Betting on Failure
The acronym CDS has become part of our lexicon of financial disasters; right up there with Enron, dot.com and mortgage backed securities. But the definition of a CDS or credit default swap continues to be elusive to most Americans. A simple example may be helpful in providing an explanation:
Let’s say that you are a member of a social group of nine other people. Everyone in the group knows a guy named Frank. He’s a lovely guy but he is perhaps the worst driver any of you have ever known. One day this group of nine is hanging out at the local bar when one of the members reports that Frank has bought himself a new car along with an insurance policy that will replace the car in case of an accident. After a few moments of reminiscing about all the previous accidents that Frank has been in, all nine of you get on your cell phones and buy insurance policies on Frank’s car. Then you sit back and wait. After a few weeks of careening around the neighborhood Frank does the expected and has a crash that totals his car. He walks away without a scratch and because he has an insurance policy he gets a brand new car. And because the nine of you had the same insurance policies, all of you get a new car as well.
This is the essence of how a CDS works. It is, in simple terms, an insurance policy. For several decades it has been used as a hedging technique. If an investor bought a bond that had a low rating but promised a 10% return, he or she might buy a CDS for the equivalent of 2% of the expected return. In doing so, the return would be reduced to 8%, but it was a guaranteed 8%. The problem is that while it is not legal for your group of nine friends to buy insurance on someone else’s car, it is perfectly legal for you to buy insurance or a CDS on a bond that you don’t own.
The dimensions of this problem are becoming more apparent. On the day that the House of Representatives voted against Secretary Paulson’s bailout package the value of the stock market was $20 trillion. On that same day the face value of the CDS’s being traded on unregulated auction markets was in the neighborhood of $63 trillion. To give you a sense of the magnitude of that number, it is equivalent to the gross domestic product (GDP) of all the nations of the world. That $63 trillion dollar face value was insuring debt instruments with a face value of approximately $6 trillion, a 10 to 1 ratio.
Many of these bonds are mortgage backed securities although they also encompass derivatives based on car loans, student loans, credit card debt and a host of other consumer and corporate based obligations. It is easy to see that defaults are having a greater than expected effect on the financial system; the firms that wrote these insurance policies have no hope of paying them off. AIG is perhaps the clearest example of this problem, it is likely that there are many more to follow.
But there is a more insidious problem here. If you ask any quantitative analyst (these are the mathematical wizards who valued derivatives as they were being packaged and sold) how they asses the viability of a company they will tell you that the gold standard for valuation is the credit default swap. In other words, we have built a financial system based on estimating the likelihood of failure rather than success. This is not just a play on words. This is an underlying principal of the system. What was once a hedge against loss has become a systemic bet against success.
The corrosive effect of this is profound. We are a country built on the entrepreneurial spirit, a “can do” attitude that has been the envy of the world. What we have done is create a financial system that bets against our heritage and our future. It is as though there has been a self-awareness that the consumption we engage in is ultimately a loser’s game. It is as though we knew all along that shopping was not the answer to the complex problems that we face and that we have a long proud history of overcoming.
Unfortunately, we are still at the beginning of this crisis. The financial systems will continue to unwind and we will begin to see failures in the corporate sector; names of these companies will shock us as much as the financial firms that no longer exist. That’s not pessimism; it is an acknowledgement that the failure that we wagered on with the proliferation of the credit default swap is upon us. It has little to do with the goods and services that we produce and the dedication of the employees of a company that goes bust.
In any crisis there is opportunity. The kind of confidence that the markets are looking for will have to wait until we decide that we will once again bet on the potential for success rather than profit from the likelihood of failure.
Thanks for the information. I know I’m not the smartest guy in the room when it comes to these type things so I’d like to ask you a couple of questions.
1. are you 100% sure this is how the CDS market works or has been working? If so, isn’t this like naked shorting the stock market? Selling stock you don’t have hoping for it to go down in price?
2. How can you legally buy a CDS contract on something you don’t have any connection with? This sounds so crazy I can’t believe it has been happening.
3. what, in your opinion, is the solution?
It does boggle the mind but you can actually buy a CDS on a security that you don’t own. A CDS is in essence a security in its own right. And, yes, it does have a similar smell to it as naked short selling.
The problem of derivatives is not in the derivatives themselves. Option contracts are a form of derivatives and they have been essential in everything from farming to international trade. The problem occurred when they became the source of “growth” necessary to pay the interest on the compounding debt. Chris has masterfully communicated how that works. The market searched for something to inflate in value and derivatives fit the bill.
The real problem is that it is nearly impossible to unwind all this stuff. The example I gave about Frank’s car is very simplistic. CDS’s have become incredibly “sophisticated” and can rely on several underlying securities (which in turn can be derivatives) to determine their value. The key point here is that they are necessarily estimates of the likelihood of failure.
All the best,
It would seem to me that a fundamental requirement of "insurance" is that the entity insuring the asset must have an interest in that asset; which is why it is illegal for the nine friends to buy a 3rd party insurance on Frank’s car, in which none of them have an interest.
What has happened here looks analagous to Frank’s nine friends going into the local bookies, and making a bet that Frank will crash his car. Obviously, the bookie needs to set profitable odds: If the payout is to be the price of Frank’s car, everyone who bets would have to put a pretty big stake in. One that reflects the odds of Frank crashing his car in the next year and that wouldn’t bankrupt the bookmaker. The problem is that with betting, there is usually a counterparty that bets the opposite way, and there seems no mechanism to bet against Frank NOT crashing his car.
So, a CDS looks in fact like a one sided bet; even to me, a layman, I can see that a huge premium should be required to price the risk adequately. With insurance, the insurance company can know roughly what the maximum payout will be; with this, surely the more people that buy a CDS the greater the payout, so the potential payout risk rapidly exceeds the premium income as more CDS’s are sold on the same asset? Am I wrong here?
It seems that although the likelihood of default on the original asset remains the same, the IMPACT of that default rapidly climbs to armageddon style levels making the risk unpriceable. Yes?
How were these things ever allowed? Were we, are we MAD?
Your point is well taken and it speaks to the manner in which my example of Frank and his friends doesn’t work. Virtually all of the underlying assets that the CDS’s insured were rated AAA – there was a belief that they would not fail and so CDS’s became just another derivative whose value was determined by something thought to be rock solid. It seems like a lifetime ago, but there were assumptions that the housing market would always rise in value and that people would always pay their mortgages. This latter assumption was based on the idea that a house was a home. But the housing bubble turned homes into ATM machines and removed a good deal of the emotional attachment. So we turned the places where we make and raise our families in to just another investment vehicle. It seems to me that one of the fundamental problems that we are facing is determining what has value, what is worth working for, what defines us as human beings. Not a very popular discussion in the halls of the financial wizards but one that I think we are all going to be dealing with in the not too distant future if we haven’t started already.
Great column once again, Bill. Indeed these instruments are not really about "investment" or "risk management". By the way, I think that further insight can be obtained about the workings of OTC derivatives if one includes in the explanation the words "gambling" and "casino"…
It seems to me that one of the fundamental problems that we are facing is determining what has value, what is worth working for, what defines us as human beings. Not a very popular discussion in the halls of the financial wizards but one that I think we are all going to be dealing with in the not too distant future if we haven’t started already.
I think you are spot on – surely at all the best times in our history, this what we have been concerned about.
I just feel dumped on from above, and a bit of a fool. Whilst all my compatriots and not a few friends were merrily remortgaging and enjoying new cars and holidays, debt and risk averse me was busily putting all my spare cash into paying down my mortgage. Ok, my mortgage is now only 10% of the current reduced value of my house, but my savings are shot, and my pension is worthless. Guess I shall be working until I am too sick or too dead to carry on so it’s lucky I love my job.
There are a lot of people like me, ordinary savers who resent being shafted to bail out the feckless, and governments would do well to remember we can vote too. Not that Gordon the Moron in the UK will.