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Credit Default Swaps Are Not The Bad Guys

David Shafer is a frequent commenter here on BHB and his insights often make me think.  We do not always agree, but I always listen to what he has to say.  He recently posted an interesting and (typically) well written article entitled Credit Default Swaps; The real financial WMD.  You can imagine from the title his take on these instruments.  Part of the article quotes from a recent 60 Minutes segment on credit default swaps  called The Bet That Blew Up Wall Street which is a hatchet job… I mean fair and balanced investigation for which this particular news show has gained such renown.

I commented on this article to the point that it was obvious I was writing a post, which brings us up to date.  I do not agree with the popular sentiment regarding CDS’s and I definitely do not agree with the simplistic view put out by sources such as 60 Minutes that imply derivatives are nothing more than gambling.  The problem is not with the tool but rather the hand that wields the tool (and no doubt, some of the hands at the helm of the credit default swaps market belonged to real tools, if you know what I mean).

Read this very carefully: Credit Default Swaps serve a very legitimate and important purpose.  Derivatives are a must in the market place and here’s why: they provide a hedge on risk.  The ability to hedge risk is an extremely important aspect of our markets.  Without it equities would be lower, rates would be higher and capital would move more slowly.  Derivatives are NOT some bastardized form of gambling.  The suggestion by 60 Minutes and others that they should be outlawed only reflects their rudimentary understanding of how markets work.

I’ll give you an example using a derivative called options, which were my area of specialty as a floor trader.

ABC company insures the debt of XYZ company, allowing XYZ company to borrow desperately needed funds for expansion, research and other job creating endeavors from a large pension fund that would not otherwise have bought XYZ’s bonds (lent them the money).  In turn, ABC company short sells XYZ’s stock, thus hedging their risk.  That way, if XYZ does default on their debt obligations and ABC has to pay the pension fund themselves, they recoup much of their losses in the profits made from shorting XYZ’s stock (which has obviously tanked after defaulting on their debts).

This, by the way, is what made the recent ban on short sales so laughable.  Congress, in all its market ignorance, tries to help companies find liquidity by removing one of the mechanisms that allows them to get liquid.  But I digress…

Let’s go back to our example and let’s say that ABC company does not want to short the stock.  There may be many reasons for this: the cost of carry is too high, shorting the stock may send the wrong sell signals to the market at a time when XYZ is trying to grow and ABC is insuring that growth and so on.   So how does ABC hedge their risk?  They buy puts in the options market (a derivatives market) which allows them to make money should the stock go down.  Again, this “derivative” that is so maligned has been instrumental in helping a company grow and adding jobs to the economy.

With that understanding of the possible good to come from a derivative, let’s take a look at credit default swaps.  These were basically insurance policies written by one company to “insure” or raise the credit rating of another company so that the latter company could borrow money.  Very reminiscent of our previous example, isn’t it?  The difference being that instead of shorting stock or buying puts to hedge risk, they simply carried the risk.  “Ahhh,” you say, “but that is a big difference.”  Plus, there is a big problem arising from that difference: with no regulation there is no minimum reserves required of the insuring company like there would be with a formal insurance company.  There was no way to know if the insuring company – the one trading on their AAA credit rating – could in fact handle a claim (never mind multiple claims).

So how in the world did all these financial giants expect to participate in this unregulated market?  What was supposed to be the regulating aspect?   Once again we get to point our tired fingers at the Credit Rating Agencies.  THEY FAILED AGAIN.  If they had been doing their job (instead of just collecting a fee), they would have looked at a company that was over-extended (didn’t have the reserves to justify the default swaps they were doing) and lowered that company’s rating (hey now, there’s a novel idea).  That would have ended the transaction on the spot.  But none of this happened.  The press has not investigated and – other than appearing before a Congressional hearing a couple of days ago – there have been no repercussions for those ratings agencies that were asleep at the wheel while the whole train barreled down the tracks.

One last thought: an easier way to fix this problem than counting on the ratings agencies who have shown themselves to be completely untrustworthy.  Utilize an open exchange for these products.  Again, regulation does not solve the problem nearly so cleanly or simply as just putting these transactions out in the open.  The Chicago Board Options Exchange (there’s my bias again) is made up of multiple open outcry options pits.  Every trade is called out for anyone to do and every transaction is posted and recorded transparently.  No specialist system (like the NYSE) to create legalized theft and no back room shenanigans such as existed with the credit default swaps thus far.  In an open exchange a company over-extending themselves would be clear for all to see and the market – just as the ratings agencies would have done had they valued their responsibilities rather than the warm embrace of bribery – would have ended that particular company’s growth in credit default swaps.

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  • 16 comments

    16 Comments so far

    1. chris e October 30th, 2008 8:46 am

      Why everybody spends so much energy on the subject and all the experts are going to town “explaining”the situation.
      The whole thing is a house of cards.
      Credit is advanced for the benefit of people that extend credit.
      Who ever thinks he owns anything that is not paid in full needs to have his brains examined.
      Every one is a small participant with the major holder the “lender”.Who is calling the shots.
      Moral of the story.Plan to OWN something out right.Borrow in short terms,pay of your loan faaaaaaaaast.Forget the tax benefit hook.
      Be a captain of you own ship.Period

    2. JDallas October 30th, 2008 8:56 am

      As far as banning short sales, I think that was more of a political move as opposed to a move to actually solve a problem. Short sellers in a way actually help the market. If you want to short sell a stock you have to go against the grain (zero-uptick rule). And if you are going against the grain, that also means you probably have put some work and research into the short sale and sniffed out that something was amiss.
      Take for example Enron, people who looked into their balance sheets saw they weren’t making any money. In turn they were able to short sell and we all know what happened to Enron.

    3. David Shafer October 30th, 2008 9:21 am

      Sean, Great article. I tend to agree with you on creating a marketplace for these CDSs solving most of the problems. Add in a reserve requirement or even a requirement to hold derivatives on the books in total as a liability (like Warren Buffett I believe) and you have the best of both worlds, safety for stockholders and the benefits of derivatives.

      Chris e,
      The reason for debt is to create leverage. Leverage is a requirement for producing wealth. You simply can’t produce wealth without it. Now, there are other ways of creating leverage of course, but for the majority of folks they are not going to take the risk of starting a business or have the talent to add value to assets so they are left with debt as a way to get leverage.

    4. Brian Brady October 30th, 2008 9:22 am

      Why not a web-based exchange? It achieves the same transparency but with historical documentation

    5. Michael Cook October 30th, 2008 3:53 pm

      Sean,

      Thanks for writing. I am so swamped at work, its a nice break to read these kinds of articles. I will have to agree and disagree with you today though. You are 100% correct that derivatives were created as hedges. Most are used that way all the time and are quite helpful. Farmers sell futures contracts or options to lock in a price come harvest time, General Mills buys futures contracts or options to lock in a stable price through out the year, its normally win – win.

      At some point down the road when neither a producer nor a user are involved in the derivatives transaction, its becomes less of a hedge and much more of a gamble. If banks and insurance companies were simply using CDS instruments to hedge their risk, we would not be in the situation we are today.

      Many of them however were using them for extra leverage. In my time at Bear Stearns, I saw people that could combine derivatives in ways I would not have even imagined for the sole purpose of producing more yield (higher returns). These transactions are akin to gambling with slightly better odds. Note, I see nothing wrong with this behavior. Derivatives are a zero sum game. If you win, I lose and if I win, you lose. My only point is at some point it moves beyond pratical uses and simply becomes educated gambling.

      Ask Goldman Sachs how they felt about the subprime meltdown. They were on the “I win” side of a lot of those derivatives transactions, Bear, of course, was on the other.

    6. chris e October 30th, 2008 3:54 pm

      Sean
      “The reason for debt is to create leverage. Leverage is a requirement for producing wealth.”
      I respectfully disagree as leverage works ONLY in market that is climbing and is devastating when is declining.
      It is extremely speculative and to be used ONLY from people with experience.What you see today of the result of its use by the mases (5% or nothing down on a fully blown market).
      Wealth is created and sustained by EQUITY. Equity is created by adding VALUE.To expand one needs capital and here is the secret.Obtain the cheapest capital that the venture needs with the most favorable terms and make sure that the expansion will be big to justify the loan and PAY THE LOAN OFF AS SOON AS POSSIBLE.

    7. David Shafer October 30th, 2008 4:09 pm

      Wealth is sustained and created by equity. Well duh, but if you start off with no capital or little capital what kind of return do you need to turn it into real wealth without leverage?
      Why do the majority of Americans have the largest percentage of their wealth in homes that were bought with mortgages (debt) and leveraged?

      Why does every study of wealthy individuals demonstrate they used leverage (usually debt) to create their wealth?

      Did some people buy inflated assets with extreme debt? Sure, but now they can walk away with little damage except to their credit scores which will get back to acceptable in a few years if they are good boys and girls! Ask Jeff Brown, how many of his clients created wealth with debt?

    8. chris e October 30th, 2008 8:15 pm

      To David Shafer

      “Well duh, but if you start off with no capital or little capital what kind of return do you need to turn it into real wealth without leverage?”

      Well duh if that whas true then why all this people that got in to real estate with 5% or nothing down (extreme leverage)are now in foreclosure?
      Read very carefully what I wrote and you will notice how,when and why leverage works or not.
      Jeff Brown like many of us have witnessed success of people using the method, but as I mentioned in my writing it is not for any one.The fact that we have so many foreclosures now is a proof of wrong use of leverage.

    9. Sean Purcell October 31st, 2008 12:35 am

      Michael,

      My only point is at some point it moves beyond pratical uses and simply becomes educated gambling

      I have to disagree. Most investing is “educated gambling.” When a person buys shares they are “gambling” that the stock will pay dividends, appreciate, mitigate a risk or some combination. The farmer needs derivatives in order to hedge risk, but the trader in the pit has no principle interest, not does the investor on the other side. We are only reduced to those directly involved at settlement. Everyone else is simply providing liquidity – for an expected profit – to a market that exists to lay that risk off.

      There is no doubt that what happened with CDS instruments was way, way out of control. But the purpose they serve is important and the people that trade in them, even without being producers or users, are equally important. The key is a transparent, open exchange.

    10. Robert Kerr October 31st, 2008 2:53 am

      Plus, there is a big problem arising from that difference: with no regulation there is no minimum reserves required of the insuring company like there would be with a formal insurance company. There was no way to know if the insuring company – the one trading on their AAA credit rating – could in fact handle a claim (never mind multiple claims).

      I agree completely.

    11. Michael Cook October 31st, 2008 6:29 am

      Sean,

      I agree with you at the trader level, but as you keep getting further from the producer and user it definitely becomes more akin to gambling. I am not talking about traders on the exchange, they are doing their jobs and have a very good handle on those products. As you keep moving away, you get to traders on a desk, then financial engineers and/or quant people (the “geniuses” of Wall Street) that only know the underlying asset as well as the data they have collected over the past 20-50 years.

      They then combine this data to produce some oddball strategy that “would have made money” in the past and assume that it will make money in the future. At the height of the CDS markets, this was very pervasive. I saw it in action and it was simply a gamble. Its essentially what took down Bear Stearns. They have about 1/10 of the knowledge of an every day trader of the commodity and to make matters worse they were combining a lot of different products to get more volatility. Add a lot of leverage and stir.

      These are pure gambles because as we all know, “past performance is not indicative of future performance.” Econ101.

    12. Michael Cook October 31st, 2008 6:41 am

      “Did some people buy inflated assets with extreme debt? Sure, but now they can walk away with little damage except to their credit scores which will get back to acceptable in a few years if they are good boys and girls!”

      David, you understate the significant of a tremendous loss of equity to one’s wealth. If you are trying to build wealth and as you say keep a tremendous amount of equity in your home, a complete loss of that equity could mean 10-15 years of hard earned money have gone out the window. And I guarantee a lot of those homeowners will not be able to get back to square 1 in 2-5 years in this economy.

      I think you and Sean are both right. To Sean’s point, it takes equity to start, grow or maintain equity. No one gives you debt if you have no equity. Additionally, what I have seen in the market today is that most debt providers are forcing you to put up an even higher equity position than in the past.

      To your point, the fastest way to wealth is clearly excessive leverage. As long as your return is higher than your cost of borrowing, pile it on. Particularly if you have the ability to continue to produce equity income, like say in passive real estate investments. Unfortunately most Americans do not have the ability to produce equity income on a consistent basis to make excessive leverage a sound strategy because like Sean said it cuts both ways.

      Rule #1 in the use of leverage: If I owe the bank $100,000 and cant pay, I am in big trouble. If I owe the bank $100,000,000 and cant pay, the bank is in big trouble. Its why Donald Trump can go Bankrupt four times and still be a Billionaire, but why Joe the Plumber only gets one bite at the apple.

    13. Eric Bramlett October 31st, 2008 8:00 am

      Really good discussion on this here:
      http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365

      The discussion on credit default swaps begins at around 29:40.

    14. David Shafer October 31st, 2008 8:05 am

      Please quit being so absolutist. 1st, you should know what you are doing or at least have some experienced guidance if you are going to be an investor in anything!

      Second, if you bought a home with no money down and go into foreclosure you are out only the payments you made, so no loss of equity there.

      Third, the example of folks having lots of home equity is only an example of how the majority of people have built their wealth, such as it is. It is not what I would say to do.

      Fourth, there are many parts of the country that have had minimal real estate value decreases since 2006. Not every place is SoCal or Florida.

      Fifth, you might want to access the data of wealth here in the good old USA. Real Estate is the #1 category for those with net worths over $1M and for those over $10M. Secondly, outside of their home equity the average person with a positive net worth has less than $40,000 in wealth mostly in retirement plans (401K, IRAs), which is probably worth not much more than $20,000 now that the stock market has gone into a bear market. That is the reality of most folks. So the choice to use leverage or not use leverage is really a choice to have a chance at a decent retirement or not.

      I really get tired of folks who tell everyone it is too risky to use leverage, look what happens to folks that do, etc. when this advice is totally untethered from the reality of peoples financial lives. For example, see “folks that use debt in real estate are now in foreclosure statement.” Totally untrue. The majority of folks use debt in real estate and the vast majority are not in foreclosure. The reasons for foreclosure is not excessive debt, but insufficient income combined with poor economic histories that led to a history of poor credit before they were given a home loan. Those that had good credit and an economic history of consistent work are for the most not in foreclosure even if their homes are upside down! They may choose to walk away if they bought at the absolute height of re values in 2005-06, but that is just bad judgement on the timing on buying, not bad use of debt. They will pay a price for that in lost equity and poor credit scores, but has nothing to do with the debt.

      You all act like everyone bought their homes in 2005. Only a small majority did. The rest of us either have owned long enough to build up substantial home equity or have taken out the equity for our own reasons (spending, investing, etc.) You act like the sub-prime foreclosures aren’t 30% while the conforming foreclosures are closer to 1.5%.

      OK, off my soap box now!

    15. chris e November 1st, 2008 8:22 am

      David Shafe
      Relax.There is nothing absolute about in what I said.
      Leverage is ONLY one of the tools if is used properly.Wealth is deriving from Equity.
      Say you bought something with 1% down and you financed 99% at 1.5% interest on the loan.If your market is level what is your equity/wealth? It is 1% and your dept is 99%.In a down market there is negative equity witch means you are done.Now if one knows what he is doing and gets in an appreciating market then the principal of leverage is beneficial.
      Leverage is one of the ways to create Equity, assuming that one understands the markets he is venturing.Those principals are not exclusive to real estate.All business operates on the same principals.

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