Posted on 09/27/2008 9:13:31 PM PDT by Porterville
Of all the really bad ideas that have infested the finance business in the last 30 years, the most dangerous is probably the credit default swap (CDS).
CDS is almost a brand new investment vehicle, but the market is already 20 times its size in 2000. The principal amount of CDS outstanding equals $50 trillion, or more than three times the U.S. Gross Domestic Product and bigger than all the U.S. credit markets put together. And the CDS has been a huge source of "financial engineering" profits, both for Wall Street and the hedge fund community over the last few years.
The first true credit default swap was carried out as late as 1995, although various types of credit protection derivatives existed earlier. Its structure is similar to an ordinary interest rate or currency swap transaction, and the CDS market is covered by the International Swaps and Derivatives Association Inc
Under a CDS, a bank originates loan to a company. A second bank (or other financial institution) can agree to cover the credit risk for the loan, by agreeing to make payment to originating bank if the company defaults on the original loan. The originating bank pays a small insurance premium to the second bank for assuming the risk of the loan.
Typically, payments under a CDS would only be triggered by the company’s failure to pay interest or principal on its debts due to bankruptcy or some other severe liquidity issue. But there are a host of intermediate or special cases that will doubtless provoke lawsuits when something goes wrong (CDS being a new market, it is by no means "recession-proof").
Credit default swaps were sold to the world as hedging transactions. Investors were told that they were simply transfers of risk, so that banks that made loans could transfer credit risks to insurance companies, which did not make loans directly, or to foreign banks that could not easily make loans in the U.S. market.
And if an originating bank sells its loan exposure only once, and sells it to a financial firm of undoubtedly solid credit, the CDS does indeed act as a hedge for the originating bank; it transfers the company’s credit risk from the bank to the financial firm that bought its CDS.
But the product did not work as advertised.
Enter the Traders Salesmen and traders took over, and expanded the volume far beyond what was required for hedging.
After all, bonuses depend on the volume of business. Therefore, bank traders sold the credit risk of a loan not just once, but as many as 10 times. And they sold it not to solid banks and insurance companies, but to three solid banks, one solid insurance company, three dodgy brokers and three hedge funds. Then the traders went out and sold other CDS products that were not even related to actual loans on the books, but to imaginary indices of credit quality in the "widget" industry.
The credit risk of the system was hugely multiplied.
Instead of one $10 million credit risk loan, there are now ten $10 million credit risks on just one loan.
•Three on solid banks - but will they stay solid? •One on a solid insurance company - probably OK. •Three on dodgy brokers - who knows? •And three on hedge funds - probably not OK in a real downturn. The total credit risk in the system has been increased from the original $10 million loan to somewhere between $160 million to 200 million, depending on whether the banks and insurance company are financially solid.
Of course, a lot of those credit risks offset each other, so that if the company that took the loan goes bust, the only risk to the bank that sold all those CDS is to the profits it expected to make. But since it probably hedged those positions against others, if the company does go bust, and dodgy brokers and hedge funds stop paying up, the total losses in the system from that company’s credit risk are likely to be a substantial multiple of the original $10 million loan.
But please don’t think I was exaggerating when I said as many as 10 credit default swaps got sold for each loan.
The U.S. commercial loan market is worth about $5 trillion, yet the volume of CDS outstanding is currently no less than $50 trillion. In other words, a huge number of traders, salesmen and quants have been making money off this product, without any real "hedging" rationale at all.
And it all worked fine while the volume of defaults remained low, which is why the market expanded from $2 trillion to $50 trillion between 2000 and 2007.
A Ballooning Problem There are two reasons reason why the CDS market has been able to expand so much beyond the size of the underlying debt markets:
•Banking regulations and the lack of funding requirements for CDS: Banks are required by law to hold a certain amount of capital for loans they make - about 8 cents for every dollar in principle, but there are a number of loopholes that allow it to be less for certain types of loans. But there are very limited capital requirements for CDS, so banks and other CDS market participants can take on much more credit exposure through CDS than they could directly. •A loan must be funded: If you lend someone some money, you have to borrow it or use your own capital. However, if you take on the exact same risk through a CDS transaction, there is no need to put up any money, provided your counterparty will accept your credit risk. For both these reasons, hedge funds have been large participants in the CDS market, because through credit default swaps the funds can take on much more risk (and receive much more in premiums) than their modest cash reserves would normally permit.
Big Defaults, Big Trouble Suddenly home mortgages along with corporate credit and other types of consumer credit are in question and loss rates, which were very low in 2005-06, are soaring.
That spells big trouble for credit default swaps.
If just 10% of CDS underlying risks go bust, somewhere in the financial system there will be $5 trillion in losses.
Yes, there could well be $5 trillion of profits elsewhere in the system, because derivative transactions theoretically balance out. But once defaults start piling up, it’s possible that many of those losses will become real, while the profits simply won’t.
For example, hedge funds that have offered credit protection on risks far in excess of their current capital will quickly be unable to pay claims. Their counterparties will suffer unexpected losses, even though they thought they were protected by a CDS.
There are two sources of likely loss on CDS:
•Default by the underlying borrowers, the companies that originally took out the loans. •And default by the banks or other financial firms that bought the credit default swap - counterparties in the endless chain of banks, insurance companies, hedge funds and general riff-raff that have done these deals. Since the total outstanding balance of the CDS market is $50 trillion, compared with the entire U.S. home mortgage market at about $11 trillion and the subprime part of that market at only $1 trillion, you can see why people are worried.
American International Group Inc. (AIG), the insurance company, lost $7 billion on its CDS portfolio in its fiscal quarter ended November 30, and that was on "super senior" CDS. The losses on this type of investment vehicle can get very big, very quickly. And since CDS are so new, they’re completely untested in a real economic downturn.
The annual cost of credit default swaps based on the Markit CDS Investment Grade North America Index, which had bottomed out at 29 basis points (0.29%) in February 2007, soared to 220 basis points at the time of the Bear Stearns Cos. Inc. (BSC) bailout. The index was recently trading at 147.5 basis points, a significant improvement due to the U.S. Federal Reserve orchestrated rescue of Bear Stearns.
But Bear Stearns CDS were recently trading at 330 basis points, despite the guarantee of its obligations by the first-class credit of acquirer JPMorgan Chase & Co. (JPM), which means that investors are still wary.
If the CDS market itself thinks things are about to go wrong, they almost certainly are.
As Oliver Hardy used to say to Stan Laurel: "Another fine mess you got us into!"
There were probably CDS hedges out on that scenario as well... ;-)
As you said, the 'wave' is devouring everything in the financial marketplace. Paulson can't stop it no matter what. If he's not careful, he will exacerbate the problem greatly by inadvertently causing more defaults.
I do hope history remembers that.
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I just skimmed the beginning of your article but will look at it in the light of day. I saw you had an analogy of a car wreck - so perhaps I'm on the right track.
“What people do not realize is that Paulsons proposal is to bail out foreign banks also, and that Fortis Bank in England is bankrupting this weekend.”
Correction: Fortis is incorrect. Bradford and Bingley is the correct English bank. Fortis, a huge Belgian Bank, is failing this weekend also.
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marker
The Credit Default Swap (Derivitives) are backed up by only 1 thing.....the promise to pay for the losses, if certain default criteria are met. It is backed by a piece of paper, and I do not mean Federal Reserve Notes. When called upon to perform according to their agreement with distressed banks, they simply say, they can not pay. Then every other entity who wrote "insurance derivitives" with that company scramble to get liquied, but news moves faster than sales....so.........the system starts crumbling.....That is why AIG was bought (79.9%) by the government. This cannot be stopped now. Our government has alreadby spent $700 billion, and is asking for another $700 billion.....it will be to no avail. This country just spent its way out of existence.
I heard today there was a run on the Fortis BAnk.
*BUMP* ! . . . Thanks for posting that helpful info !
If just 10% of CDS underlying risks go bust, somewhere in the financial system there will be $5 trillion in losses . . .
I want to remind all freepers and lurkers that approximently 40% - 50% of mortgages are unenforceable through foreclosure Why ___ ?
The debt paper (i.e. mortgages) are seriously flawed. Lenders sold, resold, resold and resold toxic paper to the whole world. In some cases, the notes were forged outright and sold with criminal intent to defraud. Every time a note was sold more than once the net effect was the same as selling a forgery. This bailout will reward criminals !
Therefore, a more realistic picture is that 40% - 50% of all CDS risk is itself toxic !
Do the math yourself. This will end badly regardless of what Congress does with this bailout legislation.
Dubya's fault? I doubt it...
Greenspan exacerbated the problem with his absolutely horrific monetary policy errors (late 90's with deflation and now the inflation we enjoy today). He deserves a whole lot of the blame.
No he doesn’t.
I have no idea, but I know one thing. The overwhelming majority of these traders are big-time contributors to the DNC.
Great response...way to back it up...
Your welcome.
Senator GREGG (May 21, 2008) Remember: Probably the biggest threat we face as a nation--fiscal threat--in fact, the biggest threat after, in my opinion, the threat of Islamic fundamentalism and the terrorists using a weapon of mass destruction against us--is the impending economic meltdown of this country as a result of the burden that our generation, the baby boom generation, is putting on the next generation through the entitlement accounts. There is $66 trillion of unfunded liability, $66 trillion--a huge number. Nobody knows because it is hard to define what $1 trillion is. But if you take all the taxes paid since the beginning of this Republic--I think you are talking about something like $37 trillion--and if you take all of the net worth of the American people--all their cars, all their homes, all their stock--and add it together, you come up with something like $45 trillion.
Check too, the budgeted revenue for running the US government. The budget plans HUGE increases in revenue - increases that depend on maintaining a "value bubble," or else the income and resulting economic activity and taxation will not materialize.
Congress is eventually going to lose its grip on the economy. It is inevitable. None of the current occupants want to be there when it happens.
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