Reading Between The Lines Of David Einhorn's Attack On CDS
The $26.5 trillion (gross notional) CDS market is under siege. Or such is the latest news from the formerly pervasive (ab)user of CDS trading strategies, David Einhorn. In an op-ed in the FT, Einhorn states "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." His full opinion can be found here, while for an extended blame session on CDS we refer readers to his complete VIC speech we posted earlier.
We agree with Mr. Einhorn's cautionary perspective in principle: his warning that CDS has a feedback loop quality, and a negative convexity nature courtesy of a much increased correlation among various assets, is quite obvious to anyone who has traded or is familiar with the product. Which Mr. Einhorn undoubtedly is, having made hundreds of millions precisely courtesy of leveraged bets using CDS. The "about face" coming now from the Greenlight founder is surprising, although we have some thoughts that explain it.
Some other arguments he presents:
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”, Mr Einhorn says.
Yet one could have made the same claim about derivative holders of any other asset class: options (equity derivatives) are of course not spared from this, neither are interest rate or FX swaps. What is unique about CDS, Einhorn claims, is that it provides a synthetic (and very liquid) way for stakeholders higher in the capital structure to influence restructuring/reorganization negotiations in a worst case scenario. Is that bad? Not at all.
Ultimately, the strongest bargaining position on the table wins. If CDS is part of a pre- or post-facto basis trade (we are not sure one can attribute ethics to a trading strategy), where a corporate raider loads up on billions of evil CDS and buys bonds only after the cash product trades down to the low single digits in order to have a blocking stake in any prepack or Chapter 11 free-fall discussions: well, that's just the way the free market is. After all, this is simply yet another way to express the conviction of one's beliefs. This is a strategy rumored to have been used widely by Carl Icahn in the early part of 2009 on numerous distressed corporate names. Again - what is wrong with that? Remember, with derivatives buys and sells are matched. For every CDS that Icahn (or Einhorn is his less idealistic days) or whoever buys on company X, someone has to sell it to him at a price that both agree on. And last time we checked, nobody holds a gun to the head of Prime Broker Y (which may or may not have an immediate risk pass thru with "AIG Z", although these days more likely not) to sell these CDS at a price that is determined at arms length negotiations. A first year analyst can do a waterfall analysis and determine what the equivalent bond recovery is, contingent on a CDS level of XYZ bps. Then that same analyst can express a directional bet on the underlying asset value - and if he/she can find someone in the marketplace to take the opposite side of that bet, it will happen: after all that's what free markets are all about (and we are not talking about HFT in CDS, although the irony is that now that a clearinghouse is much more tangible, rumors are swirling that several entities have already expressed an interest in developing High Frequency Trading strategies for CDS. Letting a TBTF hedge fund loose on something like that, where momentum alone would determine risk levels, would truly be the end of the financial world as we know it).
Where CDS opponents do have an argument is when the "raider" is either backstopped by the government, too big to fail, or has a massive economy of scale when it comes to CDS accumulation/hedging capacity. But that is a different discussion altogether, one that gets mixed up in otherwise rational observations of the (f)utility of the CDS market.
And at the end of the day, does CDS really have such a huge cataclysmic capacity? According to DTCC data, net notional exposure for single names is about $1.4 trillion, while index and index tranches add another $1.2 trillion in net risk, for a total of $2.6 trillion. This is about one tenth the total amount that has been backstopped by the US government currently, as Obama attempts to fool the investing public that things in the financial world are once again ok. So if the entire market were to collapse, and assuming DTCC is not misrepresenting netting, a complete implosion of every single CDS contract would only add another $3 trillion to the financial bailout package. That's about 30% of the budget deficit over the next 10 years. Financial Armageddon? Hardly. We already experienced the first and most powerful nuclear bomb when AIG blew up, and when gross CDS notional collapsed from $65 trillion to far less than half. Ironically, the CDS market can somehow police itself best (even when aberrant sinkholes of risk like AIG are bailed out) contrary to what CDS haters would want you to believe.
Ironically, how US CDS can be trading as tight as it is, is a mystery: perhaps Mr. Einhorn should consider the amusing ramifications of a US basis trade in which China decides to bring America to its knees via CDS (already being long and strong the cash leg). Wait, advocates would say that can't happen cause it is a "special situation" as the US can never default. Alas, that is the whole problem with derivatives: everything is a special situation of a special situation (or eventually becomes one, and when it does, it makes someone very rich, and someone else, poor). Truly, where one person finds fault, another finds opportunity. Some can gripe about put options in the same way, others: about Interest Rate and FX swaps.
The bottom line is: in every trade there is a buyer and a seller. What needs to happen is the risk skew has to be eliminated and everyone has to be on equal footing. If an AIG or Goldman is aware that they can sell CDS in a company X all the way to zero because if the bet goes against them, they will be "rescued" by a moral hazard encouraging Federal Reserve. In doing so they will squeeze the natural market to a point where enough opposite bets emerge in order to arrive at some imbalanced equilibrium. The imbalance would disappear if Goldman were to realize that it has the same risk/return profile as a Carl Icahn or any other CDS player. If you want to have an efficient CDS market, remove the government backstops of its core players: AIG some years ago, which was more an implicit understanding of their TBTF status, and Goldman Sachs and all the TBTF banks currently, courtesy of explicit guarantees by the government. That is the first and critical step to making CDS trading sensible.
Even with a myriad of cons, CDS has its pros. Credit Default Swaps provide the most liquid and effective mechanism to express a directional bias. With equity volumes ransacked courtesy of HFT systems and various algos that have taken the equity market to unsustainable valuations all with the administration-backstopped desire to provide the "image" to the retail public (and their 401(k) holdings) that things are ok, it is next to impossible to hedge positions for the downside, as every equity short gets run over (courtesy of the Fed), and purchased puts expire worthless: in essence the equity market is broken from a hedging perspective. This only leaves fixed income as some semblance of providing a hedging opportunity. This of course excludes cash bonds (good luck finding borrow to offset long bonds anywhere even close to 1:1), thus leaving asset managers with only CDS as a natural hedge to any and every risk imaginable: from corporate, to duration, to interest rate, to counterparty.
All those who would see CDS extinguished, should consider that without this most liquid product, there will practically be no way to express bearish opinions on the most critical part of the capital structure. And as we live in a valuation vacuum and true enterprise values are well below the equity tranche for the bulk of corporations (yet above 0, we hope), CDS is precisely the principal and only way to express a valuation bias for such time as the Fed decides to stop fighting the market and tightens (which may or may not happen in our lifetimes). Absent CDS, we will revert to the day when the mutual funds could only go directionally long, and when selling begins, look out below with no natural bids on the way down. A CDS ban is to the fixed income market, as a shorting ban is to equities (and a much more dangerous version of an uptick rule which the SEC is once again curiously investigating. Apparently S%P 1,100 is not enough for Larry Summers).
The best outcome for all involved is not seeking a ban of all CDS transactions (well, maybe it is, although it is as impractical and, well, futile, as crusades get) but an exponential increase in transparency of everything related to the product. Even with all the recent so-called opacity removing measures, we challenge Barney Frank to show us one free, open, and public venue where we can find what the bid-ask spread on Goldman Sachs CDS (1 through 10 year) is at any one moment during the day (a 15 minute delay work just as well). It simply does not exist, unless, of course, one is a wealthy client of QuoteVision, MarkIt, or one of the many investment banks that blast out CDS levels every time they print or are looking for naturals. Talk about a two-tiered market. Furthermore, a centralized clearing system would be a tremendous improvement as that may be the only way to aggregate this data (which would allow a much more efficient CDS market, than merely one which can be used and abused by a select cadre of hedge funds and investment banks). Of course, due to the immediate margin compression for the broker dealers that this increased informational efficiency would translate to, one can expect even a clearinghouse not be a realistic outcome for many, many years. And lastly, why not just open CDS to retail participation as well? If Joe Sixpack is allowed to trade in equities, cash bonds, and options, let him trade in CDS as well. If collateral needs to be posted in order to do so, fine. But open the CDS market up to everyone: why should it be the plaything of the rich and famous, while 99% of the investing population is unable to participate, and thus have no say whatsoever in what appear to be such "high level" CDS-banning negotiations.
Lastly, CDS opponents seem to forget that there are daily actual physical collateral netting arrangements at the end of every single day between OTC counterparties in any given CDS trade. Thus, the threat of a massive imbalance in the market would result in a liquidity impact of net positions only from the time it opens (around 6 am domestically although CDS are traded 24/7 courtesy of the market being open somewhere in the world all the time) to the point intraday when there is a risk flaring event. Everything prior to any given day will have been squared out and neatly tucked away under lock and key. As such, the CDS trading risk is far more contained than the informational surprise courtesy of assumptions about a bank's balance sheet which usually hide7 hundreds of billions more in mismarked assets that the entire CDS market netted. In other words, if every single bank's assets were to be marked to a realistic market, the fall out would be far, far worse than the abovementioned $2.6 trillion in net notional risk arising out of CDS. And likely orders of magnitude worse. Yet the two are, of course, intertwined: with all assets now trading as one major class (we refer readers to recent charts of implied correlations), a sudden and dramatic reversal would likely also have a disastrous impact, but not because of CDS (although the former would not help), as all market players rush for the exits. At this point, as Zero Hedge has long been warning, not even printing another $23 trillion in actual dollars (printing, not mere guarantees) won't save the financial system.
And while Einhorn is discussing banning CDS, why is nobody more concerned about the $1.2 quadrillion in interest rate exchange traded and OTC swaps currently in circulation? The IR market is simply the latest and greatest bandwagon idea out there, leveraged to the nth degree. If you want an Armageddon scenario, look no further than this. The cataclysm scenario that nobody is contemplated, simply because it is simply so improbable (where have we seen this before?), is what would happen when there is a black swan event at the core of the fiat monetary system: be it a failed US auction, or a parabolic move in the price of gold. At that point, watch for $1.2 quadrillion in interest rate bets to politely (or not) line up in front of the single file exit door of the burning theater. This begs the question: who has "sold" this incomprehensible amount of IR protection, and has bet the ranch, city, country, and basically all of capitalism, that a black swan in the IR arena will never happen? If you want to find your next AIG, find the answer to this question. Which is why, if one is dead set on banning CDS, one should also ban IR swaps, and virtually all derivative products, as all these asset classes reinforce one another. But the problem is that all derivatives do, when one gets down to it, is provide a monetary equivalent for the global lack of assets, as the globalized economy has gotten far too big for its own good. Fiat banking hard at work.
Remember the liquidity pyramid?
As the graphic shows, derivatives account for 1,000% of world GDP, in essence allowing the world to believe fiat money is worth something only courtesy of financial sleight of hand which involved derivatives and securitizations. Yet all those calling for an end to CDS also have to realize that due to CDS intertwined nature, the world fiat system would need to do away with all derivatives (not just CDS), and when you do that you basically eliminate the other hybrid asset classes: securitizations being chief among them. What this would leave us with is a liquidity pyramid which ends with bank loans, which are much more manageable and whose risk can be controlled. It would also leave the world with a fiat currency system, which would lose about 10x of its value overnight, thereby leading to an instantaneous and global unwind of fiat money, and rolling waves of domestically denominated hyperinflation. A spectacular race to the bottom of the asset pyramid. And who will rather commit suicide than see that happen: why the Federal Reserve of course.
Which brings us full circle: an attack on CDS is an attack on excess liquidity, which is an attack on the global asset/liability imbalance (as world GDP and otherwise output has no chance of catching up with the liquidity that is currently available), which is an attack on fiat money, which is an attack on the perpetually low price of gold (because if and when derivatives and securitizations are done away with and tangible assets regain their true value, gold would go up by at least the same magnitude that fiat currencies are devalued), which is an attack on the heart of our broken financial system itself, and, an attack on the Federal Reserve, the Fractional and Central Banking System in principle. Well done David.
We hope Einhorn is successful in bringing more people to understand not just what the risk implications of CDS are (while also demonstrating the positive value that they do in fact provide in a rigged and broken capital market), but also what the underlying thematic subject of his attack really is: a busted fiat system. In essence, David believes in a fresh start. So do we, because on a long enough timeline...