The former General Counsel of Long Term Capital Management – it of the late 1990s near global financial meltdown – James Rickards, had a comment in the Financial Times a few days ago (Feb 11, 2010) on the credit default swap market and Greek sovereign debt. Key section:
Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?
When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.
Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.
Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.
This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.
When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.
I have general doubts about this being a complete, or accurate description, of the incentives in the CDS market. In particular, I have two questions about this description of CDSs:
- First, is this a genuinely accurate description of the CDS market? This presents it as being unmoored from the fundamentals, partly on account of the lack of an insurable interest (e.g., Goldman Sachs as an empty creditor at the time of the AIG meltdown) – but also because the parties have a massive agency failure problem in which the costs fall upon the hedge fund investors getting charged fees. But is this really the case? Are the parties on both sides, and the middle, in the CDS market really not checking against each other, quite apart from whether there is an insurable interest or not?
- Second, what is the argument for not requiring an insurable interest in the creation of an insurance market? Liquidity and depth in the market?
Mark N. says:
On the first question, a partial answer could be given empirically by looking at how well CDS prices do, in fact, predict defaults. They may not have been around long enough to have good data on that, though— or at least, I’m unable to find a good paper on that subject.
February 13, 2010, 9:20 pmEnlightenedDuck says:
Many years ago, one often took life insurance out on other people…I remember hearing the Pope was a popular person to take out a life insurance policy on.
February 13, 2010, 9:39 pmSenatorX says:
Regarding the first, it seems so. Here was one of Denninger’s takes on it.
February 13, 2010, 9:39 pmDoc Merlin says:
The characterization of the CDS market is mostly true.
The reason to not require insurable interest is that removing it makes the market function as a really good short term prediction market.
February 13, 2010, 10:38 pmDoc Merlin says:
I should have explained a little further. The main purpose of CDS markets is for prediction. The insurance aspect of them is secondary. The insurance aspect is just what allows the prediction aspect to work by aligning the incentives such that people have a benefit to making a ‘bet’.
Its completely different than real insurance, in that real insurance is mostly risk pooling. CDS is much more like betting. This means we can see large price changes when the chance of a default shifts, wear as changes in the price of insurance come AFTER the event has passed.
February 13, 2010, 10:55 pmDavid Bilek says:
Doc Merlin: Perhaps this is exactly the point Rickards is making, but isn’t there a pretty darn fine line between the CDS market predicting failures and the CDS market causing those failures, or at least doing nothing to prevent them even if they possibly could?
February 13, 2010, 11:05 pmwm13 says:
Umm, dudes, it’s February. If spreads come back in, your hedge fund manager will have big losses by December and won’t be getting any performance fee, or even any more asets under management. So Rickards’s chronology is nonsense.
Now, if the theory is that, without regard to time of year, there is a bubble here, and that each hedge fund manager thinks I’m going to let my short (=buyer of protection) position ride and sell as soon as the market is at its peak, then that’s more plausible. That is, indeed, how bubbles operate. But if all the shorts are hedge funds, it is mathematically impossible for all of them to sell at the peak, and there are going to be a bunch of guys going back to work as FA’s at Citi (or one of the other places where busted hedge fund managers end up) in 2011.
February 13, 2010, 11:06 pmTCO says:
He’s basically right. It’s just a bunch of derivatives, a bunch of bookies. Now that may be ok…or it may be wrong. But it’s what it is. That’s why the bailouts were so moronic. who CARES if some derivative crapshooters lose money? Bailing out hedge funds and “banks” (and they were essentially trading companies, not FDIC concerns) was very silly. Much smarter to let it all unravel and let people take their haircuts rather than general taxpayers paying for New York financiers.
February 13, 2010, 11:21 pmDoc Merlin says:
Nah the CDS market doesn’t make a failure. The failure can happen though if people systematically rely on their ‘insurance’ (CDS or not) in ways that the seller didn’t account for.
The same thing happens in real insurance markets when a hurricane hits that ends up being a lot worse than people expected. The problem however isn’t the ‘insurance’ it is the hurricane.
I think what we is referring to is this: The problem is CDS allow you to launch a newfangled type of bear raid. You try to damage a company then reap profits from your CDS’s. This however is really hard to do unless a company is already badly hurting. (As Bear Sterns was.) The CDS type tricks (and similar tricks involving other methods) is the kind of thing that Soros likes to talk about when he talks about “reflexivity.”
CDSs themselves don’t cause the damage, they just make it possible for someone to profit from it using “reflexivity” try strategies.
February 13, 2010, 11:31 pmDavid Schwartz says:
There is absolutely no reason whatsoever to require one, and requiring one prevents people from freely entering into mutually-beneficial agreements.
The type of harm to third parties that is used to justify prohibiting it is of the nonsensical variety. Me buying a burger at Burger King might harm McDonald’s. They lose the chance to sell me a burger and their competitor may use the money to expand. But that’s not an argument to prohibit me from buying a burger, is it?
February 14, 2010, 1:28 amCDSs, Greek Bonds, and Insurable Interests? | Liberal Whoppers says:
[...] more here: CDSs, Greek Bonds, and Insurable Interests? [...]
February 14, 2010, 1:31 amCB says:
Here’s an excellent article for explanation: http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/
1)
2)
(And that’s where the taxpayers come in to save the world from destruction)
February 14, 2010, 2:41 amLaura S. says:
CDS market is well known among all participants to be at risk of manipulation. Mostly, this is because they are too small.
Do CDS markets create harm? I don’t think so. Look, the mechanism of supposed harm is that A buys insurance on B. Then pushes B over. The trouble is that this is insurance only on default. The only reason B can be pushed over is that he’s already insolvent. i.e., debt is being issued to pay for existing debt. That’s a crisis. So I don’t think its far to say that B was pushed. B has already toppled in all but name only.
February 14, 2010, 3:03 amCB says:
Demands for settlement on hundreds of billions of dollars of credit default swaps contracts offered by a division of AIG led to AIG’s financial collapse, requiring U.S. taxpayers to bail out the world…and you don’t think the CDS market as it currently operates doesn’t create harm? And AIG is an extremely sophisticated investor…not a fly by night outfit. I don’t believe they were already insolvent…they were on the wrong side of the deals.
February 14, 2010, 3:28 amrhhardin says:
If you require insurable interest, you won’t find buyers to offload your risk on, which is a problem if you have a risk and don’t want to be in the betting business.
February 14, 2010, 5:29 amMrs. Davis says:
what is the argument for not requiring an insurable interest in the creation of an insurance market?
If there is no insurable interest, it’s not insurance, it’s…gambling.
And I have nothing against gambling, but it shouldn’t be done with other people’s money.
The next level of problem is that it isn’t really fair gambling in the sense that roulette is, when played with a fair wheel. It is more like poker where there are factors other than a random occurrence. And once the bet is made against Greece, there is every reason for one party in the bet to do everything in its power to see that Greece fails and far less that the other can do to see that it does not. That’s how Soros got rich.
February 14, 2010, 7:47 amluagha says:
In the beginnings of CDS, you were supposed to have an interest, but just not an insurable interest.
I buy material from A and I like buying my material from A. B owes A money. If B goes down I risk not being able to buy my material from A, so I estimate the cause of that risk and ensure it.
But ‘not an insurable interest’ is meaningless, and leads to everything you see above.
February 14, 2010, 8:37 amCheckEnclosed says:
The trouble with not requiring an insurable interest for CDS is that the potential notional value is without limit.
Suppose the total U.S. Mortgage market, approximated by what Fannie & Freddie cover, is about $5-$7 trillion. Then, even if 20% of those mortgages were to become completely worthless, the loss would be $1-$1.4 trillion.
But, because AIG and others could sell CDS to anyone, and because buying CDS was a lot like shorting the mortgage backed security market, lots of folks who thought there was a housing bubble wanted to go short, so AIG and others faced potential losses substantially exceeding $5 trillion.
Not that being able to see & measure short interest in an asset class is a bad thing, per se, but the absence of any insurable interest requirement, plus poor regulation, plus people underestimating the counterparty credit risk of even large insurers, plus failure to see the importance of short interest led to disaster.
February 14, 2010, 8:49 amEandJsFilmCrew says:
The CDS market has problems but not the ones named in the article. The problems are related to lack of transparency and counterparty solvency, NOT to insurable interest allowing some participants to game the market. If CDS contracts were more standardized, traded openly and had good collateral posted all around then there would be no problem – any more than there is a problem when outstanding interest in pork bellies on the futures exchanges exceeds the number of pigs in the production pipeline. The problem that Bear, Lehman and AIG all had was that no one knew what if tangible assets they had backing their contracts. It turns out of course that they had none, but we had a market that allowed them to play anyway. This needs to end.
All that said, the notion in this particular case that “when we look behind CDS prices, we don’t see an objective measure of the public finances of Greece” strikes me as hilarious. Here we have a gov’t that for decades has falsified it’s books in exactly the same ways that AIG did, i.e. generating near term revenue by engaging in hugely risky long term derivative contracts, yet we are supposed to believe that the problem is unscrupulous market participants preying on the isolated members of the herd. What a joke. Greece would have long since been unable to roll its debt were it not for game playing like this. The roll of derivatives here has been to enable them to be irresponsible liars for longer than the otherwise would have been. I think we see a much more objective measure of Greece’s public finances in CDS spreads than we’ve ever seen in the Greek gov’ts accounting statements.
February 14, 2010, 9:23 amMartinned says:
True, obviously. But then, what’s wrong with simply looking at the bond spreads? Which, BTW, is by far the most commonly observed variable these days: the Greek-Bund bond spread. Like here, on A Fistful of Euros, or here in Martin Wolf’s FT column. CDS markets are just too all-over-the-map to be useful these days. (If ever.)
Who’s “they”? Surely not the market, which runs into the tens of trillions. (At least it used to.)
February 14, 2010, 11:03 amPkSully says:
I think both EandJs and CB are pointing to the solution. The CDS market should be cleared on an exchange. The exchange and member clearing firms have rules for margin and guarantee counter party risk. The big players in this market don’t like exchange cleared products because it pulls back the wizard’s curtain a bit and therefore leads to market transparency. The margin rules restrict the size of their positions and the presence of independent market makers make market manipulation more difficult. At the fateful time these instruments were exempted from any regs whatsoever, CFTC head Brooksley Born argued for exchange clearing of these trades and pointed out that they are not insurance as neither counter party has an insurable interest. She was slammed as a power hungry woman and forced out. She was right.
February 14, 2010, 11:14 amBill says:
last year, in an incident vaguely reminiscent of the plot of “The Producers”, a small fund sold CDS contracts covering a bond that was considered nearly certain to default. The CDS premium was something like 80% to 90% of the face value of the bond, but it was considered a sure bet, so a bunch of hedge funds took the bait.
But it was a trap.
The total notional value of the CDS contracts sold on this bond was many times greater than the total amount of the covered bond. So the CDS seller had enough money that it could, as a seemingly disinterested third party, pay off the bond (preventing the expected default event) and walk away with a tidy profit.
The lack of an insurable interest requirement led to the CDS buyers getting ripped off.
February 14, 2010, 11:19 amSenatorX says:
Every government cooks it’s books. It seems the Greek problem though is that they can’t manipulate their way out of their public overspending via the usual methods becuase they are trapped in the EU.
For that matter financial companies also cook their books and I have to assume technically most are insolvent. The repeal of mark to market accounting rules and a return to mark to myth last year wasn’t for no reason. We have Japanese style zombie banks right now.
February 14, 2010, 11:39 amPkSully says:
In Bill’s example, if the CDS on that bond issue were commonly cleared, the market participants would have seen the open interest grow and as it’s underlying value reached that of the debt issue prices would react making it hard if not impossible for one player to corner the market. I think common clearing is the answer for the CDS market and probably the CMBS market as well but there is not an identifiable group that will profit from it other than the taxpayer so it won’t happen. I’m not including exchanges like the CME as possible winners because they don’t profit much from low volume products like these.
February 14, 2010, 11:39 amMartinned says:
Actually, the original post isn’t really about the Greeks cooking the books, but about Wall Street cooking them. Greece cooks its own books as follows (from Afoe, today):
February 14, 2010, 11:49 amOren says:
Well, I think Wall Street marketed particular financial arrangements to Greece that were designed to make the deficit look smaller. For instance, taking one-time payments for future regular proceeds (airport landings, lotto).
My first instinct was to say the Greek government is (metaphorically) mature enough to enter into voluntary financial arrangements however they see fit. On reflection, this is plainly incorrect — they act like teenagers who will do anything for immediate gratification and push off liabilities into the future. The plain truth is that the government of Greece needs to be put into protectorship of some sort because they are incapable of honestly writing their own budget.
February 14, 2010, 12:28 pmOren says:
Trapped? Are you kidding me?
Every *other* government in the world must borrow at the prevailing market rate for their bonds. They can cook the books in the short term but eventually will have to either pay up or default. The latter, of course, will wreck their currency and any future lending prospects. See, e.g. Russia’s default in the late 90s. Greece is blessed with the fact that Germany is shackled to its corpse.
For insanely wealthy countries like Japan, they can coast for a long time in gradual decline. Japan is also still wildly productive as well, which gives the government the tax revenue to spend on the downside.
February 14, 2010, 12:33 pmMartinned says:
They have been, to the extent possible. (In case you’re not familiar with diplomat speak, the relevant language is in the 4th paragraph, which essentially establishes a system of monthly Commission assessments.) The problem is that they can’t be put into protectorship by the people who are really their bosses, because the Greek people fully support this approach.
February 14, 2010, 12:48 pmMartinned says:
That’s too simple. What Greece can’t do, that it otherwise could, is compensate for its loss of competitiveness by devaluating the currency in order to boost exports and stifle imports, thus making it easier to “pay up”. Since they can’t do that, they’ll either have to go through an internal devaluation, or they’ll have to get the rest of the Eurozone to catch up with them, inflation-wise.
February 14, 2010, 12:53 pmOren says:
Sorry Martinned, you are absolutely correct and I wasn’t clear. The Greek People have every right (as “boss”) to write their own budget. What I was getting at was honest disclosure of the substance of that budget to their creditors (e.g. the ECD). To the extent that the ECD and Eurostat are now going to do this (and to the extent that they can compel from the Greek government the documents they need to accomplish this), I am upbeat. That is certainly the first step towards fixing this mess.
Wall Street was complicit in this dishonesty, and for that I have mixed feelings. One should not put a stumbling block in front of the blind (as it were) but one should also not object to a sovereign government arranging weird financial deals either.
Finally, the quote about inflation is quite interesting. I suppose this is because wages are (foolishly) written in terms of nominal currency and not real currency. I’ve long been of the opinion that almost all contracts/statutes should be assumed to talk about real currency unless explicitly nominal (case in point, the 7A to the US Const). I digress….
February 14, 2010, 1:12 pmMartinned says:
The absolute level of inflation is much less interesting than the question of whether it is predictable. So I agree with Krugman that an inflation target of, say, 5% would be better.
Writing contracts in real terms is problematic because that raises the question of the most appropriate measure of inflation. Krugman uses the GDP deflator, which is my favourite as well, but that measure, like the Paasche and Laspeyres CPIs, and their progeny, has its flaws, not to mention that there is often no principled reason to prefer one over the others.
In practical terms, one of the problems of writing contracts in real terms is that it causes more inflation, since it causes more prices to be adjusted more frequently upward. That is why, IIRC, many countries used to ban contracts written in real terms in 1920s and 1930s. (i.e. Such contracts were unenforceable in court.)
February 14, 2010, 1:43 pmOren__ says:
Well predictability is fantastic but getting Europe to agree on a number would be worse than herding cats. Germans with their life savings in low-interest nationalized banks probably prefer 2.5%. The Greeks would love 6% to inflate away their debt. How you can have predictability in that environment is beyond me.
Only in the presence of either huge economic growth or insane monetary expansion.
I can see it being an issue if they are unbalanced — merchants have to pay their employee in real dollars but their suppliers in nominal dollars, for instance. The answer there would be to hedge it out, of course. If real dollar contracts were, in fact, universal then prices would steadily go down since efficiency/productivity/technology are steadily increasing.
February 14, 2010, 2:07 pmMartinned says:
Actually, with a predictable level of inflation at any level, no one’s debt is inflated away. The current ECB inflation target is 2%. For the reasons explained in Krugman’s blog post, that could easily be increased to 4 or 5%. There’s not much of a practical difference between agreeing on a target of 2%, and agreeing on a target of 4%.
That wouldn’t give any creditors a break, but it would mean that you could have nominal wage development ranging from 2% to 6% averaging at 4%, meaning that technically nobody has to take a pay cut, and the average still ends up at 4%. If the target is 2%, it is much more difficult to get there without anyone taking a cut. (That’s the Akerlof et al argument.)
Also, there’s this: There have been some discussions about whether a negative nominal interest rate is possible, and IIRC even some experiments, but effectively the minimum stays at zero. If your ordinary interest rate is a few points higher, there is more room for interest cuts.
February 14, 2010, 2:39 pmLT says:
This is a flawed article.
1. The biggest flaw is the line, “Eventually the money flow will be reversed, when a bail-out is announced.” This assumes that the participants in the market are expecting a bailout, which is ridiculous. See e.g. Lehman.
2. The author also overstates the value of an insurable interest requirement. In his example the hedge funds buying protection don’t have an insurable interest, but most parties buying CDS protection do have an insurable interest. For example hedge funds will often buy the bond and the protection to arbitrage the difference between the two cash flows.
3. To blame wall street for Greece is laughable. International economists have known about the Greek problem for at least a few decades. Greece’s economy has fundamental problems that the EU has complained about for a long long time.
February 14, 2010, 3:35 pmLT says:
One other note.
4. Later in the article, the author claims that sellers of CDS protection are not regulated to ensure they have sufficient reserves. This is a common misconception. One would not buy CDS protection from a seller without thoroughly inspecting their books, and being satisfied with their capital on hand. Sure, and insurance regulator isn’t policing their reserves, but the buyer of the protection is. And if your reply is that insurance regulators are better at policing reserves – do I need to remind you that AIG was an insurance company?
There is so much more I can write about why this is a flawed article, but I’ll leave this be.
February 14, 2010, 3:50 pmCB says:
I think the problem with just letting the gamblers lose is that anyone who had money in money market accounts would have lost money, not just the gamblers. These banks and other financial entities were using off-balance sheet transactions, i.e. the shadow banking system, to borrow in supposedly safe, short-term money market funds in order to fund their unregulated speculation. I believe when all the moms and pops who had thought their money was safe in their money market accounts awoke to a huge haircut due to rampant speculation by the financial community using these “safe” funds, off their books and outside the regulated traditional banking system, there would have been hell to pay. And well deserved hell to pay.
Think everyone taking their money out of money market funds all at once when they realized they weren’t safe at all. The entire economy would have shut down and pitchforks out. In fact, I believe that is what started the crash, people starting to remove their money from money market funds when they realized they weren’t safe.
February 14, 2010, 4:39 pmMark N. says:
By that definition though, any financial company with less than 100% capital ratio (i.e. all of them) is permanently insolvent, so you’d consider them to have always “already toppled”. In fact almost all large companies are insolvent in this sense: their liquid assets can’t cover their outstanding debt, so they rely on a combination of it not being called in (i.e. banks hoping there is no bank run), and rolling over bonds in the capital markets when they come due (issuing debt to pay for debt). There are very few large companies that are able to cover all their outstanding debt with cash on hand. (A few cash-rich companies like Microsoft and Apple are exceptions.)
February 14, 2010, 5:21 pmLN says:
And if your reply is that insurance regulators are better at policing reserves — do I need to remind you that AIG was an insurance company?
AIG Financial Products was not regulated in the same way that AIG’s more mainstream insurance operations were. I believe that the holding company is not even an insurance company, so the overall institution was not regulated as an insurance company (although its insurance subsidiaries were in fact regulated like regular insurers).
February 14, 2010, 5:28 pmOren says:
Mark is spot on: a company is not ‘underwater’ so long as there are creditors with enough faith in the present value of future profits — this is irrespective of their liquid asset/debt ratio.
In the case of Greece, the concern of bond holders is that the ability of the government to tax (and not to spend) is greatly imperiled.
February 14, 2010, 5:50 pmRicardo says:
Second, what is the argument for not requiring an insurable interest in the creation of an insurance market? Liquidity and depth in the market?
I’m not a trader but as I understand it, a CDS does not necessarily need to be linked to an actual tradable security which makes it much more useful as a way to hedge market risk. For instance, you will be pretty unlikely to find a CDS on a municipal bond issued by, for instance, Sunnyvale, CA. But you probably can find a CDS that is linked to a larger pool of California munis with about the same risk characteristics.
Requiring an insurable interest would be very difficult to enforce in a situation like this. If there is no trading asset that tracks the pool of munis the CDS issuer is tracking, what is an acceptable substitute?
February 14, 2010, 11:08 pmEzra says:
People instinctively seem to think speculation is bad, but diversification is good. They go together, for the most part. In any case, the insurable interest is risk. There are lots of ways that risk is transferred. If I’m a creditor of a company (say a supplier), I might want to buy credit insurance to protect my exposure. Well, an insurance company can sell me credit insurance. But then, how does it hedge its own exposure? It can try to lay off a portion of the contract, but often, it’s more efficient to use a capital market counter-party to hedge via a CDS. (And if it can’t do that, the cost of its insurance may be higher.) Or take the case of an orange grower, who may want to buy insurance against a decline in orange prices. Should no one be allowed to help him transact around this risk unless they’re already short oranges? Should growers and sellers be required to contract directly, as opposed to via market participants?
I don’t see a problem inherently in this sort of risk-reallocation, and market participants who are purely speculating add liquidity, which has a positive value as well. I do think, however, that counter-party risk isn’t sufficiently priced and disclosure isn’t particularly good on CDSs and derivatives, generally. There is definitely systemic risk created when the notional value of derivative trades exceeds the total capitalization of market participants. But that suggests the risk here isn’t on Greece (whose bonds are being speculated on), but rather on the institutions that are facilitating the speculation.
February 14, 2010, 11:22 pmLT says:
That’s not quite true (and any way, how competent are insurance regulators if all you have to do to skirt them is set up a subsidiary?), but if AIG isn’t a good example for you then look at the monolines.
February 15, 2010, 12:08 amOren says:
Interestingly, in this case it actually can decrease liquidity and increase volatility because the underlying security market that is being ‘insured’ is not deep enough. That is, if the value of the CDS’s on a particular debt are far in excess of that debt itself then a small movement of capital on the debt-market makes a much larger splash in the CDS market.
In particularly perverse cases, a party that holds a decent fraction of a shallow bond pool and a pile of CDS’ on that debt can start playing the market’s anxiety. When bad news come out they can pile it on by selling the bonds (taking a small loss) but pushing their CDSs way up. The same happens in reverse on days when the market dynamic looks good for the debtholder.
This only works, of course, if the bond market is not deep enough to iron out these wrinkles. IIRC, the total market value of all Greek sovereign debt CDSs outweighs the value of the actual debt by worse than 6:1 at this point.
I should add that I’m all for CDSs and CDOs under appropriate circumstances.
February 15, 2010, 3:34 amferridder says:
Another problem with CDS, even when used as a hedge, is that the party holding the CDS may have an incentive to push a failing company towards a default event (impairing the bond but making the CDS pay off), as opposed to the “optimal” restructuring for the future of the company.
February 15, 2010, 5:28 pmMichael F. Martin says:
A frustrating comment thread. Nobody answered the questions posed.
Here are my guesses:
1. Yes. The key issue is the time horizons for traders without insurable interest vs. traders with. Why should a rational counterparty’s time horizon not shrink to match the time horizon of the average trader (who, without an insurable interest) has time horizons to short to internalize any substantial portion of the ex ante risk of default?
2. Yes and no. The grand dream of insurance derivatives was a market in which any kind of risk can be sliced up and sold off to the cheapest risk bearers. The requirement of an insurable interest does not, by itself, defeat that dream in theory. But the fact that insurable interest holders need insurance tells you something about their willingness to accept unconventional risk relative to other entities.
On my view, the combination of no requirement of insurable interest with the proliferation of unregulated derivatives led to instruments too complex to be valued accurately by even the largest financial institutions. Once you had a situation where Bear, Lehman, Citibank, and half the rest of the institutional investors in the world were buying and selling CDO^2s without worrying about the fact that a back of the envelope calculation showed that an order of magnitude more money was flowing into subprime than could realistically be serviced by such borrowers the problem was obvious. But stopping the train before it got that far down the tracks would have required a far more conservative institutional culture than has prevailed on wall street for some time.
The repeal of Glass-Steagall and the Volcker Rule are a good start on reform. But ultimately the aggressive types that get into managing wall street banks have to be given a compelling game to play that doesn’t put the entire world’s capital at risk. That should be another goal for reforming. Simply taking the marbles away won’t avoid another catastrophe.
February 15, 2010, 6:45 pmThales says:
A commenter discusses the flaws of the article as s/he sees them, and writes:
“2. The author also overstates the value of an insurable interest requirement. In his example the hedge funds buying protection don’t have an insurable interest, but most parties buying CDS protection do have an insurable interest. For example hedge funds will often buy the bond and the protection to arbitrage the difference between the two cash flows.”
In my experience this is not true, and logically it can’t be true in cases where the amount outstanding of a bond is dwarfed by the notional amount of the CDS that are traded on such bond. Many institutions, for regulatory or other reasons, have an incentive to take a “synthetic” position on a bond, i.e. one where the underlying security is neither purchased nor sold. It is for this reason that so many CDS contracts have been written, and (for better or for worse) that feature of the market would disappear if an insurable interest were required.
February 15, 2010, 9:40 pmreadery says:
After the CD fiasco, nobody can deny that gambling laws have a rational basis.
Indeed, exempting CDs and similar “insurance” from the gambling laws may have been a huge mistake.
February 16, 2010, 4:53 amLT says:
Another misconception. Many parties both write CDS protection and buy CDS protection on the same bond (making money on the spread), which increases the notional value of CDS contracts without increasing the outstanding value of the underlying bonds.
February 16, 2010, 5:23 pmThales says:
“Another misconception. Many parties both write CDS protection and buy CDS protection on the same bond (making money on the spread), which increases the notional value of CDS contracts without increasing the outstanding value of the underlying bonds.”
Right, though my use of “dwarfs” was meant to indicate that if there are *many* multiples in CDS of the underlying assets, the market is not limited to parties buying insurance/protection for their investments (which is fine, and basically uncontroversial), but is also speculative and highly volatile (everyone that works with CDS and related derivatives knows this to be true). I also understand that without netting the total exposure written and purchased by the same counterparty with respect to the same risk, you don’t learn a lot from notional amounts in a vacuum. However, an examination of the contracts written by AIG’s problem unit, Lehman, and others does point to a large and problematic speculative market, with insufficent transparency and regulation (i.e. none) regarding concentration of counterparty risk and sensible margin requirements or exchange clearance.
February 17, 2010, 12:08 pmOren says:
Moreover, it stacks a “deep” market on top of a “shallow one” (at least in the case where the underlying bond is a small-issue, e.g. a muni).
February 17, 2010, 12:45 pmcheburashka says:
To answer the questions:
1. The description is not accurate, but the market is “unmoored from the fundamentals.” The market is unmoored from the fundamentals because there’s no really good way to price credit default risks. It should fluctuate inverse with unsecured debt, but it doesn’t.
The remainder of the description is inaccurate, however. A CDS buyer may be able to show a profit if the value of the CDS goes up, but this is not because they get cash out of margin payments.
And the description also assumes that CDS traders are able to coordinate their activities. Why did they pick Greece anyway? More likely, the Greek CDS price rose because the market accurately perceived increased risks of a Greek default, but the short-term price fluctuations might time larger and more wild than they otherwise would have been because of large-volume technical trading.
2. You are correct, the argument against requiring an insurable interest is that not requiring one brings liquidity into the market, making CDS’ tradeable instruments rather than insurance.
3. To close the loop, the perceived relationship between (a) requiring an insurable interest, and (b) “fundamentals” pricing, is inaccurate. Insurers often price based on the return they expect to receive on the “float,” expecting to break-even, or close to it, on the insurance policies themselves. Insurance prices are set on a market. As an example, consider the workers’ compensation insurance market in the mid to late 90s, in which insurers turned out to have been writing policies at far below cost for years, there were a wave of bankruptcies, and rates skyrocketed. These kinds of cycles in insurance are not uncommon. See also, auto insurance, life insurance, etc.
February 17, 2010, 2:44 pm