Sunday, November 16, 2008

Edify Yourself

Devilstower at DailyKos has a long but informative post up about credit default swaps and how they made the financial markets explode, spawned by the current GOP spin trying to pin the crisis on anyone but themselves. Go read it.


Anonymous said...

Article filled with inaccuracies!

The author has misstated the size of the CDS market, you have made false claims about the assets of the participants, and you have falsely claimed that the market lacks any regulation. I apologize if the explanation of how this article is inaccurate is too technical; however, I felt it was important to support my claims of inaccuracies with supporting evidence.
Size of the Market:
Fact 1: Contrary to many reports, the CDS market is much smaller than the bond market and nowhere near $70 trillion. The CDS market related to mortgages is even smaller.
The author stated “And yet in 2007 the total number of credit default swaps traded far exceeded the value of all loans. In fact, it may have touched $70 trillion dollars, which puts it above the gross domestic product of the entire planet.”
Evidence 1: The $70 trillion that you are quoting the gross size of the amount insured of the global CDS market. The net amount is much, much smaller and the value of that net amount is a fraction of that. The net amount of CDS is much lower because the same investor both buys and sells CDS. Under pressure from the Fed (note: a regulator), over $25 trillion of needless CDS trades have been torn up in the last several months without a penny change in the actual value (
Evidence 2: When there is a default, up 95% of CDS contracts cancel each other out. Why? Every 3 months, the CDS changes the standard maturity that is traded. Currently, the liquid CDS contacts that are traded will expire on December 20, 2013. On December 21st of this year, the CDS market will trade contracts that expire March 20, 2014. If you bought insurance the expires December 20, 2013 and sold an equal amount of insurance that expires on March 20, 2014, you have two very different instruments that you do not cancel each other out today as a default could occur after December 20, 2013 but before March 20, 2014. If there is a default, the only question is “Do you have valid insurance?”. It doesn’t matter if you insurance expires the next day or 100 years later. If there is a default before December 20, 2013, the CDS in our example completely cancel each other out. Pre-default you can only cancel out CDS with the same maturity date (e.g. the $25 trillion reference above.)
Evidence 3: The amount covered by a CDS contract is nowhere near its value. If you buy $100,000 in insurance on your home, the insurance policy isn’t worth anything near $100,000. Its value is close to zero as the premiums that you pay for the insurance is roughly equal to the value of the protection (plus some incentive for the insurance company). By comparing the gross amount of what is insured in the CDS market (which is nowhere where near the value) to the GDP of the planet, the author is comparing apples to oranges. One is value. The other is not.
Evidence 4: The amount of money lost (and gained) in CDS is a very small fraction of the amount lost on bonds. The amount lost (and gained) on Lehman CDS ($5.2 billion) was less than 1/20th of the amount of CDS lost on Lehman Brother bonds ( At the insistence of the Fed (note: a regulator), a central database was set up at DTCC to administer the cash payments in CDS. The amount of CDS on the top 1,000 entities is available free to the public at You can compare for yourself the amount of net CDS to the bonds of the companies.
Evidence 5: You will notice on the DTCC website the significant amount of CDS that is not related to mortgages (e.g. State of Italy, General Motors). Most CDS has nothing to do with the mortgage market. If the author is going to reference to overall gross amount of the CDS market in an article related to mortgages, they should at least note that only a very small fraction of that amount is related to the mortgage market.

Fact 2: You do need assets to be in the CDS market.
The author claims that “You don't have to have any assets to issue a swap. The investment bank of First Me and The Change I Found In the Couch Cushions can offer swaps for all the debt at Morgan Stanley, and that's okay.”
There are zero retail investors investing in the CDS market. By suggesting that anyone can buy and sell CDS, the author is doing a major disservice to their readers. The market is entirely an institutional market.
While there may be a concern that your CDS counterparty does not have enough assets to cover their obligations when they are due (e.g. AIG), that does not mean that they did not have any assets when the contracts that were first made. If the assets that your counterparty has when you initially make the trade are mortgages back by subprime mortgages, you may have a problem. The problem with counterparty risk is precisely why central clearing agencies are being set up (at the demand of regulators). The central counterparty in CDS will not make bets in risky assets like subprime mortgages. It will simply offset risks… and demand collateral. The concerns with the ability of participants to honor their obligations are legitimate; however, the contention that no assets are needed to participate in the CDS market is completely inaccurately. It is time the CDS discussion had reasonable and informed voices.
Fact 3: Swaps are not unregulated
While most would agree that the CDS market needs additional regulation, regulators that claim it is unregulated are trying to expand their regulatory authority at the expense of other regulators. (How many comments do you see from the Fed and from the Treasury that the CDS market is unregulated?) While the CDS market may not be covered by state gambling laws, that does not mean that it completely lacks regulation. To claim it is unregulated does disservice to some regulators but (more importantly) masks the problem. Regulation doesn’t keep investors from making bad investment decisions. When additional regulation comes, the ability for AIG (or the likes of Lehman Brothers or Bear Stearns) to make poor investment decisions will not disappear.
Fact 4: CDS is no more gambling than buying a bond or stock is gambling.
The author claims “A single loan can be covered by multiple swaps. There's a complicated fiscal term for this. It's called gambling, and at this stage, that's all that remains of those little "insurance" policies. They no longer protect anyone from anything, they just offer a chance to place enormous overlapping side bets on everything.”
Anyone that thinks investing in CDS is gambling must think that investing in bonds is gambling. Selling CDS on General Motors is in many respects the same as buying a General Motors bond.
You buy the bond to make a return. You sell the CDS to make a return.
If GM defaults, you can loose the same amount in the bond as you did in selling the CDS.
While more regulation is needed in the CDS market, it seems that those that claim there is a problem with selling insurance on an asset that you don’t own are people that haven’t considered why people invest.
Unlike a house or a car, you don’t buy a bond or stock to use it. You buy it for the return for a given amount of risk. If you can do that in a more efficient way (e.g. CDS), you do.
You may lose money but that is a reflection more of your investment decisions that the tool itself.
When all the investors that bought General Motors bonds/stocks loose when GM defaults, will we call for a ban on bonds and stocks?

The Squire said...

I posted this back in the thread - it attracted enough attention to have parts 3 and 4 debunked so far. It's a bit late after the post cycle - if you have other issues, you should contact Devilstower directly. Perhaps if you posted there on the dkos story itself rather than in some weirdo's pseudonymous blog you might get a better argument.