Friday, 20 March 2009

A bubble that no one understands

UK housing bubbles are straightforward affairs. They start with poorly regulated banks, extending too much credit to punters gambling on house price inflation. They end with credit evaporating, falling prices, and the punters losing money. Beyond the housing market, there is always a follow-up recession, lasting perhaps two to three years, with unemployment invariably rising to 3 million.

The UK is now sliding off the top of the fourth bubble in as many decades. We've been here before, and we will come here again. Everyone understand the rules of the game.

The credit default swaps bubble, on the other hand, is a total mystery. It is huge, it has lasted only four years, and no one knows what will happen when it finally bursts.

According to the last Bank of International Settlements survey, in June last year, the outstanding notional value of these derivatives amounted to $45 trillion. The annual GDP of the US economy is just $14 trillion. Here's another number that you can use to frighten little children. Since 2004, this market has grown by 880 percent. Explosive growth doesn't quite capture it.

Credit default swaps are insurance policies on financial products. An investor buys a bond and wants protection in the event that the bond goes bad. In principle, this doesn't seem like such a dangerous idea. After all, we insure our cars and houses, so why not financial products.

Insurance is fine so long as it is not used as a vehicle for speculation. Suppose for a moment, that ten of your neighbours take out fire insurance on your house. One day, you come home and there is a pile of ashes where your home used to be. While this may be a personal tragedy for you, it's payday for the neighbourhood. The insurance company, instead of covering the cost of one house, now pays out ten times that amount.

Credit default swaps allow speculators to take out insurance on assets they don't actually own. Derivatives traders call this creating synthetic credit exposure. When a bond defaults, speculators who suffered no direct loss, are now entitled to payment.

Here we come to the scary bit. Take another look at that number of outstanding credit default swaps. Yes, it really is $45 trillion. Which insurance companies wrote out policies amounting to three times US GDP? Well, AIG is one such company. Could they cover these credit default payouts if there is a rapid increase in bond defaults? Let me be gentle; it is highly doubtful.

The credit default swaps market is unregulated. No one fully understands the risks involved. However, it doesn't take a degree in financial mathematics to understand that massively over insuring a particular risk will lead to a question about the viability of the insurance company writing out those policies.

The process of winding down the CDS market has already started. The notional amounts stabilized in 2008, and hopefully the next BIS report will show this number declining. In the meantime, let us hope that the world can step away from the abyss of a credit default swap induced meltdown.

20 comments:

Elby the Beserk said...

"Insurance is fine so long as it is not used as a vehicle for speculation."

Funny that. I always thought of insurance companies as being bookies; the only difference being that they do their damnedest not to pay out when you win.

In other words, stick to bookies.

fajensen said...


Could they cover these credit default insurance payouts if there is a rapid increase in bond defaults? Let me be gentle; it is highly doubtful.


No problem:

The CDS are hedged - of course - by buying the same kind of CDS as one is writing.

Hahahahaha. One wonders how much AIG has bet against itself.

Anonymous said...

Willem Buiter had a good piece in his FT blog on this very subject. In his view, the lack of 'insurable interest' (i.e. you can only insure your own house) creates moral hazard.

Irrational Doomsday Blog said...

In my opinion, this is the single instrument most responsible for introducing systemic risk into the global economy.

Without this instrument, you don't see a rapid collapse like at Lehman, and then that in turn touches off a total credit freeze because there are a bunch of companies that now can't cover their CDS contracts or are afraid of not being able to cover the next rapid negative-basis trade collapse.

In other words, remove the CDS and I think you have a good shot at letting these companies that were stupid with lending standards fail as they should- and that's the end of the crisis. The people that were not irresponsible then come in and pick up the pieces at a discount and set the bottom.

Additionally, it's hard to envision the world getting so overleveraged and caught in this web of shared risk without the CDS instrument there as "insurance". A false sense that you are able to hedge the risk of purchasing a securitized debt instrument when you have no information about its underlying creditworthiness.

A couple times I think they have tried to get a CDS clearing house off the ground to try to break the chaining counterparty risk spreading problem:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a9u22xsaGZdo

I haven't heard anything about whether they are actually clearing anything though.

Anonymous said...

if they let aig go under and all of its fictional CDS evaporate wouldnt it be solved?

do companies which hold these fictional entities put them on their balance sheets as some kind of asset where they depend on their worth or something?

Irrational Doomsday Blog said...

Anonymous-

If you let AIG go under then everyone getting payments from AIG takes a hit- possibly driving themselves towards insolvency, and everyone that has CDS written on AIG failure gets paid.

Unfortunately, some of the counterparties that are supposed to pay if AIG failed are likely to be in a naked, no capital position like AIG was, and are either unable to pay or make themselves insolvent.

Then all the companies that had CDS on those counterparties have to pay when those companies fail, and they may have been unhedged themselves.

And so on and so on....

Anonymous said...

IDB, why do you think CDSes contributed to LEH bankruptcy? It was a bog standard run on the bank except with an investment bank the collapse is quick-time. The CDSes worked perfectly with LEH and the scaremongering about "trillions" at risk turned out to be a loss in the low billions.

The issue with AIG is that it cost no extra money to write insurance policies because they were triple A and so needed to post no collateral to back up the insurance. So if you are a trader at that firm it is simply a no-brainer to write more and more business because it costs you no extra money and you are screwed anyway if the market goes against you. NB I say trader not firm. NB again that the reason AIG could do this was because of idiot regulation.

As for people that have CDSes written on AIG they will have got paid ages ago as we are well past a credit event - remember the trigger for insolvency was the belated downgrading of the credit quality of AIGFP.

As for the growth in CDSes, you are vaguely right but for the wrong reason. The Basel 2 regulations mean that if you have a credit asset + a CDS protection on it then more or less for regulatory purposes you now have a risk-free asset, which you have to hold less capital against. Again people weren't blind to the risks, it is just the regulation meant those risks "disappeared"...

One final point is that the face value looks so impressive due to the way these products are traded. I buy a 5 year CDS and six month later want to close out my position, then selling a 4.5 year CDS means taking a liquidity hit so i write a 5 year CDS instead. Theoretically i am taking a small basis risk and possibly a small counterparty risk, but certainly the risk isn't now 2x where it was x before.

Alice Cook said...

Anon 18:44

I was aware of this regulatory issue. However, it is hard to see how $46 trillion could be explained by banks managing their regulatory capital.

Alice

Irrational Doomsday Blog said...

Yeah I think you're right on Lehman and negative basis- I think that opened up the NB trade on the other banks not the other way around.

lars said...

At this point, the US government, along with its counterparts around the world, should simply abrogate all naked CDS contracts. If you do not own the underlying bond by some pre-date, contract is nullified: and if possible unwind the contract with fees being reimbursed on some formula between the contracting parties. It will piss a lot of people off, but tough, force majeure this stuff out of existence as the CDS market does threaten the entire financial system and was simply a form of financial gambling.

electro-kevin said...

'Notional value'

It must be just a load of old cock then. I bet this can be fronted out with the right attitude.

Anonymous said...

This blog is the scariest site on the internet.

Anonymous said...

Alice, I think the point is that the size is a factor of the trading. What i was trying to say is everytime i enter and exit a trade the increase in the number of CDSes out there is not zero rather 2x, where x is the size of my original trade. Also CDSes are used to synthesize either risk-free assets or risky assets. Roughly government bond + writing credit insurance = risky bond. NB i use the word risky in the technical sense of not being risk-free not in the perjorative sense.

The point i am trying to make is that the market is nowhere near as big as people think.

Lars exactly what is your problem with naked CDS contracts? I mean I'd like something more precise than it is bad or it is gambling. What is the concern that is so huge that you think retroactively abrogating contracts and trashing a key part of the economy makes it worth it?

lars said...

Anon 5:53,

First, CDSs are not a key (or necessary) part of the running of the economy, real or financial.

The reason the US taxpayer has put $180 billion into AIG and counting is because of the systemic risk that would have rippled through the financial system.

I see no reason why taxpayers should foot the bill for the cost of CDSs and I further see no reason why they should suffer the consequences of the failure of the system as well.

So in my mind, the decision is easy. For the greater good, abrogate the contracts and be done with too big to fail as relates to CDS rippling effect. As to why naked, one can argue there was a legitimate business rationale for the investment. Naked CDSs are purely gambling (irrespective of hedging). But quite frankly, I have no problem wiping them all away.

Life is not fair, and in a perfect world the CDS market would have been regulated and this mess would have been avoided, but it wasn’t and we can’t sue the Federal Government over their failure to regulate. So someone has to be a loser in cleaning up this mess and I have no problem throwing CDS contracts under the bus (taxpayers are already carrying a disproportionate share as it is).

Time to end privatizing profits and socializing losses.

Anonymous said...

The taxpayer hasn't put 180billion and counting into AIG because of CDSes. They put it in because AIG were able to build up a huge position due to idiot regulation. It could have been futures - as it was with Barings - it could have been mortgage bonds - as it was with the S&Ls in the late 80s - it could have been tulips like it was in the 18th century or lending to third world countries in the 70s. I wonder how much the tax the US government took in from growth underwritten by the reckless lending that looked less reckless because of how regulation treated credit risk? I'll bet money it is more than 180billion by a long long stretch. I would love to see a comparison of the corporation tax receipts from banks, income tax, federal and state tax from banks. To see the tax from consumer spending underwritten by property prices and asset prices and have that compared to the 180bn. I am willing to bet the government comes out in the black by a long stretch.

This call for banning CDSes is another example of kneejerk reactions by morons who don't understand either how the market works or what the issue is. Here's a trivial example of why your ban doesn't work - i own a corporate bond and buy a CDS to cover a credit event. When i sell the bond i then HAVE to sell the CDS which means i am going to get gamed by the counterparty who knows i have to sell by law. This presumably is why Mr Soros is so keen - easy pickings for him.

Fact remains that the vast overwhelming majority of the CDS market has worked perfectly and it is not entirely obvious to me why AIGFP's portfolio hasn't simply been auctioned off.

lars said...

Hey Anon,

I’d rather be a moron that an ASSH&LE like you.

My view is based on having worked on Wall Street as a senior investment banker in a bulge bracket firm. And I have no skin in the game on this topic, which is obviously not the case with you.

I am sorry that your living would be destroyed but I don't give a sh&t!

The world of finance worked just fine long before CDSs came into existence and it will work just fine without them.

Anonymous said...

Just to let you know I retired in 2005. I have zero skin in the game, I don't trade even on my own account. I now live in a country where one of the ministers had the guts to tell retail investors that they can't have thought some of the structured products they bought could pay a higher than risk-free rate and not have risk.

I can only assume you were on the corporate finance or retail side because there is no way someone could make such schoolboy errors and work on the wholesale trading side ( OK maybe equities... or did i miss something and bear stearns become "bulge bracket"? ). The issue i have with your suggestion - apart from it being stupid - is that is simply misses the point. The world of finance DIDN'T work just fine before CDSes came along, i gave you a truncated list of similar crashes and if you had a clue you'd know that before CDSes came along you had sorta CDSes based around buying the bond and shorting govies or something similarly crude. So sure, feel free to propose a panacea but don't bitch when the disease isn't cured....

lars said...

Anon,

Blah, blah, blah, blah, blah...

You sound like a typical trader and why corporate finance always looked down on your type, and with good reason. You figure if you say it long enough and loud enough, it will somehow make it true. It don't.

And for the record, I, too, am retired from a successful career as a mergers banker and private equity guy.

Enjoy your time in the country with your minister. It best suits your... huh... talents.

Over and out.

Anonymous said...

Ah well as a mere trader, i obviously cannot hope to compete with the lofty oratory of corporate finance, I assume insults and resort to authority are what passes for forensic dissection of arguments in Team Xerox.

Facts are that CDSes have worked as expected under the most trying of times, most of the scaremongering about it's growth misses regulatory and micro-structure reasons for the increase in *nominal* value. Also that banking panics regularly happen and all it needs is a product that offers a low cash upfront requirement followed by an increasing cash payout with a non-zero probability. I gave a short list but honestly there are these crashes regularly it is just what you have to live with in a capitalist society - the dizzy highs followed by lows. The idea that "innovations" or "complex products" - and CDSes aren't particularly complex - are the message and not the medium is to miss the point and ensure this happens all over again sometime in the not so distant future.

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