Monday, January 22, 2007

To The Moon, Alice

There is no doubt that financial derivatives are a booming business. Actually, booming is too mild a word. "Bang, Zoom, To the Moon" is a better description, to quote Jackie Gleason from the classic US TV comedy series The Honeymooners.

According to ISDA , the global Credit Default Swaps business has gone from $920 billion in outstanding notional amounts at the end of 2001, to $26 trillion at the end of June 2006 (see chart below). A 26-fold increase in just 4 1/2 years undoubtedly qualifies as "zoom". And keep in mind, this is not an annualized figure - I estimate that the 2006 year-end figure was around $35+ trillion.

Global GDP is around $45 trillion and total debt is estimated at around $120 trillion, so $35 trillion in CDS is around 78% of global GDP and 30% of all debt. How long before the whole of global economy and debt become "credit swapped"? More importantly, who is selling all this credit insurance?

The US Office of the Comptroller of the Currency (OCC) reports that CDS positions held by commercial banks ($8 trillion) are heavily concentrated: 95% are held by just 4 banks: JPMorgan Chase (54%), Citibank (17%), BofA (15%) and HSBC USA (9%). Likewise, it is highly likely that in the global business no more than 10-15 institutions (commercial and investment banks plus a few hedge funds) carry the vast majority of the $26 trillion on their books.

Which begs the question: who "insures the insurers"? How can issuers hedge themselves against such massive exposure? It's not as if CDS's are proper swaps (i.e. a balanced exchanges of one risk for another). They should more properly be called credit put options: the option writers (the CDS sellers) collect a premium and must purchase the defaulted bonds at par in the case of a default event. For CDS's backing corporate bonds the most likely hedge would be shorting stock and it is possible that even a small rise in default risk could cascade into a self-fulfilling domino effect.

Furthermore, CDS issuance is not limited by the actual amount of debt outstanding: $1 billion in bonds issued by a single borrower may have $5 or even $10 billion in CDS's outstanding against it. Thus, a $1 billion default could snowball into many times more losses: instead of a risk hedge we may end up with a risk multiplier effect, like a runaway nuclear reaction.

No wonder Warren Buffet has called such derivatives "financial weapons of mass destruction".


  1. I think that a lot of people are assuming that when a financial crisis occurs, then at least the major financial institutions will have the resources to survive.

    What you've shown is that they'll be the first to go.

    John J. Xenakis

  2. Hellasious: Thanks for the explanation of the Credit Default Swap.

    It begins to answer a question I've had in my mind as to who benefits from a dramatic increase of foreclosures in the housing market, and who, and why, someone would want to take over risky debt.

    As I understand it, the basic premise of the ARM's for high risk buyers is that you (almost) can't lose; the housing market keeps going up, and by the time the ARM comes of age, the value of your home has gone up enough that you can either "flip" it or refinance it based on the new appraised value of the house. That's fine as long as the values keep going up. But guess what...

    So, if that was one of the games that was so nastily perpetrated on people recently, of course, the same game with a variant could be played as a credit default swap. It works as long as it works.

    As they say: "de-nial is not just a river in Egypt."

    The big terms (e.g., credit default swaps)are good. In my mind, however, I hear other expressions swirling around, namely: the potential for hanky-pank is great; the potential for a poo-poo storm is great; and those who don't learn the lessons of history are ...