CDS As Insurance Contracts

From Peter Tchir of TF Market Advisors

CDS As Insurance Contracts

This Washington Post article about CDS being an insurance product one very useful point was brought out.  At the same time, there seems to be flaw in the argument and much of the argument is misdirected.

Typically, an option or futures contract expires, and it either is in or out of the money. Any tradable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year. No interpretation is required. Why on earth would anyone need a committee ruling for a trade?

I found this paragraph interesting.  While CDS does actually have a closing price and many of the other features of “any tradable asset” it does seem relatively unique to have a final determination of whether a “Credit Event” has occurred, thus triggering a final settlement provision. Barrier options have that feature, so it is not totally unique, but think it is an interesting argument in saying that CDS has more insurance elements than other tradable assets.  I will think about that point more, though I think exchange traded and fully cleared CDS would go a long way to alleviating the issue.

What I fail to understand is the point that making this an “insurance” product would somehow fix things and citing repeatedly that AIG was the only failure in CDS so far seems wrong.  The Insurance industry and regulators seem to cause far more problems than they fix, and if AIG – an insurance company – is the poster child for what went wrong with CDS, why is there any belief treating it as an insurance company would have any benefits? 

We have included the testimony of the National Association of Insurance Commissioners before a government committee with an even longer name.

AIG Financial Products and Holding Company Are Federally Regulated


By purchasing a savings and loan in 1999, AIG was able to select as its primary regulator the federal Office of Thrift Supervision (OTS), the federal agency that is charged with overseeing savings and loan banks and thrift associations.


AIG Financial Products is not a licensed insurance company and is not regulated by the states. Financial Products is an investment unit based chiefly in London. It was able to evade regulation under the British Financial Services Authority because the AIG holding company was registered with an “equivalent regulator,” the OTS.


Although OTS has acknowledged its role as the holding company supervisor, it is worth noting that credit default swaps were exempted from regulation under the Commodities Futures Modernization Act of 2000, which prevented both the C.F.T.C. and the states from regulating these instruments.

Talk about regulator cherry picking and arbitrage.

Anyways, there is a lot of confusion about what AIG FP did and did not do. 

AIG FP was a small entity that wrote huge amounts of contracts.  Some were done as credit derivatives, some were done to look as much like insurance policies as possible.  Many of the deals AIG FP wrote were pure pass through deals – basically the thing they referenced was the only deliverable.  In a typical CDS, any debt guaranteed by the company is a potential “Deliverable Obligation”.  In pass through trades, which virtually all of the mortgage deals were, it really is payment against specific loss of a specific asset (sounds more like insurance, and was something that the early corporate credit derivatives were careful to avoid since it did look more like insurance than a tradable asset).  So while people say AIG wrote CDS, the truth is AIG FP entered into a lot of contracts that had little or nothing to do with a typical corporate Reference Entity CDS trade.

AIG FP believed the risk of “super senior” protection was negligible.  The market thought so too, as it traded at less than 10 bps per annum in some cases.  Super senior was deemed to have very low risk of actual loss.  Collateral calls based on mark to market were a concern.  Although people expected zero realized losses, they were concerned that the mark to market could move against them.  This was a lesson learned by FSA, monolines and re-insurers early in the “super senior” game.  As they pushed back on the street and wanted to do deals with no collateral provisions, an opportunity was set up for AIG FP.

AIG FP wanted to write the protection and wanted to do it without having to post collateral.  The banks would not take AIG FP risk directly.  It was an undercapitalized entity in the AIG family of businesses (one of my favorites was Banque AIG – somehow Banque AIG sounds much sexier than Bank of AIG but it was also adept at using various parts of AIG to indirectly reduce funding costs).  The banks were happy to face AIG FP with better collateral terms if AIG FP had a guarantee from AIG (the holding company).  So the seeds of destruction were sown.  Banks would agree to buy protection from AIG FP, so long as it was fully guaranteed by AIG, AND they wouldn’t charge collateral unless AIG was downgraded below a certain threshold. 

AIG’s main asset was the insurance business it owned.  AIG was AAA primarily because of its insurance entities.  So you have a structure where AIG holdco is rated AAA because of the insurance businesses it owns, but it uses this credit rating to insure little know AIG FP which has nothing to do with the insurance company (in spite of selling things that looked a lot like insurance contracts – particularly the mortgage pass through trades).

Why weren’t insurance regulators concerned with what AIG was doing?  As the size of AIG FP’s exposures grew, why was no one in the regulatory community concerned?  Why was it so easy to take the insurance company AAA rating and whore itself to AIG FP without insurance regulators having a say?  Frankly, because the laws seem designed to let this sort of thing occur, and for whatever reason, too many people ignore guarantees when looking at potential exposure  (think about all the guarantee programs in Europe right now like EFSF and LTRO that the market is largely choosing to ignore). 

Had AIG not guaranteed AIG FP, the AIG FP business never would have started.  Once AIG was going to be downgraded, because of the AIG FP exposure, the collateral calls were going to kick in.  Had collateral calls been started on day one, this entity would have been shut down in early 2007 at a reasonable cost.  They would have had to come up with collateral in the early stages of the sub-prime crisis.  Losses would have been large, but the game would have been over.  Instead, the mark to market losses grew and grew, but so long as the margin call didn’t come, they were able to survive.  It was the threat of margin calls on the downgrade on what were now staggering mark to market losses, that caused the problem. 

In theory AIG holdco could have been wiped out and the AIG insurance companies would have been fine.  I am not sure many people believed that was possible given the high level of interconnectedness of the business and the artful use of regulatory cherry-picking by AIG, but in theory AIG FP should have been left to fail, and AIG with it.  Instead, the Fed pushed the rescue because banks had relied so much on “credit derivative” contracts with AIG FP, that they were concerned what would have happened if AIG FP and AIG had failed.

While AIG FP often made the contracts look like insurance products, the banks were very careful to make sure that the products were “credit derivatives” because they needed the regulatory capital relief provided by them.  Didn’t the Fed at some point get concerned about the counterparty exposure to AIG FP?  Isn’t counterparty risk something that the Fed is responsible for monitoring (or the ECB in the case of foreign banks)?  When the Fed let MS and GS become bank holding companies and get the ability to use Fed lending programs, didn’t they ask about the AIG FP exposure?  Goldman, which always claimed it was hedged, must have had a massive short position in AIG CDS to be hedged – again, no one at the Fed noticed this?  CDS may be unregulated, but when virtually every big financial company in the world has large notionals on with AIG, huge mark to market gains on those positions, no collateral from AIG, and big shorts in AIG CDS, couldn’t someone do their job?   This should have been noticeable in 2007!

It is not that CDS should or shouldn’t be an insurance contract, it is that the regulators of banks and insurance companies did horrible jobs and the rules help avoid those regulations that are in place, far too easily.

CDS should be fully cleared and exchange traded.  The concept of “net notional” and “gross notional” is unnecessary.  That can and should be changed.  Getting CDS indices, sovereign CDS, and bank CDS (where the self-fulfilling death spirals and virtuous circles are most obvious) onto exchanges and fully cleared should be an immediate priority of any regulator or politician who wants to create a fair, but more stable system.


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