen in the USA and the lower end products, made in Indonesia-to-China and S Korea, not the high end stuff. None of our leaders really know this so they let venture capital and investment bankers make the choices for society. The truth is that the US needs to be the center of technology, not its end user. This will create jobs, keep IP stateside, and then the bankers can make money by being investors, not scalp traders.
By Ronnie on Nov 6, 2008
If a CDS is an insurance contract, then the seller violated state insurance regulations.
If a CDS is not an insurance contract, then it is a bet and the seller is a bookie, and neither has rights as “bets” are not enforced in 49 of the 50 states and the “bookie” was not registered with the Nevada Gaming Commission.
The Sherif of Maricopa County in Arizona has a very cost effective solution. It is called Tent City.
By fedwatcher on Nov 7, 2008
I’ve been arguing that CDS are unregulated insurance contracts since March. CDS that are used to make bets as opposed to insuring a debt obligation should be void as against public policy in the same way that a court is likely to void buying insurance on property you don’t own. But, just because an argument makes sense doesn’t mean it will get any legs.
By Arthur Kimball on Nov 7, 2008
If I understood correctly then the capital requirements apply to the total positions, not to the net ones. That is, if A sold protection to B and then bought some from C he would still have to keep cash as collateral for the entire protection sold, even his net position and risk is much smaller. Of course that makes sense because of counterparty risks, otherwise B would have an indirect counterparty risk to C, without having entering a contract with him.
If I am getting this right, then it really is a liquidity sponge.
By art_madd on Nov 9, 2008
“The money is not gone, it’s just stuck waiting for things to get better or get worse. Sure eventual payouts might be needed and that would be bad for those who have to pay, but then at least the money could be put back to work by those on the receiving end. Right now CDS seems to be working as a big liquidity sponge, sucking up cash into collateral accounts and keeping it from greasing the economy. This is likely happening to everyone, though on a scale smaller than AIG.”
What in God’s name are you talking about? Posted collateral can be rehypothecated, liquidated, applied to the CDS seller’s balance sheet, etc., under standard CDS terms. That’s how collateral accounts work. The CDS market isn’t a “liquidity sponge.” CDSs are marked-to-market and margined daily, so they’ve been a huge and constant SOURCE of liquidity.
Obviously you haven’t been trying to “keep abreast” of the CDS market enough to actually look at an ISDA Credit Support Annex.
How can you argue for months that CDSs are “unregulated insurance contracts” if you haven’t actually read a standard CDS contract? Voiding CDSs where the buyer doesn’t own the underlying would be catastrophic for the global financial system. If the CDS market poses a systemic threat, it’s only because people keep making those kinds of ridiculous and dangerous proposals without understanding how CDSs work.
By Economics of Contempt on Nov 15, 2008
People need to settle down
By Plumber on Jan 30, 2009
Very helpful. I liked your advice.
By Max on Apr 20, 2009