Last week, Scott Lewis SLOP’d about the San Diego County pension system’s sizable investment in D.E. Shaw, a hedge fund that is heavily involved in so-called "credit default swaps."
If you’re like most people, you probably started to lose consciousness by the end of that last sentence. But stay awake if you can. Because it turns out that San Diego’s fortunes are very much tied to these arcane financial instruments
Credit default swaps, or CDSs, are basically a form of insurance that lenders of money purchase in order to ensure that they will be paid back. That, at least, is the idea. Let’s examine a hypothetical, certainly oversimplified, but hopefully illustrative day in the life of a CDS.
Excellent article Rich.
Excellent article Rich. Fascinating how everyone involved just assumes that they’ll be ok because it seems like someone else will be holding the bomb once it goes off.
Agreed. Seems like the hard
Agreed. Seems like the hard part might be tracking down where the bomb might actually be. Guess we’ll find out when it goes off.
I think the “best” scenario
I think the “best” scenario would be for a small, but not trivial, default insurance writer to go under in a noisy way.
There would be a sudden shock to the CDS pricing market
(technically all the fitted parameters in their GARCH models would start to hum and spit out new valuations on the price of the option) and mortgages would probably get repriced back to where they should have been.
The biggest risk isn’t trading, it’s fraud. Namely credit insurer pretends to write much more insurance than it really has collateral for, and the bank providing the clearing to the fund is snookered by some accounting tricks and fibs.
Fund blows up, principals abscond to extradition-free locales, and the bank is on the hook for risks they never thought they had.
Thank you Rich. I had been
Thank you Rich. I had been wondering what happens to these loans after the banks sell them off. Your cleared up a lot of things for me.
Great explanation, Rich. I
Great explanation, Rich. I didn’t know about credit default swaps. It’s scaring the heck out of me.
Some things to know about
Some things to know about credit default swaps:
– The term credit doesn’t always apply to the traditional form of credit but also applies to Government, Corporate and Municipal Bond financing.
– Some of the most common credit default swaps are correlated to corporate bonds.
– Credit default swaps are far more liquid than they were when they first came out.
– They are actively managed just like traditional derivatives and can be sold if there are inefficiencies in the market to realize a gain.
– One scary aspect of these instruments is they haven’t really been tested in a credit crunch situation.
Yep, it’s gonna be a big,
Yep, it’s gonna be a big, ugly, heated mess as defaults accelerate and folks look to ‘insurers’ for relief.
The prior Great Depression resulted in the shutting down of multilevel corporations (some companies had as many as 8-9 levels of partially- or wholly-owned subsidiaries).
This Great Depression will result in the shutting down of the multilevel parsing away of credit risk.
jg, I’m very interested in
jg, I’m very interested in your views of an upcoming Great Depression and your prior comment that you are 100% in gold mutual funds. Could you elaborate on your reasoning, and also why you think that gold is the answer, and why Roubini says gold is nothing but a metal (although I disagree with him too).
What if there’s no bomb?
One
What if there’s no bomb?
One scary aspect of these instruments is they haven’t really been tested in a credit crunch situation.
While that’s true and I understand the reasoning, I wonder if there is really a bomb left?
Here’s my question and thought on it. Are the exotic mortgages such a bad deal for the consumer, points paid up front, excess interest rates, etc, that each layer tkaes their “profit” up fron and discounts the remaining sales getting back to the point where the groups “holding the bag” can actually absorb a 25-30% default rate with a 40%-50% drop in foreclosure resale prices a still market more than the risk free rate?
In essence, has the discounting of the stated loan MBS’s gone to the point that if people actually pay the exotics back that the people with bag find it filled with gold?
There’s something I don’t
There’s something I don’t understand from the longer article. You said:
___
The CDSs … are traded back and forth to the extent that it’s not even always clear — to the insurees, financial regulators, monetary authorities, or anyone else — who’s on the hook should a borrower go into default,
___
From my naive view, if they’ve been papering these transactions, at any given time it’s exactly clear who is on the hook. It’s either the holder of the MBS if there is no insurance, or the insurer if there is (depending on the terms of coverage). I can see the terms of coverage being ambiguous, or I can believe there would be fraud as one other commentator mentioned. But I’m hoping that it’s always clear who is holding the bag.
Can you explain in more detail where the ownership uncertainty might reside??
I’m not the person you
I’m not the person you replied to but I think I can give one answer.
The credit default swaps are, in some ways, roughly like options on a stock.
They are both “derivative” securities which depend on some fundamental underlying one for their value, and their purpose is to shift around some of the typical risks of the underlying.
For a stock option, the underlying is stock, and the principal risks are of course the usual fluctuations.
For a bond—and CDS are to bonds what stock options are to stocks—-the usual risks is of course credit default, very sharp downside gaps in value.
If everybody were solvent and really was going to honor their contracts, then there isn’t really a systemic problem: somebody may have made bad bets but these are counteracted by the other person who took the other side of the trade.
The central remaining issue is “who guarantees the enforcement of the contract?” And that’s where the problems lie.
On listed options, this is done by the “Options Clearing Corporation”, i.e they have the legal central reponsibility for ensuring the creditworthiness of the option transactions and the members have “skin” in it. Roughly you may say that the OCC is the contractual counterparty for all option exercises, so if the (unknown to you) person on the other side of your option defaults, then you don’t bear that risk, the OCC and its partners do. It is SEC recognized.
For CDS there isn’t any central, legally recognized, counterparty. The problem is what happens when one party (e.g. hedge fund) takes on lots of risk, the bets turn against them, and they are unable to make good on their contracts. Now what? Who is going to make good on it?
Usually I guess it would be the banker (prime broker) for
the hedge fund who might be repsonsible, but maybe not? What
happens when one of them starts to be unable or unwilling to cover their clients’ losses?
What happens to the owners of the supposedly ‘insured’ bonds who don’t receive their insurance payment that they paid for?
You can see that conceivably there is a sudden “run on the banks” in the event of some credit shock (large bankruptcy) combined with a hedge fund or other blowup. And here is where fraud can be the problem: somebody doesn’t know just how risky and levered their clients are.
As this happens the banks will start to pull back on their risk and underwriting CDSes which means that people start to disbelieve them and they start to dump their underlying bonds which might triggers more price-based CDSes which would put more pressure on the banks, and you can see the
runaway effect. First bank out survives, last bank or fund out gets shot.
What happened at the LTCM blowup was as they were starting to lose, other traders and hedge funds who got a whiff of this started making intentional trades to put more and more pressure on to them to get them to crack. Same could happen with credit swaps.
Nice clear explanation of
Nice clear explanation of the structure, Dr C.; thanks!
Counterparty risk is
Counterparty risk is definately a big factor in the CDS market. And hedge funds are probably the riskiest counterparties in the market. But are they a big enough force to bring the market to its knees?
I don’t have recent information but one investment bank estimated that in 2003 hedge funds were 13% of the total CDS market which at the time was about $5 trillion notional.
And we have seen seen the CDS market tested a couple of times already. And I’m sure a few small hedge funds failed.
Once, in summer of ’05, when GM ‘Convergence’ trades failed because Kirk Kerkorian bought GM stock and many hedge funds had on a long cds vs short stock trade. (BTW some estimates are that there is at least $3 trillion of notional CDS written vs. GM debt)
Second, Delphi filed for Chapter 11 and an administrative nightmare ensued to match counterparties for the CDS trades.
Anyone out there who is really interested in CDS may want to call the investor relations departments of the big investment banks and ask them for a CDS primer.
I wonder what is the dollar
I wonder what is the dollar amount of loans extended by the banking system to hedge funds that are writing the CDS protection for the loans on the balance sheet of this same banking system? That is, are banks financing the insurers of the loans that the banks are insuring? If so, then the credit insurance the banks have purchased is no insurance at all.