The Creature from the Credit Default Swamp

There have been many vehicles which got us to this credit crunch, but the vehicle of choice has been the credit default swap. They are infinitely variable, unregulated and a plaything of the rich and ... well, rich is good enough, but big helps, too.

Without ever truly coming to a working knowledge of them, and without letting that ignorance get in the way of having an opinion or spew about them, Guambat has let the CDS topic pop up many times in posts over the last few years.

For instance, Guambat noted back in February that AIG was toying with CDS valuations in ways that were, shall we say, fanciful or eccentric.

But now they're being blamed, along with the nudists trading in shorts (which Guambat is having trouble envisioning), with the come-downance of the markets.

The WSJ's Deal Journal pins CDSs for the whackage done on Goldman Sachs and Morgan Stanley this week:

So what is driving the financial wolf-pack to tear down the stocks of two reasonably strong firms? Schorr points to an over-reliance on dour indications from two sources: ratings providers and the opaque market in credit-default swaps, which are contracts that bet on a firm’s chance of filing for bankruptcy.

The problem with CDSs is that their value often overreacts to short-term news without taking into account a firm’s long-term liquidity.

Additionally, the traffic in CDSs is even more opaque and prone to manipulation than the short-selling of shares: CDSs are traded very quietly, among a select group of sophisticated investors. Yet they have gained outsize influence over the stock prices of financial firms. “The world should really be concerned about this ...."

But the world didn't invent CDSs. The likes of Goldman Sachs and Morgan Stanley not only invented them, they spread them around the world and armed them with the poison tips that are now paralyzing the market participants. It's like Frankenstein, or the Creature from the Dark Lagoon, coming back to us in our nightmares. (Always count on Guambat to split his infinitives as well as his britches, and to mix his metaphors as well as his medicines.)


FOLLOW UP 19 Sept.:

One of Dr. Frankensteins nemesis-es, Jessie Eisenger, also points out that the creators and users of CDSs have only themselves to blame, at least in the case of AIG (HT Barry):

What's taking down these grand financial icons such as Lehman and A.I.G.? It couldn't possibly be that the companies themselves made stupid and shortsighted decisions. So it must be a conspiracy of the short-sellers. It must be some wrong-headed accounting rules and bad regulation.

For several years, A.I.G. dove headfirst into an insurance-like product called credit default swaps. It wrote hundreds of billions worth of protection mostly on the top slice of mortgage-backed structured financial products. Short-sellers and accounting rules didn't cause A.I.G. to enter the C.D.S. protection business.

Supposedly A.I.G. had an expertise in insurance, being the largest of its kind in the world. Insurance is hard to price correctly. When the hurricane hits, were you getting enough money from homeowners all those years? It's a difficult question. But when it was initially writing all that C.D.S. protection, A.I.G. thought it wasn't possible to take a penny of losses because its contracts were backstopping such highly rated, highly protected slices, according to an ex-A.I.G. Financial Products employee I spoke with this week. (That makes perfect sense since this was the same mistake made by the bond insurers M.B.I.A. and Ambac.)

Each time the company wrote one of those contracts, a grain of sand should have dropped to the bottom of the hourglass until an A.I.G. risk-management official said: "Enough. You can't write anymore." But that didn't happen. Short-sellers and accounting rules didn't make the company put little-to-no capital against these positions.

A.I.G.'s counterparties didn't require that the insurance company put up any collateral—called initial margin— because its rating was so high. This wasn't an accounting rule. This was a general agreement among the players in the C.D.S. market.

Then the underlying mortgage-holders started to default, leading to the value of the super-senior tranches to decline and the spreads on the C.D.S. to widen. Counterparties wanted some collateral to reflect the changes in the market. The credit-ratings agencies downgraded A.I.G., leading to even more demands for collateral.

Does anyone seriously think that the counterparties said to A.I.G., "Hey man, we don't want you to put up any cash. We know it's stupid, but our hands are tied by those damn accounting rules!" Hardly. They wanted their cash now. If these positions were marked-to-model rather than marked-to-market, does anyone think that the counterparties wouldn't have written any collateral triggers into the contracts?

Now for the sake of argument, let's say that the market overreacted horribly. Let's contemplate that short-sellers were too convincing. They caused needless panic, helping drive the spreads on the C.D.S. protection way too wide, in turn driving the value of A.I.G. equity down to absurdly low levels. This was causing paper losses, but there were also real credit rating agency downgrades. But it wasn't anything substantive—a mere liquidity crisis at the insurer.

If that were so, why didn't the insurer find buyers? Why didn't the private-equity firms swoop in? They did examine A.I.G.'s books this past weekend. What they found was that the amount that A.I.G. needed was undeterminable. It was an unfathomable black hole.

A.I.G. got into something it didn't understand and didn't protect itself properly. The market-based watchdog—the rating agencies—failed to assess its risk properly. In the market panic, A.I.G.'s counterparties acted rationally to demand more cash, their actions having nothing to do with accounting rules.

FOLLOW UP 20 Sept:

Floyd Norris provides the best description of how Credit Default Swaps work -- and don't work, in this NYT piece:

Credit-default swaps are a way of transferring the risk of owning a bond. If I own a bond issued by General Motors, and have also purchased a credit default swap on G.M., then I am covered if G.M. defaults. I can recover my losses on the bond from the institution that sold the swap to me.

There are now many more credit-default swaps outstanding than there are bonds for them to cover. They became a way to gamble with almost no money down. For a small fee, my hedge fund can bet that a company will go under. And your hedge fund can collect that fee, and produce instant profits. Years down the road, you may have to pay, but big companies rarely default anyway, so the risk is minimal. Or so people thought.

One way to think of the swaps market is as insurance that is issued by companies that do not have to keep reserves and may be totally unregulated. I can’t legally buy fire insurance on your house, since I have no stake in it, and letting me have insurance would give me an incentive to burn it down. But I can buy a credit-default swap on G.M. even if a G.M. default would not cost me a penny.

That brings up “counterparty risk.” If my hedge fund bought a G.M. swap from A.I.G., and sold one to your hedge fund, then my fund has laid off the risk. If G.M. defaults, I will have the money to pay you as soon as A.I.G. pays me.

But if A.I.G. has taken lots of those positions — and it did — then who knows which banks and funds and investors will be in trouble if A.I.G. cannot honor its obligations? My fund may have a perfectly matched book, but it is suddenly in deep trouble if a counterparty is defaulting. Since no one keeps track of all the moving parts, no one knows just who may get into trouble if one participant fails.

The theory that beguiled legislators and regulators was that the market could regulate itself. Each bank would be careful to deal only with counterparties it could trust, and so the whole system would be trustworthy. But even if you believe that, remember that most swaps are good for five years. Not long ago, A.I.G. was a Triple A company, whose credit was viewed as sterling by everybody.

It is worth remembering that A.I.G.’s credit standing did not fall even after it was caught helping other companies rig their financial statements. Nor was it hurt by evidence it had fudged its own numbers. Discovering that a company is run by people with what we might call flexible integrity should have been a red flag.

But who would have looked? The insurance subsidiaries were regulated by state insurance departments, and activities of the parent were not their focus. Had anyone suggested an aggressive audit to see what other games A.I.G. was playing, I am sure that neither the Fed nor the Treasury would have thought they had jurisdiction.

Now they say the national interest required them to step in. “A disorderly failure of A.I.G.,” the Fed said, “could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.”

That may sound outrageous, but it is probably true. By the time A.I.G. was on the verge of failure, the government’s options were limited.