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Ban All CDS! (Except the “good” stuff)

Bruce Krasting's picture




 
Those that are looking for a ban on CDS should consider where this takes
us. The mother of all CDS providers in the US is the FDIC. Throwing
stones at the evolving CDS market should be done with an eye to where
the stones might fall.

The FDIC does not provide much detail on its current status. The last
annual report was from 2008. From this we get the Insured Deposit
number on 12/31/2008 of $4.5T. I don’t have a more recent number but I
think the 4.5t is still a reasonable estimate +/-5%.

In November of 2009 the FDIC finalized a $45 billion three-year
prepayment of insurance premiums. The link to the
FDIC
re the details.

Put this together and you get an estimate on the pricing of the FDIC
insurance. $4.5T divided by $45b equals 1%. Divide again by three and
you have 33 Basis Points a year.

Now consider this slide on the recent pricing for CDS on BoA. Note that
the price to insure $10mm of Senior bonds is $116,000 (~1-1/8% per year)
payable each year for the five years.

Some observations:

-A comparison of BoA’s CDS pricing to the FDIC average pricing produces a
similar result. Yes the CDS are triple in price but there is
justification for that differential. One insures deposits, the other
insures so called senior debt. But in actuality the depositor’s rights
are more senior (less risk). Also, the FDIC insurance is plain vanilla
and limited to a maximum of 100k, while the CDS market will handle many
multiples of that and provide maturity flexibility. And finally, the
FDIC is not trying to make a profit. Wall Street makes nothing but
profits. The difference between .33 and 1.16 is not so significant, the
variance is justified.

-The FDIC does not charge a flat fee to all of the member banks. They
have a rating system called CAMELS that is used in establishing an
individual bank’s costs. The CDS market does the same thing. Costs for
protection vary from institution to institution based on perceived or
measurable risk.

-Both FDIC and CDS have annual up front costs and future pay as you go
costs. Those that get the protection pay for it. In the case of the
banks, they pass this onto the depositor/customer. Those that seek to
protect some downside (or those who merely want to make a ‘bet’) using
CDS pay the price for protection.

-If a bank defaults the FDIC pays the depositors 100% but gets the loan
portfolio to offset some of the losses. The writer of CDS absorbs the
losses up to the remaining value of the collateral. The settlements have
similar features.

-There is no true public market or opaque disclosure on either the FDIC
pricing or CDS. It would not be practical (if not impossible) to change
this in any meaningful way without undermining the utility and
functionality of these roles.

-Buyers of naked CDS are attempting to make a buck. Every Wall Street
house has a brokered CD business. They sell $99,000 FDIC insured high
yield CDs to their customers. They are gaming the system, there are big
numbers involved. Everyone is out to make a buck.

-On the business of making a buck let me point out that there has to be
risk takers in any functioning private market. Stocks, bonds,
commodities, you name it. If you take out the risk capital these markets
will not perform in a way that we need them to. Same is true for CDS.
Markets create capital and share risks. Putting a plug in that process
will end badly.

-An argument has been put forward that CDS creates excessive leverage
that could collapse the writer and thereby trigger a systemic risk. The
position is that there is not sufficient capital supporting this growth
of CDS. A valid argument given that AIG is still staring at us. This
may well be a fatal flaw of the CDS writers. But it is worth looking at
how solid the FDIC is.

The answer is that the FDIC is as good a credit as the US Treasury. They
both have full faith and credit guarantees from our Uncle Sam. They
have about $40b of cash left from the “Prepay” and they have an unused,
but immediately available, no strings attached, line of credit from the
Federal Financing Bank (Treasury) for up to $500 billion. So it would
appear that there is no comparison to the private sector providers of
CDS.

Today the FDIC has no equity. They ran down their rainy day fund of $55
billion last fall. They functionally borrowed equity through the prepay.
But at the end of the three-year period it is unlikely that they will
have replenished any of their reserves. The FDIC is very solvent, but at
the same time it is broke.

We will resolve the TBTF issue. And soon thereafter a former TBTF
will fail and it will fall to the FDIC to save the system. With no
money in the till they could not withstand a “Top 20” bank failure, so
they would draw on Treasury to make good on their promises, but the
taxpayer would once again be stuck with the tab.

The wart that both CDS and FDIC share is that there may not be enough
behind them if things go upside down again. The FDIC is striving to
replenish its reserve to 1.2% of deposits (from zero). That comes to
~$60billion. It will take them years to get that, and they will be lucky
if they do. But even that much money is not so big anymore. Any of the
current TBTFs would take out that reserve and then some. The equity
behind private label CDS is equal to that percentage up front. It grows
every year. For me the systemic risk that will take our breath away
comes from a failure/bailout of the FDIC. Not the blow up of a top ten
bank from a bad CDS book.

Without the FDIC our banks would implode. With them would go a good
number of foreign financials. So the FDIC is central to the system.
Without them we go “poof”. But we need to understand that their business
model is pure CDS. And it is 100% leveraged. Dump this at our risk.

 

 

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Tue, 04/06/2010 - 16:32 | 289029 Bruce Krasting
Bruce Krasting's picture

I have been harping on this some time now. As a writer I am pretty frustrated. I am not getting the point across. Those that hate CDS will hate it worse if they get their way.

We can't roll back the clock. That never happens.

I am giving my effort a grade. D-. Too bad because I thought it was important. I will drink a vat of gin and forget it.

bk

 

Tue, 04/06/2010 - 15:48 | 288950 jmc8888
jmc8888's picture

So we're supposed to continue the swindle because banning it would destroy the markets?  Seems like it was the creation, adoption, and reliance on these scams that did it.  Not the unwinding of it....because that was for certain, the day they were created.

 

Besides only in monetary world does this even matter.  In an American Credit System you can create or transfer whatever passes the glass/steagall standard, and create the leftover.  Which means as we switch over, and watch all this stuff burn, the  gov't can create new credit dollars equal to, or around the amount, that the FDIC just lost by ending the madness. 

 

So why should we have insurance for people who bet that another thing is going to default when the models are so inaccurate that the cost of that insurance is complete bull?  Otherwise CDS would cost almost the face value of the loan they're betting against.  Who is going to bet 1 million dollars that 1.1 million dollars is going to default?  Some sure, but will the scope for all these derivatives beyond CDS total a nominal 1.4 quadrillion?  I don't think so.  When you give an 80+ percent discount, you DO.  We have.  We're toast.  What we have are rigged bets.

 

I'm not saying destroy all CDS's and the like because they are wrong in principle, just in real world practice they can never work the way they are.  Risking complete loss of 1 million to potentially get 1.1 million IF whatever entity defaults, is how CDS's SHOULD work.  These are rough numbers, but it's the difference in scale that matters, not whether it's 80 percent discount or 83. Thus this entire market that is gigantic, shouldn't even exist, unless someone paid the other side of the equation off with cash, up front. 

 

There is no way in hell anybody can legitimtely sell these types of insurances without it nearly equalling the asset being insured.  Otherwise it's a scam.  This is what makes them wrong.  The entire market is fraudulent exactly because of this. If it were to be done correctly, the market basically wouldn't exist. 

 

It's obvious that AIG and basically everyone else that wasn't exposed because of the bailouts, has been selling CDS and the like of every nature at about a 80+ percent discount to what it should have. 

 

Now, if they were sold like they should be, does anyone think there would really be a market for it?  NOPE.

 

Which is why you shouldn't ban CDS's, you should just realize they're scams, and anybody issuing them is bascially making an investment that will lose all of its equity at some point in the future.  The amount lost versus the amount they sold it for is how much they undersold it by.  So AIG allowed people to bet by the trillions, by undercharging hundreds of billions.  Then when it all blew up, we have to pay for the catalyst of way too cheap insurance being sold?  But the same practice and underselling this stuff should continue?  BS.

 

People should take a step back and realize that pretending this game isn't happening or that we're neck deep so we have to continue it, will only corrupt more real wealth and make the eventual destruction of all this stuff more destabilizing. 

 

It's not the idea of CDS, it's the way they've been misused.  The effects of Statistical modelling errors rear their ugly head again.  (now if everyone would just ask how many other things use the same type of procedures to just like AIG get it vastly wrong.....you'd see all derivatives, cap n trade, global warming, deathcare, and all the others are on the same fraudulent side of things).  The corporate sides of both parties would like you to forget you understand that.  Because again, why did AIG and everyone else sell it so low?

 

Because the statistical model they used told them the appropriate price.  Except it didn't.

Tue, 04/06/2010 - 02:33 | 288164 Budd Fox
Budd Fox's picture

Bruce...never said ban them.

But:

1) Trade them on an Exchange with transparent prices.

 

2) Clear them through a centralised Clearing House

 

3) Pretend that anyone buying an insurance owns an exposure to the underlying risk. i.e. I should NOT be allowed to buy a fire insurance on Bruce Krasting home...as I don't own it.

 

Is this asking too much as a regulation??

Tue, 04/06/2010 - 10:00 | 288417 Bruce Krasting
Bruce Krasting's picture

Yeah, too much.

1) I am okay with exchanged trade to the extent reasonable. But let me ask you a question, how much of the volume on the NYSE happens "upstairs" or "on the curb"? The answer is most of it. Next, how much of the FX market goes through the futures markets (regulated) versus the interbank market? Answer: peanuts. How about bonds? Here again the cash market is bigger than the regulated futures market.

2) This is being done. But understand that if you get more efficient settlements and netting you will get a bigger market. Making it more "efficient" will make it bigger, not smaller.

3) There is no market that you can point to that works that bans speculative equity.

We created a system, now we have to live with it. That we all have computers and can more easily see risk and reward is just evolution. CDS may be something that compresses the time frame where a "problem" becomes a "crisis". For me, the side effect of CDS forcing issues to move more quickly than might have happened historically is a good thing. Everything is moving more quickly.

Tue, 04/06/2010 - 12:37 | 288637 Jean Valjean
Jean Valjean's picture

Summary,

Bruce is saying: "Let the pigs play in their slop"

Budd is saying: "That's a problem when the pigpen is not fenced and the pigs are trampling all the corn"

I'm beyond Budd.

Ban all CDS. Even good ones.  You should not be allowed to insure something you don't own.  If you buy a bond, man up and take the risk that goes along with it, or don't buy it.  It's that simple.  Financial "gurus" are ruining our country.  They are idiots that can't do anything "real".  Their "inventions" are designed to make them rich not to help society.

Ban them.  Ban them.  Ban them.

Slaughter the pigs.  Slaughter the pigs.  Slaughter the pigs.

 

Tue, 04/06/2010 - 11:44 | 288558 Greyzone
Greyzone's picture

We don't care about the size of the market. The idea behind a neutral central clearinghouse is the same as the futures market. The market itself has to eat the loss unless they force you to pony up first. That very watchdog activity, where the watchdog itself is punished if it fails its assigned duty, is what makes the futures market viable.

If a central clearinghouse makes the market bigger but more intrinsically honest then who the hell cares? What we care about is people creating CDSs, giving them arbitrary values, then run crying to their nearest sovereign when the thing blows up in their face. If you make it an honest market, the loser pays. Everyone says the derivatives are not a problem because they net to zero globally. That argument is bullshit and AIG proves it. Any player who lacks the resources to fulfill their obligations is a cheat and corrupts the system. And right now there are lots of cheaters corrupting the system.

Remove the fraud and the market can be as big or small as people want. But force the betters to show they can pony up if they lose. That is the basic idea. Do that and you get rid of the fraud.

Tue, 04/06/2010 - 12:22 | 288608 Bruce Krasting
Bruce Krasting's picture

Again I ask how much of existing turnover in stocks bonds commodities is OTC today. 20%??? 30%%?? or is it 70-80%?. I think the OTC market is bigger than the futures.

Mon, 04/05/2010 - 23:53 | 288009 ghostfaceinvestah
ghostfaceinvestah's picture

Nothing wrong with CDS.

Big problem with writing CDS contracts with no capital to back up the risk.

The FDIC has a line at the Treasury.  AIG didn't, until it was too late.

Mon, 04/05/2010 - 23:06 | 287933 jippie
jippie's picture

Very interesting analysis. Never thought of the F.D.I.C as basically being a seller of CDS with no collateral.

I am not sure if I agree with all of your conclusions. First of all it is always easy to say: Look this is bad, but that's worse so we're fine?! Of course the risk is more concentrated in the FDIC which makes the CDS books of TBTFs look less risky. But every bank has a CDS book which creates feedbacks and makes the system that much more complex and unstable. The fact that people can buy naked CDS is just another factor that increases risk for no apparent benefit.

It is no excuse to say we won't fix the private CDS markets because there is a bigger elephant in the room. If we can swap the porcellan with steel than yes the room's contents would be safer even though the elephant is still in there.

In my view there is absolutely no need for naked CDS just like naked shorts and other forms of insurance without insurable interest (e.g. STOLI - Stranger originated life insurance) are bad and are only created to cater speculation. Remember speculators are only needed as far as hedgers seek insurance. It is obvious that the hedgeable interest is limited, which implies that the speculation should be limited.

I can see that there are advantages to having a regulated transparent CDS market where only purchases are made when insurable interest can be established. However this may be too hard to enforce, I can already think of ways Wall Street could game this. Thus the best choice is maybe to ban CDS. All this would do is force people to be more diligent about the credit decisions they make, as they can't buy insurance anymore.

zerohedge puts up articles like the Rickards interview (http://www.zerohedge.com/article/ltcm-general-counsel-us-stared-near-cat...). Or the various Taleb pieces. Yet at the same time promotes articles like the one above which may be right in this particular instance but obscure the fact that overall CDS markets are not needed. We will live happyily without them, without increased systemic risks. Overall Financial services are rent-seekers that should facilitate transactions. The fact that they capture 40% of profits (in the US) is a sad fact that the rewards for risk taking are not going to the people actually taking the risk (i.e. setting up business, inventing things, sacrificing consumption, etc.). All these derivatives in the end do is capture more rent for financial intermediaries. Yes they enhance "efficiency" in most cases, but at what cost?!

There is a reason why we put up Street lights, and Stop signs in cities. To make it less efficient, but avoid excessive risks!

One should always remember to asses the counterfactual. Would we really be worse off not having all these efficiency introducing derivatives? Go back in history and compare?!

 

Tue, 04/06/2010 - 12:42 | 288642 Dirtt
Dirtt's picture

Agree.

Ponder the quest in Japan to perfect robots.  Have they noticed their crappy economy? Is the grand plan to make their society so efficient that robots fill jobs only to have the humans work on robots? This is hardly a good analogy just a point.

We don't need to go back in history to wonder if we'd be worse off if "overall CDS markets are not needed."  (Especially when the creators are certified psychopaths.) 

And even if stops signs and street lights were erected in these markets Blankfein & Co. would be sure that they owned the cops anyway. SO back to "pedal to the metal!"  Crash. Burn. USA pays again?

Mon, 04/05/2010 - 23:04 | 287928 Leo Kolivakis
Leo Kolivakis's picture

FDIC discloses stuff the way pension funds disclose stuff up here. Let's not ban CDS but make them transparent and create and exchange for these bloody derivatives.

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