I have added a new blog, Derivative Dribble by Charles Davi.
Highly recommended: Systemic Counterparty Confusion: Credit Default Swaps Demystified
I have posted about an excellent paper by Charles earlier, see this: In Defense Of Credit Default Swaps
Brussels has just approved €6.9bn of ‘urgent rescue aid’ for ABN Amro and Fortis Bank. The cash is destined to separate Fortis from both its Netherland unit and its (2007-acquired) ... [Link]
Ce n'est plus seulement le titre d'un roman d'Agatha Christie, c'est désormais la plus dangereuse crise de l'union européenne depuis le passage à l'euro (et depuis en fait 1992). Les ... [Link]
Sorry I haven’t written much recently. The recent snowstorms have tossed me around, as I care for my family, and those around me. It is amusing in a backwards way, ... [Link]
Are there any bright spots in this market?In normal times investors can use sector investing to find opportunities despite overall market weakness. The last two years have provided fewer such ... [Link]
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October 23rd, 2008 at 4:26 am
Not to beat a dead horse, but I disagree with what has happened here. And there are two different issues. One are the CDS on whiich LEH was the underlying name. The other is the CDS for which LEH was the counterparty. These are related but distinct issues.
My experience (limited, to be sure) is that the ‘dealer’ does indeed run a matched book — total MTM exposure is about 10% of the total notional. Total notional exposure might be around $100 billion but the MTM exposure to the dealer is around $1 billion. However, you would be shocked by the amount of protection selling done by non-financials (corporations such as pharmaccuticals,, stell companies, auto manufacturers!?!?, retailers) that is not 100% collateralized by daily mark to market. I doubt that these companies hedged their exposure and sold protection mainly for yield enhancement. I think there is a lot of blood on around the world and I think the banks are financing this blood so the corporates don’t have to recongize the loss all at once.
A bigger problem is replacing LEH as a counterparty. For some dealers, protection bough from LEH on various names dwarfs the exposure for which LEH was an underlying name. They are now, for the most part, 100% unhedged on these positions. Sure the dealers have their MTM as of 9/15, but they are unhedged since that point. The lack of ‘creditworthy’ names keeps getting smaller. And the corporates that could be counted on to sell protection are licking their wounds. Dealers most likely will have to carry unheged positons or rely on weaker names to buy back protection.
Given the suddenly unhedged nature of dealer CDS portfolios, the Tsy and foreign govts had no choice but to bailout the largest banks/dealers.
To say that LEH is a non-event and the netting in the CDS market worked to prefection ignores osme key facts.
October 23rd, 2008 at 5:46 am
barry:
good points, another issue often ignored is that when a non-financial loses somebody else wins, I am by no means that there is no damage rather that it’s not systemically relevant, there are many other trades than CDS where people are being blown out like the carry trade or plain vanilla swaps, or basis swaps trades the list goes on and on.
for the purpose of systemic risk the banks’ and dealers’ exposure is what matters and there is no problem there as far as CDS are concerned,and the CDS is functioning a lot better than say, the CP market or repos were trading is dead except with the fed.
the reality is that the $365 bn loss was complete non sense from day one, the big notional numbers are meaningless.
October 23rd, 2008 at 6:11 am
Apologize for both my long windedness and typos! I guess my point was that the dealers have made money at the expense of corporates and will collect that gain over time.
BTW, according to Minn. FED the credit crisis was, as the old Tempations sogn, “Just my imgaination”
http://www.minneapolisfed.org/research/WP/WP666.pdf
October 23rd, 2008 at 6:26 am
barry:
don’t apologize!
the dealers aim to make money by running a matched book, by doing so they eliminate recovery risk, the biggest risk, and they collect a risky annuity that will cease upon a credit event.
for the credit crisis, I willpost something shortly, it’s not “just your imagination”
October 23rd, 2008 at 9:10 am
Hi Barry,
You are right, there are people out there who are not matching their book (e.g., AIG). That is a dangerous game, especially for a non-expert. That said, most of the talk about regulation (treating dealers as insurers) has to do with assuming the existence of high levels concentrated CDS risk in the swap dealers, which is just absurd.
One more point: selling protection is roughly equivalent to owning the bond. People can still do that without a CDS. If they fail because of overexposure to protection selling, it’s their own fault because it should be obvious to them that they are taking a large position.
October 23rd, 2008 at 12:34 pm
“selling protection is roughly equivalent to owning the bond”
It is precisely this attitude that makes the whole CDS market seem such a grotesque aberration to some of us. From the point of view of the investor/seller your statement may have some validity. However, from the point of view of the economic value of the transaction, the statement is stupid.
A bond is used by firms to finance profitable (hopefully) activity. A CDS (that does not insure an existing bond holding) serves no comparable economic purpose. A few people (e.g. Dimon) appear to understand the importance of this distinction. The fact that so many in the financial world do not is downright frightening.
October 23rd, 2008 at 1:03 pm
Other problems with CDS:
Financial insurance as a concept is stupid. Precisely when it is most needed the insurer is all but certain to go bankrupt. I don’t think the market could exist (no buyers) if there weren’t an implicit government guarantee to bail out the insurance sellers.
It is the government’s role in guaranteeing these private contracts (e.g. AIG bailout) that has everybody up in arms about the dangers of the market. And remember these are private contracts that as a rule do not finance any real economic activity.
As a matter of principle the government should have let AIGFP fail, while protecting the parts of the firm that were engaged in productive endeavors. As a matter of international politics I recognize that this position was untenable.
Anybody who is a net insurance seller is sure to be undercapitalized as soon as the economy hits a rough spot. Conclusion: It should be illegal for any too big to fail firm to be a net seller of CDS.
The only source of stability in financial markets is firms with strong capital positions and careful analysis of counterparties. The too big to fail concept has destroyed this stability. CDS are one of the tools used to tear down the financial system.
My apologies, jck, for taking up your blog space with my rant.
October 23rd, 2008 at 5:33 pm
Hi acc,
Yes, you are right that to the corporation that issued the bond, CDS agreements naming that bond don’t add any value in that they don’t add capital. That is a valid, economic distinction between holding a bond and selling protection, as far as the underlying issuer is concerned. But so what? The CDS market helps price bonds more efficiently (e.g., without relying on the rating agencies) which makes capital markets more efficient.
As for “It should be illegal for any too big to fail firm to be a net seller of CDS,” that’s a very bold claim. I understand your concerns and I plan on writing a comprehensive piece on the systemic risks posed by derivatives. Check out my blog. I think you’ll find that you agree with me on many issues.
October 23rd, 2008 at 10:19 pm
Does this mean that bonds ought be avoided due to inefficient pricing in the bond market? Why buy a bond if the pricing is so inefficient that one must seek insurance from a counterparty with no reserve requirements?
October 23rd, 2008 at 11:06 pm
Hi dd,
Major confusion in your post. Of course that doesn’t follow? Why would it? And I never said the price is “so” inefficient. The CDS market exerts pressure on bond pricing because in the absence of that pressure, there would be arbitrage, which doesn’t usually exist for long.
October 24th, 2008 at 6:43 am
Actually, selling protection is not the same as owning a corporate bond. The seller of protection only has credit risk where as the buyer of the bond has credit risk, interest rate risk and, perhaps, other risks such as call risk.
CDS serve an efficient function in that they allow disaggregation of those risks.
October 24th, 2008 at 9:07 am
Hi Barry,
If you use the arbitrage free model for pricing CDS, the seller of protection has interest rate risk (he holds the money for possible payout under the CDS in risk free notes). His cash flows have to be very close to the underling bond or there is opportunity for arbitrage. This is a little too detailed and is off topic. If you want, email me and we’ll discuss.
Charles
October 24th, 2008 at 9:13 am
Charles, thank you for your reply. Didn’t appreciate the arbitrage perspective. Thank you taking the time to respond.
October 24th, 2008 at 12:03 pm
“The CDS market helps price bonds more efficiently ”
What guarantees that CDS leads to more efficiency not less? I’m thinking here about the creation of products like CPDOs that appear to have driven CDS premia to unreasonable lows. If there is a large body of protection sellers who don’t understand the risks of the product they’re in, CDS disrupt the market.
I agree that in theory there is nothing wrong with CDS and that they have a place to play in a carefully regulated market. I suspect that regulation will end up outlawing CDS without insurable interest — simply because it’s too hard to prevent mismarketing of the product to underinformed money managers.
October 24th, 2008 at 12:15 pm
Hi acc,
With all due respect, I don’t think we’re ever going to agree with each other.
“If there is a large body of protection sellers who don’t understand the risks of the product they’re in, CDS disrupt the market.”
You are worried about market players making poor decisions. So, of course you will be in favor of heavy regulation. I’m not so worried about that. So, I won’t be. I don’t want to spam jck’s page, but please see my articles on this subject. The CDS market has handled itself brilliantly during this crisis.
“I suspect that regulation will end up outlawing CDS without insurable interest.”
First, I hope your prediction fails, because I disagree with you (I mean that politely, sorry if it sounds rude). Second, ISDA is a powerful lobby group comprised of firms that essentially control the global flow of money. I think they’ll manage to keep the CDS market largely in tact.
October 24th, 2008 at 12:32 pm
Hi Charles,
I appreciate your willingness (and, jck, yours too!) to share your knowledge. I apologize if, at times, I was rude — and thank you for focusing on the point of my comments rather than the tone.