FReeper Guide to the REAL economic problem - Credit Derivatives

The Ballooning Credit Derivatives Market: Easing Risk or Making It Worse?
Published: November 02, 2005 in Knowledge@Wharton

When Delphi filed for bankruptcy October 8, investors had to start assessing their losses on more than $2 billion in the auto parts maker's bonds, which have recently traded at around 60% of their face value. As bad as that is, there is more. Looming over the market like an invisible and unpredictable giant is an estimated $25 billion in credit derivatives, a form of insurance whose value is directly linked to the ups and downs of Delphi debt.

This paragraph is referencing the bankruptcy of Delphi Automotive Systems, which was once owned by General Motors and was spun off into its own company in 1999. It also talks about the company’s ‘bonds’. Think of bonds as debt obligations. You’ve probably heard the term ‘corporate bonds’ before. It is one way that a company can raise capital to accomplish its business – it sells bonds to investors, in exchange for money to operate. If the company goes belly-up then the bond holders have a higher ‘pecking order’ than those investors that may have owned common or preferred stock in the company.

The common and preferred shareholders were completely wiped out in this scenario. The bond holders saw that their investment took a ‘haircut’ and was now only worth 60% of what they paid for it (worth is based on the liquidation –or sale – of any company assets).

This paragraph also talks about $25 billion in other ‘debt’ that is hanging over the ‘market’ – from those that “bet” that Delphi would not go bankrupt – and lost. The way that these investors in the market lost is by participating in the “selling of insurance” to the bond holders. When Dephi filed for bankruptcy the ‘insurance’ providers had to make good on the full original worth of the bond. In exchange, the bond holder was to hand over the bond (just like when there is a car wreck and the insurance company pays the value of the car – in exchange for the car being delivered to them). One problem with this is that the physical number of insured bonds may have not been enough to ‘give back’ to the ‘insurance’ providers – if there were more insurance providers than there were bonds. When this happens, the bonds have to be purchased by the ‘buyer’ of the insurance so that they can give them back to the insurance provider. This would be like you taking out two insurance policies on your car and getting into a wreck. You collect from both policies (highly illegal in the car insurance business) and then both insurance companies want the car in return. You only have one car to give back, so you would have to go BUY a second wrecked car of the exact same type, so that you could give it back to the second insurance company.

In summary, what you need to understand from this paragraph is that there was $25 billion dollars of ‘extra’ debt in the marketplace because of Delphi’s bankruptcy – without any of those in debt physically holding ANY common stock, preferred stock, or corporate bonds. All that they held were “bets”.

What happens to these complex contracts as the underlying bonds plunge in value? Will ripple effects amplify the Delphi damage, spreading harm to institutional and individual investors who otherwise have no stake in Delphi?

The ‘complex contracts’ that this paragraph refers to are the insurance contracts between the buyer and ‘seller’. The ‘seller’ has absolutely no physical interest in Delphi, except for the “bet” that they own regarding whether or not the bond will go into default (i.e. not get paid) This would happen if the ‘cash flow’ backing the bond was insufficient to meet the bond’s terms. This paragraph is asking the question: “What happens when there are too many ‘sellers’ of insurance? What effect might this have on the market (and economy) as a whole? Read on…

The Delphi situation points to a broader question: Is the credit derivative market, which grew from next to nothing in the mid-1990s to an estimated $5 trillion at the end of 2004 -- and is perhaps more than twice that size today -- pumping new, poorly-understood risk into the financial markets? Or are these exotic products helping to mitigate the shock from corporate crises, as their proponents claim?

Now we’re getting to the ‘meat’. Remember, this article is from the Wharton School – arguably the sharpest minds in the investment community. They’re basically saying – uh oh, what happens as the size of this thing begins to spiral out of control. Notice from the paragraph that what began as ‘next to nothing’ in the mid 90’s was estimated at $5 trillion (of “bets”) in 2004, and was presumed to be ‘twice’ that amount at the time this article was written – or $10 trillion of “bets”. In 2007, that figure ballooned to around $62 trillion dollars of “bets”. Since the beginning of this year, there has been an effort under way to identify “bets” that would be a ‘wash’. They have been destroying these insurance contracts (“bets”) by doing what is known as a “tear-up” (you can take that quite literally). As of now, there are assumed to be approximately $54 trillion dollars of “bets” in the market.

The paragraph also ponders whether it is good to pump ‘new, poorly-understood risk’ into to financial markets? What happens when there are corporate crises? Does this investment strategy help the situation at that point in time – or do great harm? Remember folks, this was written in November, 2005. I want you to write a date down on a piece of paper so that you don’t forget it as we continue these lessons – “July, 2007”.

"They're huge, and they have grown very rapidly," said Wharton finance professor Richard J. Herring, describing credit-derivatives products. "In principle, they are redistributing risk," he noted, adding that in the past few years, credit derivatives have helped the financial markets weather storms like the bankruptcies of Enron, WorldCom and Parmalat as well as Argentina's debt default.

It was believed for quite some time that the more credit derivatives in existence, the better. The mindset was something like this: If a catastrophe happened with a particular company, and there had been a huge number of “sellers” of insurance on the corporate debt, then each insurance seller would only end up paying a ‘little bit’ of the entire bill.

Here’s an illustration: Let’s pretend that you go out to dinner with four of your friends. After dinner, the bill comes and immediately somebody asks: “What’s the damage?” In our story, the ‘damage’ is $100, so each person takes out $20.00, plus a premium (for the tip) and the dinner is complete. What if only one person brought their wallet? They would have incurred greater harm because there was no ‘redistribution of risk’ – the risk being – “if you eat our food, you pay our bill”.

"Those events would have been sufficient in an earlier era to cause major problems to major banks, and even to precipitate a banking crisis," he said. "But the banks have been fairly robust, and the reason is that someone else is holding the credit risk." However, he added, "What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown."

This paragraph should have you sitting a little straighter in your chair. Finance professor Richard Herring is saying how great credit derivatives are, but stating what has now become painfully obvious. Let me repeat: “What we don't know with any new market is whether something that somebody hasn't quite thought through is going to cause a meltdown.”

There was something they didn’t think through correctly, and it is here, has been here since July, 2007, and will continue rolling forward. Let’s move along…

In September, the Federal Reserve summoned 14 major banks to a meeting to discuss troubles with the credit-derivatives market. The concern was not that these instruments are intrinsically hazardous. Rather, the Fed worried that the market has grown so quickly that participants cannot keep up with the paperwork. If trades were not processed fast enough, investors could lose confidence in the market and a normal crisis could snowball.

Here was a meeting, with the Federal Reserve and the major banks (the ‘brightest minds in the business’) and rather than focus on risk assessment from ballooning credit derivative “bets” they worried about how to fix the system so that they could handle MORE of them. After all, spreading out the ‘risk’ was a brilliant strategy – or so they thought.

The alarm had been raised earlier in the summer by E. Gerald Corrigan, managing director at The Goldman Sachs Group. As president of the New York Federal Reserve Bank in 1999, he managed the Fed's response to an earlier credit crisis, the collapse of hedge fund Long-Term Capital Management.

Here we learn that E. Gerald Corrigan was the one that wanted the Fed and 14 member banks to get together. He was the one that was concerned that more needed to be done to get more credit derivatives flowing through our economic system – and that of the world. Mr. Corrigan, who was once the President of the New York Federal Reserve Bank, was managing director at The Goldman Sachs Group. His boss was the CEO of Goldman Sachs, Hank Paulson – our current Treasury Secretary of the United States.

Eric. S. Rosen, managing director and head of North American credit trading at JP Morgan, one of the biggest players in this market, addressed this topic during a panel discussion on sales and trading at the October 14 Wharton Finance Conference. "The Fed is getting worried about the infrastructure," he said. Regulators made it clear at the meeting that "they don't care what your [credit derivative trading] volumes are; you've got to get the system in order." His company is spending $100 million on systems to handle the soaring volume. "I think the Fed has got it right," he noted.

Now, we read that on October 14, 2005, the head of JP Morgan’s North American operations told a group of high-powered financial executives that the “Fed is getting worried about infrastructure”. They were also told to not worry about trading volumes ($10 trillion of “bets” at the time), but to get their process in order, so that they could handle even more “bets”.

Yes, this is the same JP Morgan that the government has given ‘sweetheart’ deals to in the takeovers of Bear Stearns and Washington Mutual.

The credit-derivatives market barely existed before the mid-1990s. It developed when new mathematical insights made it possible to set prices for more complex instruments. Market participants were also gaining experience with other forms of derivatives tied to stocks, commodities and currencies. Banks and other lenders and investors were looking for new ways to hedge against risks. And investors such as hedge funds, insurance companies and pension funds were looking for ways to take on risk in hopes of earning higher investment yields.

This paragraph is pretty much self explanatory, except I want to expand on a couple of areas. The original credit derivatives market in the 90’s was driven, for the most part, by Investment Consultants that were sincerely looking for a larger return for their client portfolio. Over the years, they have created amazing mathematical formulas that rival the 7 spices of Colonel Sanders recipe in their complexity. There is an incredible amount of competition in the Investment Consulting industry – and there has always been pressure to get a “leg up” on your “adversaries”.

This paragraph talks about Banks (meaning both commercial and investment) looking for new ways to hedge against risk. Understand that they actually were looking for MORE risk, because it provided MORE return. The problem they faced is that the banking industry is heavily regulated and for a long time they were ‘burdened’ with managing illiquid assets that only gained a ‘good’ return. Credit derivatives was their salvation. It allowed them to create hedging strategies where they could actively participate in the “high risk – high gain” marketplace, while still ‘meeting’ the letter of the law in regulatory requirements.

One last point: Notice how insurance companies and pension funds (yes, your retirement) were getting all ‘tingly’ about the prospect of taking on more risk. Just like the banks, they had been stuck with conservative investing strategies, and credit derivatives were a thing of beauty to them.

The driving force in creating the credit-derivatives market, said Herring, was big banks looking for ways to make assets, such as loan portfolios, more liquid.

One word describes this paragraph – GREED! The investment and commercial banks of the entire world put everything at risk so that they could ‘participate with the big boys’ where it involved risk.

The next post will be Lesson Two. We’ll still be covering the same article – which will encompass the first 3 lessons.

If we do the $700 Billion bailout, doesn’t the game start up again?

Yep. It's called "moral hazard". If this situation does not end up with everybody who touched derivatives losing their shirts, to the extent that the next smart young guy who brings up the subject of derivatives trading being immediately fired, then we will have this happen again.

Yes, derivatives are fun, and can potentially produce high returns. But no institution upon which the financial system depends, like banks and insurance companies, may be allowed ever again to be associated with them.

From my understanding a “naked short” is borrowing a stock that one does not own and immediately selling the stock, thus leaving one with a “naked” short position on the stock.

Ok, now I understand how we got off the rails. You are describing a regular short sale, where the seller borrows the shares he is selling. A "naked short" is where you sell shares that you plain do not have, and potentially may not be able to cover.

Yep. It's called "moral hazard".

And the loan machine will start up too.

All those homeowners who haven't made a payment in a year or two will be foreclosed and their homes sold. Bets will be placed by the derivative folks and the game starts up.

Except when they need to be bailed out in a year, the US will be broke - we'll be third world for a hundred years.

Credit derivatives in and of themselves are essential to modern financial economics.

The term "credit derivative" encompasses many types of instruments, which may be used in many different ways. A lot of problems in today's marketplace are a result of credit default swaps (a specific type of derivative). Credit default swaps are somewhat like insurance, but without any effort to control some major moral hazards associated with both buyers and sellers. While financial "insurance" may be useful, I see no legitimate market use for a form of insurance that includes no check against fraud.

Imagine what would happen if it were legal to buy fire insurance on any property, without regard for insurable interest, and there was no way for companies to find out what other companies had written policies, nor any rule against multiple pay-outs.

If such insurance purchases were legal, insurance-fraud arson would be far more lucrative than it is today. After all, today's rules limit recovery to the actual value lost. If one could buy multiple independent policies, though, one could collect multiple times the value of the destroyed property.

Meanwhile, sellers of 'insurance' may have a perverse incentive to offer maximize the correlation of the insured risk. If the big one hits, they pay pennies on the dollar; if it doesn't hit, they lose nothing.

Are you familiar with James J. Puplava’s writings over at financialsense.com?

http://www.financialsense.com/series2/rogue.html

I used to read his columns back around 2000, when I knew even less than I know now. It seems like he had the whole thing nailed years ago.

Wideawake: Great description... Thanks!

Question though... You said, “Other investors feel the same as Alice does and Bob eventually writes 200MM of CDS on this 100MM bond issue.”

Wouldn’t there only be a one-to-one mapping between the amount of actual bond issue (100MM) and the amount of CDS “open interest” (to use stock option parlance)?

In other words, why would there be a market for more CDS’s than there is bond issuance? Wouldn’t only people buying the bonds want this kind of insurance?

Or is it like the stock options market where you might simply have bettors who think there is a good chance that Widget Inc. will go belly up?

Thanks in advance for your response...

Wouldn’t there only be a one-to-one mapping between the amount of actual bond issue (100MM) and the amount of CDS “open interest” (to use stock option parlance)?

Excellent question and excellent guesses.

No one-to-one map and one reason why is this:

Companies often have more than one kind of debt.

In order to get your CDS contract paid you need to deliver the face amount of a "reference obligation" - so a CDS holder can deliver the notes we described, or he could deliver another piece of debt - say a participation in the company's bank loans. This is because the CDS contract does not name specific bond issues - any piece of debt that has the same ranking in the company's capital structure is a "reference obligation."

Or is it like the stock options market where you might simply have bettors who think there is a good chance that Widget Inc. will go belly up?

That is the second reason exactly. Some people sell CDS because they think a credit is going to improve, others buy because they think it will deteriorate.

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