<blockquote>"
The CDS market has long since ceased to be a means of hedging credit exposure, if indeed it ever really was. At its peak, its outstandings totaled $62 trillion, more than twice the world’s total outstanding loans. What’s more, there can be no doubt that if the credit crunch had not arrived, the market’s outstanding volume would have gone on expanding ad infinitum, becoming an ever larger multiple of the loans it theoretically hedged.
If the paradigm of the Efficient Market Hypothesis really held, and markets were governed by infinitely rational investors, operating on rational estimates of risk and price, the CDS market would still have its problems of pricing and escalating credit exposure, but if those were solved, it could be contained, without representing a threat to the entire financial system. However, as the unfortunate Wall Street practitioners who hedged their exposures using the value-at-risk methodology now know, the Efficient Market Hypothesis is a poor match against the realities of the market. Markets can become irrational in both directions, and by exploiting irrational fear, it is possible to drive a company into bankruptcy, particularly if it is a highly leveraged financial institution.
That’s what appears to have happened on a number of occasions last year. Bear Stearns, Lehman Brothers, AIG, Citigroup, Fannie Mae and Freddie Mac all suffered crises of confidence that resulted either in bankruptcy or in government takeover. The theoretically rational market proved in practice to be highly irrational. At the time, market participants and the media blamed short sellers. Yet it is likely that CDS holders were very much more to blame."</blockquote>
One Casino Too ManyBy Martin Hutchinson
March 02, 2009
SourceWall Street over the last generation has been a prolific generator of casinos, in which the dealing community can make a very nice living indeed by providing investment and “hedging” services to outside investors. Of all these casinos, the credit default swaps market has been among the most lucrative. As the credit crisis has unfolded, however, it has become increasingly apparent that the CDS market’s damage to the global economy is sufficiently severe to justify closing down or at least sharply restricting Wall Street’s favorite sandbox.
During the explosion of the derivatives market in the early 1980s, in which I was an active albeit minor participant, we looked extensively at the possibility of designing credit derivatives. The need, after all, was obvious: there were banks excessively exposed to particular borrowers and equally other banks and insurance companies with appetite for credit and no exposure to those borrowers. Credit derivatives could allow participants to buy and sell credit risks, aligning their exposures with their beliefs about the market.
There were always two problems. First, there was no obvious way for credit derivatives to settle; the process of bankruptcy was sufficiently fuzzy and differed sufficiently from case to case that there was no watertight way of calculating when credit derivative buyers should be paid and how much. Second, the credit exposure taken on through trading credit derivatives was huge; the cash flows were hugely asymmetrical, with a certainty of modest annual payments going in one direction and a low probability of a massive cash settlement in the other. In that sense, they were like life insurance policies, but life insurance policies where the sum assured was not hundreds of thousands or a few million, but hundreds of millions or even billions.
Those problems were never solved. Instead, from the middle 1990s, a market grown crazy through never-ending expansion and excessively cheap money simply started trading credit derivatives without solving the problems underlying them. No watertight settlement procedure was ever designed; the current standardized settlement procedure involves a mock auction of a few million dollars of credit exposures, with the prices reached determining the settlement of exposures involving billions, or even hundreds of billions, of dollars. Needless to say, the temptation to cheat is overwhelming. Nor has there been any central clearing mechanism; the profitability of the business to the major dealers that would be lost through greater transparency is so high that the obviously necessary central settlement and clearing house proposed by DTCC has been imminent for over a year and never finally emerges.
The CDS market has long since ceased to be a means of hedging credit exposure, if indeed it ever really was. At its peak, its outstandings totaled $62 trillion, more than twice the world’s total outstanding loans. What’s more, there can be no doubt that if the credit crunch had not arrived, the market’s outstanding volume would have gone on expanding ad infinitum, becoming an ever larger multiple of the loans it theoretically hedged.
If the paradigm of the Efficient Market Hypothesis really held, and markets were governed by infinitely rational investors, operating on rational estimates of risk and price, the CDS market would still have its problems of pricing and escalating credit exposure, but if those were solved, it could be contained, without representing a threat to the entire financial system. However, as the unfortunate Wall Street practitioners who hedged their exposures using the value-at-risk methodology now know, the Efficient Market Hypothesis is a poor match against the realities of the market. Markets can become irrational in both directions, and by exploiting irrational fear, it is possible to drive a company into bankruptcy, particularly if it is a highly leveraged financial institution.
That’s what appears to have happened on a number of occasions last year. Bear Stearns, Lehman Brothers, AIG, Citigroup, Fannie Mae and Freddie Mac all suffered crises of confidence that resulted either in bankruptcy or in government takeover. The theoretically rational market proved in practice to be highly irrational. At the time, market participants and the media blamed short sellers. Yet it is likely that CDS holders were very much more to blame.
For one thing, look at the economics involved. An equity short seller wishing to drive a company into bankruptcy has to take the risk that the stock will rebound, forcing him to cover his position at a loss that is theoretically unlimited. He has little leverage available, so he must put up an amount of money that is comparable to his potential winnings. A buyer of put options does not have infinite potential loss, but on the other hand his premium is substantial and the time decay of option premiums is rapid, so that he has only a few months to carry out any nefarious schemes he may have.
Conversely, a CDS holder, like an option buyer, need pay only a modest annual premium, so his potential gain can be many times his investment. Moreover, CDS are typically outstanding for several years, so he can wait until market conditions are propitious before striking.
However, the greatest attraction of CDS as a vehicle for bear raids is their outstanding volume. There were recently $1.4 billion nominal of Citigroup and $2.1 billion of J.P. Morgan Chase outstanding in the traded equity options market, while the short interest on both banks was of the order of $1 billion. Conversely, in the CDS market, the outstanding CDS volume was over $60 billion for each bank – much of the discrepancy in volume is natural enough since financial institution balance sheets contain far more debt than equity. For a hedge fund wishing to make an extraordinary return through promoting bankruptcy, the CDS market thus offers far greater buying power, lower prices and lower risk. The choice is a no-brainer.
In the early years of the London insurance market, it was possible to buy a life insurance policy on a complete stranger. Then insurance companies noticed the high incidence of unexpected homicides among their lives assured, and the concept of insurable interest was devised, codified by the Life Assurance Act of 1774. Today, you can’t buy a life insurance policy unless you can demonstrate some loss by the assured party’s death. The business is safer that way!
The same consideration must surely apply to the CDS market. The legitimate hedging purpose of CDS today represents only a tiny proportion of contracts outstanding. The U.S. taxpayer is already on the hook for $150 billion, with more to come, through the inept CDS operations of the insurance behemoth AIG. With multiple bankruptcies and huge market instability owing at least part of their provenance to CDS, the public policy consideration for closing or at least sharply restricting the CDS market is even clearer than that promoting the restriction of the insurance market in 18th century London (at least taxpayers weren’t expected to pick up the tab for insurance policies on murder victims!)
As a minimum, therefore, CDS writing should be restricted to those holding bond, loan or swap obligations against which CDS might reasonably hedge. CDS should be distinguished from stock short positions and stock options (which have similar theoretical possibilities) because their greater leverage and higher outstanding volume make them uniquely dangerous. Such a market would be highly illiquid, but it would fulfill CDS’s essential function of enabling credit risk transfer. CDS’s other advantages, of demonstrating credit spreads over a public marketplace, allowing the hedging of baskets of similar credits, providing an instrument for hedge fund “investment” and making huge returns for the major dealers, would be lost. However, CDS’s destabilizing effect on global financial markets would also be lost, and the cost to taxpayers of rescues for those major institutions which had either got the CDS market wrong or were victims of CDS “bear raids” would be eliminated.
The free market is a wonderful thing. However, allowing unrestricted free markets in everything, without regard to the real-world economic effect of those markets, is a Whig shibboleth similar to the “Repeal the Corn Laws” unilateral free trade policies that destroyed Britain’s economic strength in the 19th century. The great and economically highly sophisticated Tory Prime Minister Robert Lord Liverpool, a generation prior to the mid-century free traders, also believed in free markets, but was a realist in their application to the world in which he lived.
The real world is messy and does not conform to simplistic equations either mathematical or moral. The wise policymaker will legislate accordingly, providing the maximum market freedom but inserting restrictions where the temptations to malfeasance are too great. The CDS market forms an open and shut case for restrictive regulation.