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Twilight of the Models, submitted by JM (pdf)
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who's JM?
Jonzalo Mira
funny how that "clearinghouse" thingy kinda got left out at CDS' inception
FYI, Credit Default Swaps having been centrally clearing at ICE Trust since 2009 ($12 trillion notional cleared so far). JM is a little behind on the news. Otherwise decent article.
Credit default swaps allow the market to cast a "no" vote on the streets latest little hatchlings, so of course they will be hated. CDS shortens the time for distribution and it impeaches mark to model. In other words it does "create" the risk that the lumpen buyers cannot hide their mistakes and that slicers and dicers cannot conceal their frauds.
Not arguing, just wondering: How do CDS impeach mark to model?
The problem with CDS is not CDS themselves but naked CDS backed by balance sheets rather than unencumbered reference securities or properly-priced "lender of last resort" backing.
The author is completely wrong to present the issue from the point of view of an individual contract. The problem with naked CDS is that they represent the potential for a classic martingale, with the attendant and inevitable sudden crash.
Exchanges are fine, but CDS that are naked and, therefore not true "swaps" are inherently destabilizing since default risk among companies is HIGHLY correlated and default risk among banks is, arguably, TOTALLY correlated.
Naked CDS lead inevitably to insolvency crises.
Credit default swaps need to be backed up by reserves if regulated as insurance, or pledges of liquid assets, if regulated via an above-ground exchange. Naked CDSs are a bad idea.
This is not hard to figure out.
The problem is that CDS AREN'T insurance because defaults are not uncorrelated.
When one person dies of a heart attack, it does raise the risk of death of those very near him, but it does not significantly raise the mortality risk of the insured pool.
On the other hand, when a bond goes into default, it makes it MUCH more likely that other bonds will default. For that reason, CDS that are backed by balance sheets like insurance are madness. CDS have built-in reflexivity because CDS do not and cannot distinguish between long-term credit risk and short-term liquidity risk. For a CDS they are exactly the same thing, allowing one to propagate the other.
The author is completely wrong when he suggests that the CDS crisis in '08 was a pure product of the real estate market. The losses were in real estate, the crisis was in liquidity.
I think we are in agreement here. CDS model pricing didn't capture the correlation risk embedded in CDOs adequately. This is a problem with the math, the model involved in pricing. A human with experience could have said: "lighten up on putting 80% Cali mortgages in this product" (just an example).
This is rather deep. Am I correct in saying that this is equivalent to an illusion of having a perfect hedge in place (via CDS), and that illusion spurs you to take even more credit risk?
Yes, there's the illusion of a hedge.
But the main problem is the cash price of CDS relative to the typical cash haircut on a default. Cash CDS backed only by balance sheets represent commitments to move very large amounts of cash from those balance sheets in very short amounts of time, relative to the ultimate haircut on the insured bonds. Most importantly, that cash has, in effect, to move TOWARDS a default.
Well, the one thing I know about cash is that cash wants to move AWAY from defaults. And cash always moves AWAY from defaults faster and in greater amounts than the cash that has to move towards the default. While small amounts of cash CDS are useful as canaries in coalmines because of their sensitivity, they are dangerous if they can move too much cash too quickly. This because cash moving AWAY from defaults also tends (especially in this HFT-dominated environment) to move relatively indiscriminately.
The industry's answer to this self-reinforcing tendency of cash CDS to move money quickly has been simply to sell more and more product. But that doesn't help. That just multiplies the amount of cash that has to move AND creates massive netting risk.
Let's be honest: cash CDS exchanges only really exist to AUGMENT the cash OTC market.
One of these days, just like in HFT, somebody is going to "turn off the machine". Somebody in the OTC market is going to step away in a way the market does not expect. That will suddenly create large exposures left hanging like cliffs for Wyle E. Coyote to fall off. I mean it WILL happen. It's just a matter of time.
I'm not against swaps, but if you're gonna swap, swap. Offer unencumbered asset for unencumbered asset and the best pricer wins. OR, find a party to back the market with VERY, VERY deep pockets who is willing and able to commit enough cash to settle trades independently of the rest of the marketplace
If a hedge fund that owns a bond wants to write protection for an industrial company that owns a bond, or some stock or a factory or mine - or vice versa, that's fine. Highly independent and uncorrelated holders of assets want to swap credit risk on discrete assets. Worst case scenario: the industrial company gets a new owner very quickly OR the hedge fund gets absorbed and the investors lose their money, and that's okay.
But a levered financial company? For cash? That's madness. A sudden deficit of cash is a virtual certainty.
It is a hedge, just not a perfect hedge. "Perfect hedge" is a technical term.
I don't follow exactly what you are saying in some of the stuff about haircuts. Do you mean CTD issues? That stuff happens with any physical delivery of underlying, not just CDS. Anyway, most settlement is in cash, so I don't follow you.
Financial markets are destabilized by default, because it implies wealth destruction. This is the bottom line. It has nothing to do with CDS per se. CDS is just another asset that has to be settled through bankruptcy. You can replace CDS with CP or anyother liability and the logic holds exactly the same.
Dude, you are describing a fucking clearinghouse!
Last first, I am describing a clearing house IFF the clearing house has access to the liquidity to meet a collapse. No present scheme for a clearing house has that kind of dough.
Don't be fooled by the term "cash settlement". "Cash settlement" implies that there is another option. For all intents and purposes, there isn't - or at least it's relatively unimportant. Because we're not talking here about the settlement of one CDS but the settlement of many and in a stress scenario. That's why I make the distinction "cash CDS": to drive home the point that - in the case of a large-scale default - there is no real option other than cash settlement.
CDS are a pledge of cash from the balance sheet exactly when it is least likely to be there.
They are that because in the event of a large-scale default other sources of cash - borrowing and asset sales - suddenly become impossible to execute at economic prices and you have insolvency. The reason that happens is not that markets become unstable, but because incentives become far too stable and self-perpetuating.
You noted that default means wealth is being destroyed. As a mental exercise, imagine a barrier at 0% return. On one side is "wealth", which has a positive return. On the other side is cash, which has a negative return. Now imagine that the cash side is further divided between "free cash" and "held cash".
Okay, how do you save wealth from being destroyed? You turn wealth - with a positive returm - into cash - which has a negative return. But the rate at which wealth can be turned to cash is controlled by (in VERY approximate terms) the price level times the lesser or 1 or the ratio of free cash to the cash needed. Everything is fine until free cash drops below cash needed. Then you start converting wealth to cash at a steep discount AND the amount of cash starts to drop precipitously, worsening the situation yet more.
Fortunately, we have a credit-based money system so more cash can generally be created on short notice, but that system depends on banks - the very entities making themselves most vulnerable.
CDS are priced in one environment of general cash availability and (in the case of a large-scale default) settled in a totally different environment. CDS writers are offered very small income streems now for collateral requirements they won't be able to meet in an adverse-case future. That's ridiculous.
A clearinghouse is more than money-bags. It enables transparency, so you can get a feel for conceptrated risk, if you are a member. It ensures proper collateral and margining. Don't count on regulators or the idiots in government to fix anything. Banks are taking care of it themselves. Dodd and the piccolo player are just putting in stone the market-determined patches.
This is called illiquidity, and you spending a huge amount of time describing one special case of a liquidity crisis. CDS is a sideshow, a special case. You are missing the big picture which is a funding crisis. To repeat a third time... there are failure modes for any number of assets, other than a credit derivative. The big picture is this: liquidity squeezes, to finding crisis, to insolvency, to default, to wealth destruction. What lies behind all failure modes for assets is crowded trades, excessive leverage, and complacency. CDS has no more to do with this than any other balance sheet liability. As long as there are markets, these factors will never go away.
This section is naive or textbook pap, can't tell which. Wealth destruction (=bankruptcy) happens as part of life. Accept it, adapt, and move forward. "Credit-based monetary system"... I'm not touching that psychadelic goo.
To repeat again... I agree with you. This is model failure. A clearinghouse will go long way to fixing it.
No offense. Just being direct.
Naked swaps are often bought as a proxy to some other underlying. Like CDS on sovreign Greek debt is use to hedge other Greek corporate debt. I think this is a legitimate use of a naked contract.
edit: I guess the bigger issue is not defining what is legitimate or not, but limiting the effect of moral hazard (bailouts) in the market.
In the current context, leverage, correlation risk embedded in real estate securitization, and concentration of risk cause insolvency. These three things are not inherent to a CDS contract or any derivative for that matter. Therefore, I don't think that CDS leads to insolvency crises.
What leads to crisis is insolvency.
While I am in full agreement with your excellent points, TheMonetaryRed, I also disagree with the author's assertion:
"There is nothing destabilizing about a credit default swap."
Inherently, the concept behind it frequently leads to destabilization.
But even when the swaps aren't naked, as long as a limitless number can be generated on an investment, that in and of itself is the destabilizing factor.
And given a chain of CDSes, the equation is always altered whenever one counterparty seeks to back out of the "risk" by generating further securitized financial instruments.
CDs is truely a financial instrument of mass destruction and was used frequently to force companies to react or go bust....as for hedging with CDs....possibly the most abused accounting trickery on the street.
Therefore we will have more CDs...
Heh: "balanace moral hazard with human ingenuity".
At least the author got one part right: moral hazard is created by government. So why not vote to stop all moral hazard??
Naah, that would be too easy!
This of course would be the perfect solution to the problem. But that solution has never and will never be attained. I believe the vast majority of voters oppose TARP, TALF, TSLP, dollar destruction, queasing, and every other policy inflicted on the taxpayer. Doesn't do a bit of good in stopping it.
They transfer risk only until the underlying insurance fraud is discovered, then there's systemic collapse.
there are morsels of reason in this article but not only are cds mispriced but they are essentially insurance instruments which lack the regulation of insurance. it's cowboy and john wayne bravada charging up a hill desperately looking for returns - not risk dispersion or transfer which in a tbtf world is utterly impossible and fucktarded to conceive....
irs are the equivalent of financial hydrogen bombs from which no amount of transparency and clearing house incubation can protect. the author speaks of market settling mechanisms but this is also a fraud in a fascist world where banksters' "innovations" are bailed out by the taxpayer rich and poor. it is the polo ground of the ivy league assholes whose trillion dollars mistakes are chump change for others to clean up....
i loved the line in the article about nationalization as a solution - a remark which puts to complete lie the notion of a free market solution which would undergird a world safe for financial engineering. nationalization is about the plutocrats keeping all the profits and socializing the losses....
we do not live in a world of free markets. hence the whole premise of the article is vacuous.
in the end jm is a quack shill for the bankster oligarchy.
The whole nationalization point is that if there are really banks too big too fail, then nationalize banks... wipe out bank equityholders and bondholders, put them in receivership, then privatize them. This was done, and it certainly fixed the mrola hazard problem. No plutocrats will win here, and certainly not excusing the reckless behavior.
I'm not being a bank supporter here. I'm just saying that CDS was only an instrument. It was deeper factors that have been around as long as markets that caused the problem.
Why are IRS the equivalent of hydrogen bombs?
Derivatives have a winner and a loser. You take the moral hazard out (let entities go bankrupt when they are insolvent) and where's the problem?
I'm sorry, but you simply don't comprehend the subject you are discussing.
Anyone who has studied credit derivatives and securitizations for any number of years understands that they truly represent a global financial virus, which is why 90% or more of the market is in the hands of only 5 connected players: JPMorgan Chase, Goldman Sachs, Morgan Stanley, Citigroup and BofA.
Now this is about the most obvious attempt to get Robo to post some photos that I've ever seen....
Aw man! That would be a good title for a porn flick ... and in the end, everyone gets f__ked!.
Hey Guest Poster,
You say CDS merely transfer risk. That is bullsh!t. To transfer risk, one must first have it.
The way these things are created out of thin air, they are merely betting instruments. I bet a huge percentage are mere bets from entities without risk at the outset.
Thus any clearinghouse is merely a better decorated casino, unless some boundaries to reality are attached. Kinda like, and as market disruptive as naked shorting.
Thank you. Folks were buying "insurance" CDSs on MBS they didn't own. They were just betting they would fail, not protecting their assets. Then the taxpayers were brought in to pay off these bets when AIG et al. couldn't pay up.
"Hey, Joe sure drinks a lot, and his eyesight is going south with age. Let's all buy insurance on his car."
As a libertarian, I don't care if people want to make contractual bets like this. It just shouldn't fall to the taxvictims to make the gamblers whole. Bankrupt AIG and let the CDS holders wait in the Unsecured Creditors line.
Sorry - I had to type this before reading the above comments, but what is it with financial types wanting to equate themselves with "atomic" types? You are NOT an engineer and you cannot apply the same principles no matter how much you think you understand the physical laws - Jesus just quit, it is starting to get embarrassing. Also, "innovations" what the hell? Anytime you try and tie physical laws, probability, and politicians, you are completely full of shit. There I feel much better.
Excellent article and much needed.
Red's point above is well taken. Some risks are not insurable, and there is certainly more correlation here than in standard insurance contracts. As a trader, I would say some progress is better than none. These instruments, as traded now, are financial time bombs. We need to defuse them.
As the author points out, transparency will help avoid crowded trades, and foolish pricing BEFORE a crisis occurs. No small feat. As to naked contracts, I don't see the problem. A grain farmer needs to hedge his price. I and other arbs can take on some of that risk, and in a well regulated exchange, pass most of that off to others. That is the essence of a well run insurance pool.
Are there still correlated risks? Yes, hell yes, but ignoring them doesn't make them go away. As stated in the article, the real problems are out of contol leverage, concentration of players who should know better, and slavish devotion to models.
Not perfect, just better.
"That is the essence of a well run insurance pool." Woops, you used that word - insurance. If it is, then it needs to be regulated as such. I understand the need, but the problem is when it is so tied together and risk criss crosses at every turn. The circularity needs to stop...or at least be tracked. Idiots who thought of the current crap - way too simple minded.
Form over substance. I don't care whether it's called a hedge or a form of insurance. The trades will often have aspects of both.
The whole point is that exchanges (especially with margin requirements) are regulation, and represent a great improvement in tracking. What we "know" about these trades now is mostly guess and begosh. We still don't have a clue what sort of crap AIG has on its books.
Not perfect, just steps in the right direction.
"We still don't have a clue what sort of crap AIG has on its books."
No, I think we know enough. The systemic risk is the amount they signed up for. If AIG was allowed to fail and given the fact they "insured" way more than they could deliver, the whole system would collapse. The problem is they were allowed to insure way more than they could deliver - forget the model. The profit incentive for this was too great. This type of behaviour is clearly fraud - but it doesn't seem to matter.
Greed and excess are not always fraud. They are characteristics of markets, and always will be.
It's a good idea to actually read at article before commenting on it, which you admit you didn't do.
"Banning them only means relocating." JM
Why would the whole system collapse? The speculators that bought CDSs on MBS they didn't own would not get paid. They would lose their premiums, but that's it. Bankruptcy would have been the normal way to deal with this.
You have to ask yourself. Do I feel lucky? Well, do ya...
Nobody says it like Clint! Do we really need OTC CDSs?
Most agree - these are nothing more than weapons of mass financial destruction. And no. I don't think Sadam had any.
Almost forgot the best part, the $money$.
Putting this stuff on exchanges opens up more markets to retail accounts in nice, bite sized chunks;)
Christopher Whalen (Institutional Risk Analytics), Prof. Michael Hudson, Dimitris Chorafas, and Prof. Jackson (University of Minnesota) are the only public personages I am aware of that fully understand the existence of complex structured OTC assets and securitization (although not known by the name yet) were instrumental in leading up to the Great Crash and Great Depression.
Or at least, know of their previous existence as everyone else claims securitization only began in the '70s or thereabouts!
From Mr. Whalen's letter/article to the SEC,
http://www.sec.gov/comments/4-560/4560-5.pdf
he cites a most accurate description by financial markets author Martin Mayer,
"In the OTC derivatives market, people who want to get out of their previous trades have to offset the obligations of that trade by creating a new instrument with a new counterparty. Take a credit-default swap, by which each party guarantees to accept the payout on a debt instrument held by the other party. It’s an insurance instrument, with some differences: The holder of the insured instrument can sell it, and the new owner becomes the beneficiary of the insurance. And the insurer may find someone who will accept a lower premium to take the burden of the insurance, allowing him to lay off his risk at an immediate profit. The one trade thus generates two new instruments, with four new counterparties, and as the daisy chain of reinsurance expands, the numbers become ridiculous: $41 trillion face value of credit-default swaps.... Once you begin to remove individual flower girls from the daisy chain of credit swaps, you don’t know who will wind up with obligations they thought they had insured against and they can’t meet."
With all due respect to these "personages", Hayek beat them to it. Hayek was so far ahead of his time that his readers often didn't know what the hell he was talking about.
Hayek understood that industrial-grade leverage was built on blocks of securities, not cash. When those blocks unwound, shadow banking collapsed. History rhymes.
Tyler wrote about this back in the blog days.
Satan (worshippers) created risk. They were the guys in grade school who wanted to shake your hand because they held the buzzer. Remember those clever shits? Yeasty beasties baking "don't taze me Bro" hand-shake risk (and protection) into every transaction.
I find it a bit humorous there are few comments here. Thanks Sac.
When the betting pool is many times larger than the market on which it is based, then it becomes a case of the tail wagging the dog. When every aspect of the world economy becomes chips in the game, the foundations of society get hollowed out and even those living large in the penthouse are going to hurt when it all topples over. Free markets and capitalism are not synonymous. In order to function a market needs a medium of exchange and when control of that medium is a private function then the rest of the market eventually becomes the property of that private party. Control of the money is not just a function of the government. Control of the money is the government. We need a system with local public banking as the foundation and any larger economy has to be what that foundation is willing and able to support. The primary function of the current national government seems to be to create public debt as leverage for the financial sector. It doesn't budget. It just keeps handing out goodies until enough legislators can be coerced into voting for whatever those goodies are wrapped around.
The global cash bond market is about $50 trillion. Net CDS exposure is nowhere near that. No tail wagging a dog here.
The "focus on net, not notional" argument assumes that net equilibrium can be achieved near instantly. The validity of this assumption has been tested in individual cases but not in a situation of systemic breakdown. In any event, there are no reliable statistics for OTC derivatives, merely self-reporting (or not). There certainly isn't any central register for these instruments. Anyone's guess is just that, a guess.
Point well taken.
When you have debt based currency and interest rates are set lower than the speculative bubbles are growing, cash can be part of the problem as well. Capitalism is drowning in capital because its function has morphed from the efficient allocation of resources to the creation of capital. They were not loaning all that money out to anyone willing to sign their life away, but because this created debt instruments that could be used to blow further bubbles. Now those bubbles are deflating and anyone trying to operate a normal business is getting sucked just as dry as the speculators.
There is nothing destabilizing about a credit default swap. You are either in the money or out of the money: one side loses and the other wins. This means these derivatives transfer risk, not create it. What creates systemic risk is bad pricing, selective margining, and lack of netting, not the instruments themselves. A clearinghouse facilitates transparent pricing, netting, and straightforward settlement with less collateral squeezes.
There is nothing destabilizing about leveraged banking. You either meet your capital ratios or you don't; if you do, you win, and if you don't, the taxpayers lose by bailing you out. This means leveraged banking transfers risk from you to the taxpayer, it doesn't create it. What creates systemic risk is moral hazard, greed, and co-opted regulators, not the leverage itself. Once we appoint the tooth fairy to oversee leveraged banking, all will be well. ACA Capital was perfectly well capitalized at 180:1...
http://seekingalpha.com/article/43538-loan-insurer-aca-capital-may-be-to...
Loan insurer ACA Capital Holdings' (ACA) shares lost almost 2/3 of their value, dropping from $15 in mid-June to just over $5 on July 24, before rallying back to a current $7. Barron's says investors' relief may be short lived. Its $326 million capital base and $61 billion loan exposure equate to 180-to-1 leverage. Critics say Wall Street lenders like Bear Stearns (BSC), Merrill Lynch (MER), Lehman Brothers (LEH) and Citigroup (C) have used the company to move billions of dollars in risky, volatile loans off their books.
Bullsheeeet.
You can't net from a broke dead man. If there's something to be paid, there's counterparty risk (and a heapin' mess of it too).
There is nothing destabilizing about a credit default swap.
Yeah, if there was only one out there and a max of the notional amount of the instrument they are supposed to "insure".
These things are ticking time bombs. A recent analogy is that the buyers effectively are getting bankruptcy protection multiple times over on xyz company.....it's like I'm taking out a $2mm insurance policy on your house which is worth $200k, and then I start stacking full gas cans around the perimeter....gee I sure hope lightning doesn't strike!
And why do you need to "insure" your investments anyway? Do the credit work and invest - if you aren't comfortable then don't buy it. That's investment strategy at it's most pure form right? CDS even gives covered investors much less reason to work out special situations and can be used to actively bankrupt companies (and indeed, countries) for short-term gain if they really are viable entities?
The biggest reason they should be strongly curtailed is that we really should not allow a small group of investors to have a vested interest in potentially destroying the financial and social underpinnings of societies, be they States, Countries, banks or municipal governments. Makes no sense - just another way that Wall Street banks can get large fees.
This is the kind of bullshit that governments want taxpayers to accept hook, line, and sinker. The only reason why an investor wants to speculate on or insure government securities or any name for that matter is because the entity is behaving in a way that increases credit risk.
CDS potentially can curb government excess by influencing funding costs, thus making them act more rationally.