warning: this post will require you to be able to intelligently ponder philosophical concepts and theories, and perhaps try to forget some assumptions you may already have. I failed in my attempt to explain the concepts below in a comment thread on NakedCapitalism, so here's the full thought process:
Let's have a quick CDS tutorial: Credit Default Swaps are insurance on the credit of an underlying company. An investor who buys CDS on company XYZ will pay a fixed fee (ie, 1% of the notional he is purchasing) every year, and in exchange, the seller of the CDS will owe the buyer money if there is a default event at the company.
The biggest problem with the CDS market was that sellers of CDS - ie, sellers of insurance, wrote checks their bodies couldn't cash. They ended up with liabilities they couldn't possibly make good on, and you know the rest of the story - government bailout to avoid Armageddon.
There is another problem with CDS, though, and that's the fact that there are many more CDS outstanding on some companies than the actual underlying debt that the CDS are supposed to be insuring. Let's consider a hypothetical example: Company XYZ has $100MM in debt outstanding. JoeHedgeFund owns it all. JoeHedgeFund goes out to the Street - the sell side broker dealers, AIG, etc, and purchases protection - CDS - for his bonds. However, JoeHedgeFund takes it one step further - he manages to buy $500MM worth of CDS - because when you buy CDS, no one asks you how much of the underlying bond you own. Why is this a problem? Because, when company XYZ runs into trouble, and goes to negotiate a restructuring, a prepackaged bankruptcy, or a reorganization, JoeHedgeFund now has no incentive to negotiate in favor of the debt he owns - in fact, he's DIS-incented from helping XYZ restructure their debt, because he's essentially overhedged by a ratio of 5-1. He doesn't care if he takes a loss on the $100MM in bonds by refusing to compromise on any sort of restructuring and forces the company into bankrutpcy, because he gets paid on $500MM of CDS.
This is what's known as "perverse incentive." Opponents of CDS sometimes say that we shouldn't allow people to buy "naked" CDS, because they don't have an "insurable interest," and thus are exposed to perverse incentives. A commonly cited example is that you can't buy insurance on your neighbor's house, because you could then burn the house down and collect on the insurance policy. You also can't buy life insurance on your neighbor, because you'd have perverse incentive to murder him to collect the payout.
Now, here's why it's fallacious logic to apply this reasoning to CDS. If I buy CDS on a company without owning any of the underlying debt, I cannot effect the health of the company. Note that I don't have an insurable interest, but it doesn't matter - the "perverse incentive" is a pipe dream, because I can't act on it. It doesn't matter how much CDS I buy - I could own a gazillion dollars worth of insurance on the debt of a given company - but that still doesn't give me any say, any seat at the table in a restructuring negotiation scenario. There is a similar analogy with short selling stocks, and it's the reason why people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company. Similarly, CDS levels do not effect the health of a company - they REFLECT the health of a company, or at least the market's interpretation of that health. Some companies will see the value of their CDS widen when people fear for the company's financial health. The CDS is a reflection of the fear, and not the cause of the company's problems. To suggest that panic from widening CDS levels causes companies to collapse is like saying that avoiding marking assets to market makes them worth whatever we want them to be worth - limiting CDS trading would not alter the underlying health of the company, it would only mask it.
So, since one cannot effect the health of the company by owning CDS - since one cannot murder the company (or burn it down) via a CDS position, the "burning down your neighbor's house" analogy goes up in smoke as a straw man fallacy. If you're philosophically inclined, you can imagine a world where I could buy life insurance on my neighbor's house, but the insurance company would give me a magic pill that would prevent me from being able to harm the house in any way - it would essentially eliminate the perverse incentive I had. In this scenario, obviously, there is no reason why I can't buy insurance on my neighbor's house. Similarly, with CDS, I can't effect default events by owning CDS alone, so the perverse incentive is a straw man.
However - once one DOES own some of the underlying bonds in a company, like JoeHedgeFund in our example, he certainly can effect the outcomes, and thus we need to propose some rules for how much CDS one can own. Now, these rules are theoretical - I don't have a suggestion for how to enforce them, so if you don't have the capacity for regulatory philosophy, you can click away now. Also note, that these rules address ONLY the "perverse incentive" concept - they don't cure the problem of the AIG's of the world writing too much insurance (CDS).
It's actually simple, and it's actually only one rule: SINCE a debtholder can effect the future health of a company, IF you own debt in a company, you cannot own CDS notional greater than your debt position. Following logically from that, if you own CDS in a company, you cannot buy debt in the company unless the notional value of the debt is at least at large as the notional value of the CDS.
That's it - just one rule. Note that under this rule, there is no prohibition on buying "naked" CDS in a company whose debt I don't own - because naked CDS buying does not cause the collapse of companies.
The real problem with CDS, apart from the perverse incentive effects which we've now solved with a simple rule, are not with the buyers of CDS - but with the sellers. Sellers of CDS historically underestimate the likelihood of default, and issued much more insurance than they could cover if things went sour. Regulating exposure of the sellers of CDS is a topic for another post - but one that will be covered amply in the news over the next 12 months, I'm sure.
-KD
28 comments:
Adding a further .25% to the fee (to make 1.25%) as CDS tax seems like a neat way to get some money into various treasury coffers. There is tax on many forms of insurance already so why not CDS?
Great, great post. Can you also make the argument for the existence of CDS in a future post? I get that they may not be inherently "evil," but that is certainly not an argument for their existence. Clearly a gun lying on the floor is harmless, but any rational person would agree that guns should be tightly regulated (or banned altogether.)
Well done.
Just one copy edit nitpick: I believe in most cases used in this post that affect and not effect is the proper word.
Thanks for this.
I would expect Goldman to load the debt on an expendable barge helmed by friends-of-goldman, then go purchase the $500M CDS. When the company goes down, the barge sinks too, and Goldman gets their winnings. If the company doesn't go down, the barge is eventually put to other similar uses.
In other words, I don't believe for a single second that there aren't a multitude of ways
to redefine the method such that the regulation doesn't apply. And if that fails,
capture has proven it'll always be available.
KD said: "people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company."
Someone wanna teach this arrogant nutjob Business 101?
Pushing down a company's stock price can directly increase its cost of capital.
also note that i did not address the perverse incentive that the sellers of CDS have - which are basically the mirror image of those of the buyers (ie, sellers can oversell CDS, then game the settlement of the contracts during default by overpaying for the debt - this actually happened - but it's a problem that should be cured when we regulate exposures that sellers can accumulate.
@faust - thanks for the effect/affect correction. i'll get it wrong again.
@RN: although markets are not efficient, they are efficient enough that short sellers do not drive a company's price to zero when the company's stock price should not otherwise be at zero. in other words, stocks go to zero when companies make bad business decisions and are insolvent - not because short sellers force the price to zero.
@John - the argument for CDS is that they are (theoretically) useful for hedging counterparty exposure: if you are a big manufacturer you might buy CDS on a supplier of yours who makes a key product in your chain, or you might buy CDS on a client who owes you a lot of money.
ironically, we had so many years of such good times in the financial world, that the default risk being priced in was super low, and sellers of CDS sold, to use a technical term, a metric ass-ton of CDS. This created a whole new problem when they started to go bad: those who bought CDS on company XYZ from Firm AAA now had counterparty exposure to firm AAA as well! the counterparty risk wasn't eliminated - in fact, it may have been enhanced.
that's why the key in regulating CDS is to make sure that the sellers can cover the insurance they are offering.
I like your rule, but I think there needs to be one more: since CDs is essentially an isurance policy, sellers of CDS should be regulated like the isurance industry to ensure that sellers have sufficient resources to service the possible payouts.
i think your theory is sound, but cds (and short selling) with regard to financial institutions seems like a special case. any bank or insurance company is, in essence, a confidence game, and cds is an elegant and easy way to trigger a run on a bank.
I loved the movie about Sirius XM: "Stock Shock" because it explains how the whole naked short selling stock market manipulation thing works-and how the company nearly went bankrupt. Good DVD. Amazon has it or stockshockmovie.com has a movie trailer.
On burning down the house, it is done through complicity of investment bank proprietary traders and subsidiary mortgage servicers. Nearly all mortgage servicers to ABX reference entities are owned and controlled by the big players. It is beyond coincidence that every single mortgage servicer to ABX reference entities has been in recent years charged with mortgage servicing fraud, not only in state and federal courts but in FTC and OTS investigations resulting in “cost of doing business” settlements and supervisory agreements. Mortgage servicing fraud is one of the largest financial scams in history second only to credit default swap manipulation in which it is a key insider trading element. What exactly is mortgage servicing fraud?
It is the practice of fabricating or manufacturing defaults through numerous tactics such as:
1. not posting timely payments or to manipulate the date the payment is received in order to artificially create a late payment.
2. applying part of the payment to something other than principal and interest often a 'suspense account' creating a late payment or deficiency.
3. not posting or crediting timely payments at all
4. force placed insurance: charging homeowner for insurance when they have current policy in place.
5. malfeasance with property tax escrow account, paying property taxes late, adding their late penalty to homeowners' account without their knowledge
6. multiple charges for BPO's (broker price opinions) that in many instances never occurred such as the infamous BPOs billed at the time Hurricane Katrina was making landfall in the area.
The following federal actions concerning 3 servicers to ABX entities should clear up any questions you have on mortgage servicing fraud or predatory mortgage servicing as it is also known or you can simple Google "mortgage servicing fraud".
EMC Mortgage Corp. - http://www.ftc.gov/opa/2008/09/emc.shtm
Select Portfolio Servicing - http://www.ftc.gov/fairbanks
Ocwen Federal Bank - http://files.ots.treas.gov/93606.pdf
Mortgage servicing fraud is the incendiary they are burning down houses with. With such a willing accomplice and knowing that short bets are a rigged and sure thing small wonder there are many more CDS outstanding than actual underlying debt that the CDS are supposed to be insuring. Amazing how profitable insider trading can be when you've got your own servicers to do the dirty work and feed servicing data into trading desks. Bloomberg's Mark Pittman has a good read on origin of ABX Index: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aA6YC1xKUoek , though this is only a small piece of the big picture. There is a vast galaxy of single name CDS which can be customized to provide protection against non-performance of highly specific reference obligations permitting "speculators" to identify targets and let subsidiary servicers go to work on them.
"It's actually simple, and it's actually only one rule: SINCE a debtholder can effect the future health of a company, IF you own debt in a company, you cannot own CDS notional greater than your debt position. Following logically from that, if you own CDS in a company, you cannot buy debt in the company unless the notional value of the debt is at least at large as the notional value of the CDS."
Gross or net notional? I assume you mean net CDS protection purchased, because otherwise the dealers, who generally run matched books, wouldn't be able to own debt in...well, pretty much any of the standard IG names.
Obviously, there are way too many operational hurdles for your proposal to actually work (no offense), but it's an interesting conceptual starting point. I'd like to see the CDS market operate with exchange-like data reporting requirements for a little bit before we commit to reforms along these lines. I'd just rather us not commit to solving perceived problems that are based almost exclusively on anecdotal information, since we're really only gonna get one shot at getting CDS regulation right.
Why not just say there can be no more CDS protection than there are bonds. (If there is 500mm debt outstanding, there can only be 500mm of CDS outstanding), no matter who owns them?
(Sorry for the double post)
Limiting CDSs outstanding to bonds outstanding would also help in finding correct pricing for the CDSs. You say they are generally under priced, the limitation would force buyers and sellers to correctly gauge the risk of default and price the security accordingly.
Taylor, that is a possible answer, although it can create problems, because i'm adamant that there are many perfectly legitimate cases where someone might need to buy CDS even though he doesn't own the underlying debt (see: counterparty exposure above). at the same time, it seems reasonable to want to allow anyone who owns the debt to buy CDS - thus, it seems reasonable that we can utilitze more CDS notional than there are underlying debt notional outstanding
ps - i don't think i said CDS are generally underpriced - i said that looking back we can see that they underestimated the probability of default. so - i guess, yeah - they WERE underpriced, not ARE underpriced
Why not apply the "short tender" rules concept. The SEC has short tender rules that limit one's ability to participate in a common stock tender only to the extent one is net long the stock. Why not apply similar rules with CDS in the event of restructurings: a CDS holder would only have a seat at the table in a debt restructuring in proportion to their net long debt position. In other words if one holds more CDS than underlying debt you'd have no say.
@cchilton - excellent idea. i like it. of course, it will require all sorts of disclosures in terms of who owns what (i don't think those holdings are clear right now) - but i love the theory
@cchilton - although, there is a problem with the equity short tender rules - as we saw them exploited, just like the long bonds, long more CDS problem: we had the case where a hedge fund was long shares of stock, and had it hedged via puts or short calls, so that they had no economic risk, and yet still had voting rights...
@Kid - the SEC's Rule 14e-4 does take into consideration long put and short call positions when determining whether one is net long for tendering purposes.
thanks - i didn't realize they'd changed it... must have been in the wake of Perry's actions with the Mylan Labs - King Pharma merger several years ago - that was the case i was thinking of
KD, one problem with your argument is that it appears that you're assuming that the corporations themselves aren't investing in CDS - at least in the case of RMBS/mortgage related industry we know that this was/is happening.
So, third party CDS investors with zero ties to the entity they're betting against may not be able to effect any kind of change in the corp. for their financial benefit. But the corps. investing in CDS (or shorting) themselves most certainly can either directly, or through the use of subsidiaries.
Mike - yes, but these are the very same institutions who NEED to hedge via CDS because of their massive counterparty exposure.
to prevent the chicanery you mentioned, we can easily add a second rule to Kid Dynamite's CDS Rules For Buyers that limits the amount of notional CDS exposure any one purchaser can buy - kinda like you have to disclose stock purchases ones you amass a certain stake...
Like buying $100 worth of insurance on a $25 bet in Blackjack?
The payoff seems to be greater.
Sorry KD if I'm mixing analogies here but your posts have gotten me more interested in finance.
On additional thought: you use the example of buying fire insurance on your neighbor's house and claim to have a financial interest in maintaining his property value to support yours. However, I would argue that you have created a moral hazard. Suppose you put your house on the market and sign a contract for sale. Now you can commit arson and collect on your neighbor. At the same time, what's to stop me from obtaining fire insurance on a home development project in the next subdivision over from me? My interest now is to slow the introduction of new supply to support my property value.
My point is that while you can cite credible, realistic rationales for the option of insuring a non-interest assest, I believe that the creation of moral hazard is unjustifiable.
Wait a second...
You're treating the CDS price (of 1% in this case) as an after thought. Keeping it fixed is a huge factor and not just some "throw-in" assumption for the hypothetical.
Beyond that--What's the going rate on a CDS for 5X the underlying loan for a healthy, normally functioning company? If it's 1%, of the notional purchased...then its highly doubtful that this CDS Purchaser/Underlying Creditor can lawfully affect the future health of the debtor. The debtor is relatively sound, no?
[Like the homeowner who has a good job, lives below his means and owes 100k to BofA. How is BofA going to affect the financial future financial health of this borrower?]
If the debtor's condition deteriorates, then yes, JoeHedgeFund can influence its future health, but that CDS for 5X the loan will also cost a lot more than 1%.
The only way the danger of this "Perverse Incentive" manifests itself is if debtor's situation deteriorates--so rapidly between CDS premium payments--that JoeHedgeFund stands to get a windfall of $500 million on a premium he bought 8 months ago for 1%.
Also, you state that most of the problems with respect to CDS lie with the the Sellers, as opposed to the buyers...
OK, fair enough...but in your perverse incentive situation, it's the Sellers who are getting burned (ie punished) for making the poor decision to sell 5X loan at 1% to the Creditor. So what? [As long as we don't bail them out!]
And finally...throughout this crisis there seems to be this sentiment that creditors owe a duty to debtors to make concessions when debtors cannot pay...be it on mortgage loans or the JoeHedgeFund example. You don't quite come out and say this...but it approaches the line of being implied.
Creditors don't owe such a duty to debtors. [Unless Creditor was bailed out...then it's the Creditor's Creditor who may impose this duty.]
The "Perverse Incentive" issue is not really problem that requires legislation. Yes, there are exceptions, but these can be dealt with through specific litigation as opposed to general legislation.
The problem with CDS Players is that we pretend that they are sophisticated capital allocators (hate the phrase)...as opposed to being what they are: Hardcore Gamblers.
These CDS players are like Pascal and Fermat, employing the newfound "Théorie des Probabilités" at a 17th Century Parisian Casino with bankroll straight from the Sun King (and levered an additional 50X courtesy of the Medicis)....
Pascal has a wad of cash in one hand and a freaky French babe in another...he's wickedly drunk and has the vague recall of The Kingdom of God and a wager, one he liked to call "Pascals' Wager" (he goes third person when loaded)...
He's not sure about all this (heavily accented) "decadence"...and he just wants to go home.
But Fermat will have none of it! "Dude, you are so money..and you don't even know it! C'mon, let's go back to the table. We'll use this new "System" I came up with last night...it's called the Martingale. It is soooo de toute beauté! If we lose, we'll just double up on the next bet and we'll get our money back and then some. We can't lose!"
Until they do.....
Dan - you're right - creditors actually don't owe anything to debtors - but I didn't want to get into that argument. And in reality, although the sellers can "get burned" for overselling 5x the notional, what actually happened earlier this year was that the firm who oversold the CDS gamed the settlement auction by overpaying for the debt - so they took a loss on the debt (they overpaid) but as a result didn't have to pay out on the massive CDS they had written - in other words, they have exactly the OPPOSITE incentive as the CDS buyer does!
Kid-
Love this discussion. Great post.
I don't think this throws a stick into the spokes of your argument, but you may need to make some amendments before you formally submit your proposal to the big shots at the treasury you've been meeting with ;)
Let's recall the ingenious Amherst Holdings CDS trade.
In March 2009, Amherst owned a bond with only $29 million ($335 face) of the loans left outstanding, but half were delinquent or in default.
Essentially, this bond looked like it was going to experience an event of default and trigger the referent CDS.
Amherst, however, wrote, to use your phrase, a metric ass-ton of CDS against the bond and collected premiums that were in sum greater than the loan balances left on the bond. No ones knows the exact amount because nobody tracks the outstanding interest like the do on exchanges. The likes of JPM, BAC, and GS were the ones who purchased the CDS in what appeared to be an "easy-money" trade but of course... Amherst used the collected premiums to pay off the outstanding loan balances (only $27M now) on the bonds.
With the bonds made whole, the banks were left holding worthless CDS and Amherst with a monster profit (an undisclosed amount).
Obviously, this trade poses problems for CDS to continue trading over the counter, where nobody has a clue as to the outstanding notional value of CDS written against any bond. The first step to dealing with the ostensible "problem" with CDS, therefore, has to be a move to have them traded on an exchange. Only on an exchange could your proposal begin to have policy traction and CDS could be monitored as "reflections" of a companies health (hopefully, they'll replace the rating agencies). Right now, prices are captured by groups like Markit which both capture the CDS market data and make several CDS markets - which has obviously been a problem.
claps a does a happy dance about the educated comments and developing logical thought. Here's a few more to add..why wasnt GS allowed to fail when it profited from the demise of AIG from whom it had bought protection from? Let's re-open that old wound shall we? The mere writing of insurance at the wrong price (via a scheme orginated way back when by JPM) meant that the poker players at GS actually went to the tax payer for money, off table and not even in the casino. What's to stop a company overprotecting itself and buying bunches of protection on its own paper and then burying the market by issuing stupid amounts? Similarly, whilst intellectually I agree that betting on horses does not affect the outcome of a horse race, there are plenty of instances where crime affects the outcome of a horse race when the stakes get so high... anyway..i may be be illegally posting, im a little under the influence (beer)..is there a law against that, like there is for securities trading when drunk?
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