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The numbers that are thrown around are so mind-boggling that they are mind-numbing. The total amount of Credit Default Swap (CDS) obligations outstanding, according to the Bank of International Settlement, was 57 trillion US$ in December 2007 (pdf).

That is roughly Four Times the size of the US GDP.

These are the things that Warren Buffet called a "time bomb".

What are they? Well, suppose that we are watching a little old lady crossing a street, and want to take out a life insurance policy that pays if she gets clobbered by traffic. Unless she is close family, or she is a business partner, we can't do that ... we have no insurable interest.

But if we were watching a company, and wanted to buy a contract that pays off if the company can't pay on its bonds, we could. We'd buy a CDS.

You Too can be an Insurance Company

Well, no, not everybody can be a real insurance company. You need to get a pile of money together, and have to submit to regulation on the assets you hold against your insurance liabilities.

And not everybody can buy insurance ... so you have to check whether the people requesting coverage have an actual insurable interest in the thing they want to get covered. If "Matches" McGee comes in for fire insurance on the bank across the street, and he is not representing the bank across the street, or maybe if its a leased premises the landlord, then "Matches" McGee  would have to be sent packing.

Ah, but that's real insurance, not derivative financial contracts. Under a Credit Default Swap, the buyer of the protection pays for protection against a "credit event", and the seller of the protection promises to pay off in the event of the credit event.

A common credit event is default on a bond.

Here's the "beauty" of it, though: the buyer of the protection does not have to hold the bond. They could be holding the bond ... or they could just be betting that the bond will fail. There's no requirement to have an insurable interest ... its just a contract that says this much money flows this way over this period of time, and if this event occurs during the period of the swap, then that much money flows that way.

So there can be $10b in bonds with $100b bet on whether the bonds will be paid off or not.

And to sell those Credit Default Swaps, you only have to persuade a CDS dealer to let you ... its a private, over the counter market. None of that nasty business of satisfying tedious, time consuming government regulations.

That's part how the CDS's get to a face value estimated at $45 TRILLION worldwide.

Laying off the bet

If a bookie takes a bet, sometimes they are getting all the money on one side ... and don't want to be betting all their own money on the other side. So they lay off part of the bet by covering the bet with other bookies.

Same thing with a CDS. A company that has sold protection thinks they are overexposed, they can take out CDS of their own. Anybody can take out a CDS after all ... well, anyone who can handle the big sums involved in each one.

Except, the devil is in the details. Take the case of Aon and Societe General:

Bear Stearns provided a loan of US$10 million to a Philippine entity and demanded the borrower obtain a surety bond from a Philippine government agency, the Government Service Insurance System (GSIS). Bear Stearns, to further hedge default risk on the US$10 million loan purchased protection contract from AON for US$0.425 million. AON, to hedge this risk purchased protection from Societle Generale for US$0.3 million believing it made a cool profit of US$0.1 million.

Easy Money! Except, there was a catch:

However, as the Philippines entity defaulted and the GSIS refused to pay on the surety bond, Bear Stearns sued AON based on the first CDS contract, which AON lost and had to eventually pay US$10 million to Bear Stearns. AON then went on to sue Societe Generale, and argued that the court's finding in the first action, that a "Credit Event" requiring payment had occurred under first CDS, mandated a similar result with respect to the second CDS.

... and Aon lost and Societe General did not have to pay, because there was slightly different wording in what credit events were covered. They sold protection against the GSIS refusing to pay, and bought protection

against a condition resulting from any act or failure to act by the Government of the Republic of the Philippines or any agency thereof that has the effect of causing a failure to honor any obligation issued by the government of the Republic of the Philippines.

... which, it seems the refusal of the GSIS to pay did not qualify for.

So what was supposed to be $100,000 easy money turned out to be a $10million loss.

And there, you have an example of the other thing amplifying the number of outstanding CDS ... laying off the risk of paying on the default by finding someone else willing to issue a CDS, who in turn may lay off the risk of some of their CDS liabilities, and so on.

And where it stops, in reality nobody really knows, because its a private over the counter dealership market.

What made CDS into Magic Money Machines are exactly what is Wrong With Them

This is from JPMorgan back in happier days (full disclosure: my checking account is at Chase), when they are peddling CDS to people engaged in international trade, who would otherwise be in the market for actual insurance:

The use of credit default swaps represented a new, less expensive, kind of risk mitigation for borrowers who could command very low spreads on borrowing, as well as pay low fees for the issuance of standby letters of credit issued for their account.


Despite the issues listed above, the market for credit default swaps continues to grow for these reasons:

  • Standardised documentation leading to improved process flow and efficiency
  • Dependably timely pay-out in case of major default
  • Investor recognition of similarities between CDS solutions and more standard insurance and cash products
  • Better use of capital and increased optimisation of balance sheets
  • Diversification through investment that not only provides better yields, but may offer access to an otherwise inaccessible transaction. According to ISDA, at the end of 2004, the notional amount for the interest rate and currency derivatives market was US$183.6 trillion Credit derivatives comprised 4.4% of the entire derivatives market at US$8.42 trillion The players include insurers, reinsurers, financial guarantors and hedge funds; but the largest players are commercial banks, who are net buyers of protection

Great! Except ... suppose that event occurs at the same time as a large number of other credit events ... and because of the massive exposure, the credit events drive a lot of the issuers of the CDS over the brink and they fold.

Oops. As Reuters noted last month:

"This was supposedly a way to hedge risk," says Ellen Brown, the author of the book Web of Debt.

"I'm sure their predictive models were right as far as the risk of the things they were insuring against. But what they didn't factor in was the risk that the sellers of this protection wouldn't pay ... That's what we're seeing now."

The Problem is Systemic Risk

The problem here is systemic risk. This is by a quite different route than How a Little House Threatens Pension Funds and Insurance Companies ... but the upshot is the same.

You can diversify against "stochastic" (random) risk. Its a straightforward proposition, and the random events that happen all the time provide a lot of data to develop quite good statistical models of what is going on. These are risks like rolling a hundred fair dice and losing big on each "1" but winning a bit on each on that is "4, 5 or 6".

The odds of all 100 dice coming up 1? Really, really low.

But as long as the economy is an interconnected system, there are events that drive other events that drive other events in either a virtuous or a vicious circle. And when its a vicious circle, that's a systemic risk.

Like the collapse of the housing bubble, where the housing bubble led to lending on the assumption that people could always sell out if they could not pay, which then led to people who could neither pay nor sell out going into foreclosure, which undermined the housing market, and made it more difficult to lend, which undermined the housing market, and so on and so forth.

And Fannie Mae and Freddie Mac collapsed, sparking the biggest settlement of CDS to date.

We Know How to Protect Against Systemic Risk

We know how to protect against systemic risks in insurance. Insurance is always exposed to systemic risks, so we don't allow insurance to be bought by those without an insurable interest, and we require the firms selling insurance to manage their assets in a financially prudent manner.

The question is, how did we forget this with CDS, and allow anybody with a large enough bankroll to act like an insurance company, and anybody at all to take out insurance, even as a purely speculative play?

Well, because systemic risks are about the birds coming home to roost. Systemic risk exposure is not realized on a steady, ongoing, basis like stochastic risk. Instead, very little systemic risk is realized from one year to the next to the next ... then there is a recession and a financial arrangement proves able to withstand that level of systemic risk exposure ... and then there is little systemic risk realized for another stretch of years ...

... and you look around and find that there the exposure itself has become part of the vicious circle.

What can we do about it?

The original incentive for scratching into CDS was thinking through different alternatives to a "Bail-Out 2.0" when the current bail-out runs out of gas, sometime later this year or early next year. But digging into it leads to thinking about what can be done to avoid this kind of massive systemic risk exposure.

Over the long term, one thing the US could do would be to explicitly rule out enforcing CDS contracts unless the recipient of the protection holds the asset that is being insured. If the court does not enforce CDS that are not equivalent to a "real" insurance contract, then that will substantially reduce the appeal of taking out new CDS contracts.

In the short term ... well, now you know why there has been so much focus on buying up shaky assets. If the government waits until firms go belly up, then that is a "credit event" and triggers a cascade of CDS payments ... or, if the firms issuing the CDS cannot pay, more firms going belly up, who themselves may have bonds for which there are outstanding CDS that have to be paid, and so on.

On the other hand, if the government prevents the firm from going belly up, so they continue to pay their bonds, then that holds the lid on an explosion of CDS obligations.

Mind you, it should not be free of charge ... that is why I favor a system of 50:50 shaky assets and equity stake, with limits on corporate pay, regulation of mergers and acquisition, and no handing out profits to shareholder dividends until and unless the Preferred Dividend to the Public is paid in full.

Originally posted to BruceMcF on Sat Oct 04, 2008 at 04:50 PM PDT.

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Comment Preferences

  •  Another key distinction... (3+ / 0-)
    Recommended by:
    cotterperson, gmb, BruceMcF

    ... is that CDS deals with speculative risk whereas insurance deals with pure risk.

    As long as there is a financial incentive for something to fail, then you must deal with morale hazard.

    The fact that a large insurance firm like AIG would ignore all basis of underwriting reality to pursue these profits with all the structural risk in this product is insane.

    I am fundamentally a D Wreck-ulator.

    by D Wreck on Sat Oct 04, 2008 at 05:04:43 PM PDT

    •  The primary CDS is a simple guarantee (2+ / 0-)
      Recommended by:
      cotterperson, Deward Hastings

      on the value of a bond.  No moral hazard involved.

      Odd that someone didn't ask why the sudden fear that commercial bonds have become risky?

      What FDR giveth; GWB taketh away.

      by Marie on Sat Oct 04, 2008 at 05:16:05 PM PDT

      [ Parent ]

      •  The moral hazard is the general ... (2+ / 0-)
        Recommended by:
        cotterperson, Burned

        ... moral hazard of insurance, gambling that event "X" simply won't happen and therefore not having prudential cover will, if the event does not occur, increase income available for distribution.

        As in Doc Hollywood:

        After dinner, the drunk Doc Hogue starts quoting Walt Whitman, so the 'young folks' go outside, comprised of Ben, Lou, Nancy Lee and Hank. Nancy Lee continues to heavily hint at her desire to leave Grady and see the big city of Hollywood. Hank makes a statement that selling earthquake insurance in California would be a no-brainer: collect premiums and if the big one ever hit, declare bankruptcy and retire. Ben makes a comment under his breath to Lou about Hanks' 'decency' and Lou tells him that no one's perfect.

        •  Well, there is that moral hazard on that (1+ / 0-)
          Recommended by:

          side of the transaction.  But AIG, Bear Stearns etc. never considered that CDS wculd bankrupt them and therefore, that wasn't their exit strategy. They were simply dazzled by all the free money the complex financial models promised.  Or the senior executives were too intimidated by the numbers whiz kids to point out all the irrational assumptions that were embedded in the high return/low risk models they were shown.  I have no empathy for those people because when I was young I bucked the pressure of a McKinsey & Co. partner who had the ear of my employer's CEO. Understood the risk I took on that to do the right thing -- that they could have fired me.  McKinsey wasn't pitching CDS but in rudimentary form it wasn't dissimilar.  A few other companies took a small bite of that apple -- when it blew, the largest loss was $300 million (this was 1981).        

          What FDR giveth; GWB taketh away.

          by Marie on Sat Oct 04, 2008 at 06:19:44 PM PDT

          [ Parent ]

          •  There may be a difference in legal liability ... (1+ / 0-)
            Recommended by:

            ... between those who fail to hold prudential cover because they are consciously defrauding the other party, or because they have conned themselves into believing in something for nothing ... but the moral hazard is behavioral. If one party makes an agreement that they cannot fulfill because they have not exercised prudence, that's the same basic moral hazard faced by the other party.

            Of course, the game theorists like to ignore the self-deception, because while its historically commonplace, its hard to analyze with a utilitarian game theory model.

            •  Here's the trick -- they thought they (1+ / 0-)
              Recommended by:

              could honor those agreements.  (Okay, they weren't thinking all that well, but most people in business don't.)  Their models told them that in the worst case scenario they could manage the losses.  They missed some basic and highly complex and disaster scenarios because they financial guarantees don't behave like insurance.  (Warren Buffett knows that -- explains why long before CDS were around he refused even to consider any type of quasi-financial guarantee -- and would later refer to the stuff as WMD.  Wall St. missed that because unlike Buffett, they don't know the insurance business.)

              What FDR giveth; GWB taketh away.

              by Marie on Sat Oct 04, 2008 at 07:00:09 PM PDT

              [ Parent ]

              •  Quite. (1+ / 0-)
                Recommended by:

                In the mid-90's, CDS's were being sold as being "like insurance but cheaper".

                That's what I mean by

                because they have conned themselves into believing in something for nothing.

                How reasonably smart people con themselves into believing in something for nothing is that they buy into complex, high powered models by whiz kids that have some fundamental flaws that are entrenched in the whiz kiddery into which they are trained.

                (In the fancy mathematical economics which was a hurdle for a Finance whiz kid, there are entrenched assumptions of ergodicity of macroeconomic systems which simply do not hold.)

                •  Enron secured financial guarantee (1+ / 0-)
                  Recommended by:

                  "insurance" to facilitate loans from JP Morgan/Chase.  Not that they called them loans and not that the contracts were in the name of Enron and JP Morgan -- offshore SPEs.    Enron paid less than $1 per thousand for the guarantees -- one time, up front premium.  Cost the insurers and bank over half a billion each.  

                  What FDR giveth; GWB taketh away.

                  by Marie on Sat Oct 04, 2008 at 07:37:21 PM PDT

                  [ Parent ]

      •  Morale hazard, not moral hazard (0+ / 0-)

        I butchered the example.

        The point I was trying to make was that the existence of this "insurance" lead to riskier behavior.

        I am fundamentally a D Wreck-ulator.

        by D Wreck on Sat Oct 04, 2008 at 08:35:10 PM PDT

        [ Parent ]

  •  You've probably already seen this, (9+ / 0-)

    but it looks like the credit default swap problem can be laid directly at the feet of only a few people:

    Decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. ....

    On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

    They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

    The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.

  •  asdf (2+ / 0-)
    Recommended by:
    cotterperson, limpidglass

    On the other hand, if the government prevents the firm from going belly up, so they continue to pay their bonds, then that holds the lid on an explosion of CDS obligations.

    And guess when that lid is going to blow off?  When Obama is in office.  

  •  They are bets, not insurance (4+ / 0-)
    Recommended by:
    Marie, cotterperson, jlynne, D Wreck

    and should not be held legally enforceable, nor paid for by the taxpayers.

    •  The risk that we are exposed to is as ... (2+ / 0-)
      Recommended by:
      Deward Hastings, Publius2008

      ... participants in the economy, not as taxpayers.

      However, yes, they are bets used as if they are insurance.

      There is no urgent argument that it would damage regular participants in the actual productive sector of the economy if speculators were left without legal recourse. And its easy enough to focus enforcement of CDS on those who own the assets, which would substantially reduce legal exposure.

      •  I agree as to things which are asset backed (0+ / 0-)

        as to the others, the majority of derivatives to my understanding, they should not be legally enforced.

        My understanding from the original bill is that we are only bailing out "senior debt."  To my understanding, that is not only asset backed, it is first priority debt.  That is the way it should be.  (I don't know if that provision survived the revisions).

      •  that's a simple "solution" . . . (1+ / 0-)
        Recommended by:

        A simple declaration that CDSs, as unregulated and unregistered instruments, are not enforceable in a Court of Law.

        Then we get back to doing business the way we did before they existed, and since that was barely a decade ago there are probably some old geezers around who still remember how . . .

        •  Simply speaking (0+ / 0-)

          that would have an effect on the market very similar to having let AIG blow up,  i.e. catastrophic, especially if not done exactly the same way by everyone on the planet

          •  On which market? (0+ / 0-)

            Letting AIG blow up because of their reckless adventures in derivatives markets would destroy a lot of insurance protection for the Productive and Household Sectors.

            Without a game plan established in advance for allowing the gambling arm of AIG to collapse while rescuing the real insurance arms, it was rescue AIG or let the whole thing collapse.

            There is no generic "the market". There are markets and market-like sets of transactions, but no "the market".

        •  I'd be wary of extending that to those ... (0+ / 0-)

          ... who are hedging an actual risk exposure, rather than speculating ... without walking through the impact on balance sheets ...

          ... but for pure speculation, I am not 100% clear why its more important that those gambling $1,000's on the failure of a company really ought to gain more protection than those gambling $20 on the continued failure of my beloved Bungles.

          •  hedging, insuring, gambling (0+ / 0-)

            The distinctions become blurred.  I'm not going to pay insurance premiums to a company that has no ability to pay a claim.  So who decides (how do they decide) that a CDS is worth more than the paper it's written on, and gives good money for them?

            There's a lot of talk about home buyers who . . . overstated their ability to pay.  But they're small potatoes compared to the institutions writing billions of dollars of CDSes that they had no ability to pay.  Somebody wasn't paying attention . . .

            •  The distinction between hedging ... (0+ / 0-)

              ... and speculating includes a bright line ... if the firm owns the asset in question when they acquire the CDS and when they exercise it, they were definitely trying to hedge.

              A consequence of applying your rule on the other side of the line is that firms that are selling protection would seek to settle with the firms that are hedging, which is far less exposure then attempting to settle all CDS.

              That avoids letting the firms that received payment for the CDS to just walk away with the money and no responsibility, which a blanket refusal to enforce any CDS in the court system would do.

      •  What about those who used to own the (0+ / 0-)


        What about those who have other exposures they were using the CDS to hedge?

        Trying to declare that you can't do this prospectively is one thing (which may or may not be a good idea) but voiding contracts retrospectively is more likely to detonate this bomb than defuse it

  •  Systemic risk is key (1+ / 0-)
    Recommended by:

    We must give more attention to financial players' interdependence, and not assume that "spreading risk" mitigates it.

  •  awesome diary! (1+ / 0-)
    Recommended by:

    this stuff is really confusing, and you laid it out in a easy to understand, digestible way that i (think!) i can understand.  am sending to my friends.

    the gambling of our and the planet's future has to stop.  it's obscene.

  •  I learned a lot in this diary (2+ / 0-)
    Recommended by:
    cotterperson, BruceMcF

    despite it being just a bunch of words, it didn't make me want to take a nap.
    I actually understood this damn thing for the first time.
    So thanks.
    plus the videos were cool. I watched them both.

  •  this diary should be on the rec list (1+ / 0-)
    Recommended by:

    I wrote a short diary on CDS (probably waaay over simplified) last week focusing on the business world's tendency in the last decade to remove risk from the equation, but I didn't fully realize that one could buy without an insurable interest. I think the Newsweek article I "riffed" off of neglected that as well.

    I also posted somewhere back in the last two weeks that invalidating CDS transactions beyond the first loss and spread the obligation amongst all who touched the risk, but I really don't know enough about what happens in each transaction.

    By the way, when you mention how risk is ameliorated through diversity, it reminds of the fiduciary duty that some of these organizations must have toward investors and that diversity is an oft stated requirement. I guess bundled securities can meet diversity standards by definition.....just an aside.

  •  Thanks! (0+ / 0-)

    Nice diary.  

    Steny Hoyer = a slam dunk argument for term limits

    by jlynne on Sun Oct 05, 2008 at 12:21:49 AM PDT

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