What if credit default swaps weren't the big problem?

The Glenn Beck Contra-Indicator indicates that the Ben Stein Contra-Indicator may be a valid substitute indicator for where the Glenn Beck Cortra-Indicator is not currently available.

Hypothetically, these two indicators could give conflicting signals, but this is not yet known to have happened. Should you find a situation where they are conflicting, the first step in the verification protocol is to have an eye exam as you probably misread something and this needs to be eliminated as the most-likely cause.

I'd like to suggest a third reason why derivatives (not just the CDSs, which were insurance policies on derivatives) were the problem.

When the market for the "higher risk/higher returns" derivatives collapsed as increasing mortgage defaults made them unmarketable, those who were buying "bundled mortgage" securities and then selling derivatives found them selves with no market for their intended product, and a need to raise cash (either because they had taken out short term loans to buy the original securities, or could not afford to have their cash tied up in bundled mortgage securities.

So they dumped those securities on the market, creating more supply than there was demand for the type of securities that Fannie and Freddie were selling.

As a result, the "market" value of those "bundled" securities took a nosedive -- and "mark to market" practices meant that the values of those securities had to be written down based on their "deflated" market price.

Suddenly, the balance sheet of a whole lot of financial institutions looked really awful -- and a lot of banks wound up in, or close to, technical insolvency.

In other words, perfectly solid banks were suddenly in trouble because of the collapse of the derivatives market, which made the secondary mortgage securities they held worth far less than their underlying asset value.

I'd be willing to bet that most banks had very limited exposure to the more high risk derivatives like the "highest return/last paid in foreclosure" traches and the CDSs -- and tht the "brokerages" had far more exposure on the high risk stuff -- but I'd love to find what the numbers are.

@Update: I don't think the logic follows. If you believe CDS' underprices the risk, why wouldn't nokia want to tie its interest to an indicator which underplays the risk (and therefore gives you a lower number). The only time it gets screwed is when default is near and they really need the debt, but more than likely some analyst is telling this is a long tail scenario.

From the banking side, they were already using CDS spreads as a way to price traded debt, so just moves that model to bank loans. It doesnt make it more or less correct if you believe they were underpricing traded debt before this.

AIG Residential Mortgage Presentation 8/9/07

http://media.corporate-ir.net/media_files/irol/76/76115/reports/Econ_Capital_Modeling_Initiative_August_Finala.pdf

Correction:
http://media.corporate-ir.net/media_files/irol/76/76115/REVISED_AIG_and_the_Residential_Mortgage_Market_FINAL_08-09-07.pdf

The problem isn't the CDS's. Say it with me again. The problem isn't the CDS's.

The problem is that we have allowed a market that insures risk to go completely without regulation. Would you buy insurance from a company that was not regulated by state regulators? Would you put your money in a non-FDIC bank account?

So what we have here is a failure to appreciate risk, measure it accordingly, and adequately control the amounts of risk that parties insure against and take on.

Thanks for this but I still don't know that I fully understand this market and it's settlement process so I can't form any opinion about whether it's the cause of our current troubles.

When you say notional value, etc. I'm not sure that's my main fear. From what I understand, it's not just the sheer dollar value, but that that value is larger than the total value of all outstanding bonds issued. So, to my mind, you can have people close to losing a lot of money without a counterparty failure.

For example, if you have 10 bond owners but have sold policies to 20 people doesn't that mean that in 10 instances you have policies that you have to pay out coverage for and for which you don't have any hope of recovering the defaulted bond?

If the formula is that the CDS seller's price is set by the auction, I think that means I have to pay out the auction price to the person who bought the protection. If I'm the swap seller, I'm hoping to collect the defaulted bonds because I will then submit them to the bankruptcy court to get back whatever value remains in those bonds to become "whole." Here though it seems to me that there are 10 obligated pay outs for which the swap purchaser will never turn over bonds resulting in a large loss for the swap seller. The size of the market to me means that even without counterparty failures these losses could be substantial.

Am I understanding this right?

Apart from this, I also have read articles that suggest that these swaps not only give people an incentive to drive a company into bankruptcy but that it provides a huge incentive to make sure the company is liquidated and not allowed to restructure. I am more familiar with equity options than credit swaps. Although equity derivatives can provide incentives for speculators to do things that aren't beneficial for society as a whole, I don't think they create these kinds of incentives to cause bankruptcy and liquidation. Maybe this is a broader question about whether all derivatives are inherently evil or whether they can be tamed by good regulation or in other words should certain instruments be outright banned? If so, which ones and why?

"the non-event of the year"?

Felix Salmon with a provocative and, I have to say,for the the time being, convincing analysis of why AIG will be the largest disaster in the CDS world, and it will not turn out to be the looming disaster it was predicted to be:

http://www.portfolio.com/views/blogs/market-movers/2008/10/19/why-the-cds-market-didnt-fail

"Why the CDS Market Didn't Fail

Jane Baird has the latest on what Alea calls "the non-event of the year": the Lehman Brothers CDS settlement on Tuesday. The upshot is that there's very little to worry about: the worst-case scenario is limited to the failure of a small hedge fund or two, and even that seems improbable.

Read his post, which argues that CDS's were better capitalized ( and so able to pay out in the event of a foreclosure, say. In other words, pay the insurance it is supposed to in the event of a foreclosure) than many people believed because the were constantly valued and known to be risky. On the other hand, other investments were time bombs waiting to explode because they were thought to be well capitalized and valued but weren't.

That then led me to this simple question ( I try to ask clear and simple questions that even I, an ordinary citizen, can understand:

Posted: Oct 19 2008 11:38pm ET
Am I right in assuming that you're arguing that ratings agencies caused the problems, because they over-rated certain investments and lulled the investors to sleep, while the unrated, at least, CDS market, was more proactive, because it didn't have a third party providing the analysis for them, and so was more vigilant?

Here's his response:

Posted: Oct 20 2008 08:54am ET

"While the ratings agencies made an enormous number of mistakes, they weren't responsible for the "quadruple-A" ratings that banks unilaterally decided to put on their own super-senior CDO tranches, or similar idiocies."

It's important to understand that he's not claiming that CDS's aren't risky, he agrees that they are. Only that might well not turn out to be the largest problem.

Again, since they are valued everyday, and so, for example, tradeable based on that value, and known to be risky, they will not turn out to be as poorly invested in as thought, although there was a lot of poor investing.

Bottom line, he agrees with moving CDS trading on to an exchange, which makes sense to me. And, if they are valued and collateralized ( capitalized ), daily as he says they are, there might not have to be a third party holding this capital, I suppose, but I would still like to see it.

I don't like CDS's. They don't pass my smell test for meaningful and sensible investments, but that doesn't mean that I believe that should be illegal, but certainly regulated. If it doesn't pass the smell test, regulate it, especially if the taxpayers are expected to bail the market out in a crisis.

Also, Accrued Interest has a plan to tame CDS's:

http://accruedint.blogspot.com/2008/10/cds-could-be-fair-and-simple.html

I'm not competent to judge it.

The problem is that we have allowed a market that insures risk to go completely without regulation

Bryan, CDSs are devices that provided protection against loss (i.e. insured risk) and they were completely unregulated.

In other words, they were what you say the problem was.

But I think your underlying point is valid -- because of the availability of these kinds of derivatives, lenders didn't even worry about the risk involved in loaning money --- they simply insure against the risk. The fact that these "insurance policies" can wind up in the hands of people who don't have sufficient assets to pay off is irrelevant to the lenders, who only care about this quarters financial statement, and not what might happen the following months.

********

As to the Lehman sale going off without a hitch... do we know who bought this stuff? Because financial institutions are so heavily invested/dependent upon CDSs that they have excellent reason to "prop up" the highly visible sale of Lehman's CDS assets.

In other words, unless the people who bought this stuff are the same people who become insolvent if no one was willing to touch it, we're far from out of the woods on the CDS issue.

lp1,

I'm not sure I follow you here:

"In other words, unless the people who bought this stuff are the same people who become insolvent if no one was willing to touch it, we're far from out of the woods on the CDS issue."

LindaS,
With regard to eliminating CDSs, I don't think that is a great idea. The CDS concept in and of itself is not a bad thing, but the way it is put into action is worrisome. Just like we require insurance companies to conform to regulations, we should expect a similar occurence for the CDS playing field.

Dow has just dropped another 500+ points (Oct 22, 2008), bringing the index back to what it was about a decade ago before the dot.com bubble burst.

This distressful financial tsunami is sweeping across the whole world. Doubtlessly, the US recession has already raised its ugly head, dragging along with it the EU and many other countries across all the continents. Yet there are still people (particularly some political leaders and those knowledgeable in economy) who do not believe in it and choose to argue that:
The world is poised for a recession, perhaps in the pipeline now; the globe is heading towards recession, seemingly unavoidable; we cannot be very sure of the onset of recession, it may be imminent…

LITTLE WONDER WHAT WAS NOT SUPPOSED TO HAPPEN IS NOW HAPPENING. What follows will be worse: The rise in unemployment, the fall in standard of living, and the greater suffering for many more especially the abject poor worldwide. (btt1943@yahoo.com)

I'm not sure I follow you here: "In other words, unless the people who bought this stuff are the same people who become insolvent if no one was willing to touch it, we're far from out of the woods on the CDS issue."

that's because I left out a key word -- "not"

try this....

"In other words, unless the people who bought this stuff are NOT the same people who become insolvent if no one was willing to touch it, we're far from out of the woods on the CDS issue."

Companies prop up the value of their own stock by buying back stocks from cash reserves when those stocks start declining in value.

Or perhaps a better example is China, Japan and other nations that hold a lot of US treasuries. If the dollar goes down, these nations will intervene by creating more demand for dollars. Its not because they really want more dollars, it because its the only way to maintain the value of the dollars they are already sitting on.

The same type of thing probably happened in the Lehman Brothers sale -- the CDS market insures 54.5 TRILLION dollars (which is far more than the assets being insured, because insurance against having to pay out on default insurance is being sold), and the Lehman CDSs represented a drop in that bucket. NOT propping up that market could mean that the whole house of cards falls down...

With regard to eliminating CDSs, I don't think that is a great idea. The CDS concept in and of itself is not a bad thing, but the way it is put into action is worrisome. Just like we require insurance companies to conform to regulations, we should expect a similar occurence for the CDS playing field.

the problem is that regular insurance is based on "natural" science which can provide reliable economic models for personal insurance (life and health expectancies) and "accidents" (auto and homeowners insurance). Even "disasters" can be economically modelled -- and the government steps in when those models fail through Disaster Relief.

But economies don't operate the same way that nature does -- economic conditions change much more rapidly than nature does, and there is simply no way to accurately model economic risk, especially in a global economy. The models work until they don't, and when they don't EVERYTHING falls apart.

Its one thing to say that the government should step in when insurance models fail because of natural disasters. The people who buy insurance don't do so in order to make a profit; all they are doing is trying to protect what they have.

But businesses don't take out loans and buy and sell insurance on loans to protect what they have -- they do it to maximize profit. They will loan money without regard to the actual risk involved as long as they can sell off enough of the risk to make a profit on the loan. And the people selling the insurance do so on the assumption that they won't have to pay out on it -- that they themselves can "hedge" their risk, and/or sell off their obligation before they have to pay off if things look like they are going south.

If you let lenders take out insurance to hedge their risk, you remove the sense that this is any risk involved. And if you let insurance hedge their own risks, you remove the sense that there is any risk involved in selling insurance to lenders.

Perhaps it is a non-event because all those counter parties have had a month to beat the pants out of the equity markets by raising cash. Just think of the mega carnage if the AID CDSs blew up. So, the AIG CDS mushroom cloud has not materialized thanks to 120 Billion of taxpayer largess.

@ Justin, You still haven't written your explanation of the cause of all this and I'd really like to know your thoughts.

My questions aren't really about whether the CDS market as a whole is a cause or if it's a good or bad thing inherently. My question about whether to ban certain instruments isn't about their ability to price risk or their inherent value especially. I read the piece about the number of companies that might have to close up shop because of being unable to roll over commercial paper. Regardless of whether the CDS market can properly price risk, I think the instruments might need to be banned if they provide incentives to try to drive at risk firms into liquidation. With an expectation that 75 companies will be in bankruptcy soon, do we really want anything tangential pushing them faster into bankruptcy? Also, if this forces liquidation rather than restructuring the job losses become 100% rather than a reduction and possible later increase in restructuring. So, my point is even if CDS aren't a risk to financial markets, they are a potentially huge risk to the "real economy." We seem to get so wrapped up in fighting the last problem that we stop looking forward to try to anticipate the next.

Also, the problem with asking for more regulation is that this doesn't start a discussion about what type of regulation is needed. For example, an outright ban has the benefit of being far more easily enforced and has less chance for people to "game the system." But, if derivatives do provide benefits to the economy as a whole, a ban might be too harsh. Other options would include requirements that you have to actually own the underlying instrument. My understanding is that is not required for derivatives currently. Thus, the derivatives market would continue but to buy an option or a swap you would have to own the underlying security or bond. Is this a good idea? I really don't know. But, i think that's the type of discussion that is more beneficial than some of the partisan bickering and conclusory statements that offer no real insight or solutions. Not that this takes place here, but it seems like a good deal of time is taken up with people trying to prove or disprove their views while the crisis rolls on. I think it might be time to start asking a new set of questions so that maybe we're better prepared for the future.

THE RATING AGENCIES

(The Adams Family Song)

WilliamBanzai7

They're sleepy and they're stupid,
Mysterious and crooked,
They're all together shakey,
The Rating Agencies.

Their models are a screa-um.
When people come to see 'em
Their living in a drea-um.
The Rating Agencies.

Moody's

S&P

Fitch

So get a Wall Street witch's shawl on.
Conflicts? Pay their fees to get them crawlin.
We're gonna pay a call on
The Rating Agencies.