Tuesday, November 11, 2008

Yes, It's All About CDS

In an extensive article about the failure of Merrill Lynch (How the Thundering Herd Faltered and Fell), NY Times' insightful Gretchen Morgenson clearly lays the blame where this blog has, repeatedly, for two years: credit default swaps (CDS). In particular, she points out the toxicity of synthetic CDOs, bonds that were created by selling CDSs on mortgage pools and/or indexes.

Here is what I said back on March 22, 2007 (The Thirty Trillion Dollar Question):

"Do Credit Default Swaps and CDOs increase or decrease stability and systemic credit market risks?
I will state my conclusion right away:

Today's market arrangement intensifies existing trends. It pushes credit spreads lower than usual on the virtuous side of the credit cycle and will likely boost them higher when the trend turns vicious."

And how about yesterday's decision by our "trailers" to raise AIG's bailout to an astonishing $150 billion? Yes, that's all about CDSs, too. AIG was one of the world's largest underwiters of credit insurance, particularly against mortgage default risk, and the bailout is designed to prevent the CDS market from getting completely unstuck.

Now, let's ponder this: why not let the CDS market get unstuck? Why not tell all market participants that taxpayer money will not be forthcoming and that they should resolve their problems on their own? It could actually work out very well - very little "retail" money is involved in this market and in the absence of public largesse the 10-20 big players would be forced to sit down and work things out between them. Yes, there would be large losses, or actually as things stand right now, there will be reversals of very large mark-to-market gains for CDS owners. And is that a bad thing? Why should the federal government in effect guarantee the gains of speculators with scarce taxpayer money?

Because, if you haven't figured it out yet, this is exactly what is going on. The "saving the global financial system" pablum fed to the public through the media is just that: mush.


  1. Bravo! I've been saying things like this for about a year.

  2. CDS is an insurance. On normal market conditions that increases stability.

    But like with normal insurances when a storm, the like of which has never seen before, wipes everything away, no insurance company can pay what they own. Letting the big boys (insurance companies) to decide in such case what they are going to pay, does not really sound quite fair to me.

    And letting them all just go bankrupt, would collapse just about all banks in the world, as they all own each others shares and bonds, and their big clients own them. It would go like the worlds largest domino-chain.

    Part of me would like to see the dominoes go, but mostly I am too rational and too afraid of the world and life that would be left after the collapse.

    I do not have any answers, but would urge caution in all decisions.

  3. Re: CDS as insurance

    Yes, but it's not insurance against "acts of God" or extremely well defined and quantifiable actuarial risks (death, disease, etc.).

    Instead, CDS is insurance against "acts of man". And not only that, it was also unregulated and extremely abused. It is not at all fair, or desirable, to allow taxpayers to shoulder the cost for the acts of a few - very few - rogue bankers/speculators who screwed up royally.

    Let them sort the mess out by themselves. Trust me: when the sword is hanging over those types they ALWAYS find a solution. ALWAYS. We don't need to bail them out.

  4. Hell: "It could actually work out very well..."

    What are the risks if it doesn't work out very well?

  5. I keep asking this question and it keeps getting ignored, what is the difference in status between owners and non-owners of the covered debt. If all CDS sellers insisted on delivery of defaulted debt (I've read that some are), the price of those bonds would approach face value as CDS buyers bid for them, losses to insurers would be minimal and speculators with no skin (insured assets) in the game would be wiped out, as they should. Doesn't insurance require proof of loss before paying out.

  6. "acts of man"

    Its really pretty damn impressive how our species gets itself into these situations. It would be perversely interesting to watch the repercussions if the gov announced these CDS contracts to be null and void per the US court system.

    Yoyomo- horrifying link you posted yesterday. I was kind of surprised it didn't mention the impact of pig and cow digestion.

  7. Yoyomo,

    If owner of the cds wishes to use the "insurance", they must give to the issuer of the cds the bonds that they have "insured".

    Thus the buyer of the cds gets the full nominal amount of the bond and the issuer of the cds the chance to reclaim something from the bankruptcy (as often there is still something to be divided amongst the senior debt holders.

    And yes, if you have bought cds without owning the bonds, you may have interesting times ahead of you, if you have left buying the bonds until after the credit event. Of course, none of the banks really go belly up in a blink of an eye, and if you are not too greedy, you normally can always get the bonds at prizes like 40-50 pct of the nominal.


    To leave the banks to sort it out amongst themselves would mean that Goldman, JP Morgan, Deutsche and few others would set the rules to fit them, and all smaller banks would take the hurt.?

  8. Dink,
    Pigs and cows don't vote, their problems can be addressed as cheaply and unpleasantly as possible.

    Another scary link:


    BTW, did you try my suggestion of going to a hunting/camping sports shop to see if they have freeze-dried provisions in small sizes so you can sample the quality.

  9. Re: delivery of bonds against CDS

    Depending on the contract it is not always necessary to deliver the bonds. This is obviously the case if the CDS was written against an index.

  10. Sounds like you want to bring the Laissez back so that we faire better.

    unfortunately we seem to have a vested interest in NOT allowing the market to work itself out.

    Big money has joined forces with big government despite having goals that will quickly diverge.

    Big money is salivating over a short term gain (as they cannot fathom their own eventual demise under big government) while big government is seizing this moment of failure to justify, well, more big government.

    I just wish the fans of big government would spend some time in a country like Hungary or Romania to see what happens when bureaucracy reigns supreme.

    In my humble opinion, a bureaucrat without accountability is soon a tyrant, and it is the goal of all bureaucrats to eliminate their own accountability.

  11. Hell, thanks for the correction.

  12. Changing status quo means someone is shot. Whatever you say to the person in front of you to keep them from shooting you may be the very reason the person behind you shoots you, You throw your hands up and say, What else can I do? The electorate is still clueless as to the severity of what this depression will turn out to be. If the electorate can't foresee that, how are they going to foresee anything else? If the leaders made this mess, how are they going to fix it? The whole damn Congress should go straight go jail anyway for there role to monetary stewardship anyway. Pragmatic, is stall over 3 years to unwind and yes the taxpayer and the amoral business deserve the pain "agony" since there will be no gain. Justice has nothing to do with legal system so you can toss that noble idea out so whats is left other than a new cycle of quid quo pro and caveat emptor. Americans are apt to be unduly interested in discovering what average opinion believes average opinion to be. I thank god hell has concern for busy people "like me"to avert the carnage to a degree.
    Thanks brother

  13. Hellasious, it seems to me that derivatives haven't really been used as insurance but more as assets on a balance sheet. So if these are assets, they can be loaned against and that is where the trouble lies - they have added to the total amount of credit in the system and have become a huge source of fictitious capital creation.

    So you can't expect the 10 big players to work it out amongst themselves because that would involve evaporating 30TR in credit (FC "money") that never really existed in the first place. They don't have the money and they never had it. Unfortunately, this "money" has already been used in the economy to buy stuff and do things and it was all created via derivatives and must die and go to money heaven to clear the system.

  14. It's a wonderful notion, but the one thing the PTB won't do is leave those who got themselves into this mess to their own devices. They have proven this beyond a shadow of a doubt which is why we WILL HAVE a sovereign debt default/dollar debacle. And while eminently predictable, it will emerge suddenly and swiftly as true justice is said to.

    Yoyomo was opining about freeze dried options and such, well, at the risk of sounding like, heaven forfend, a survivalist, I'd get a hold of those and dehydrated foods, because the odds of needing them go up every week. And scoff if you want, but PMs will come in handy. Please spare me the pish about how one can't eat PMs. Once can't eat anything but food itself, so unless things devolve to the point where all that matters is food, a medium of exchange rooted in thousands of years of human commercial activity will have value, certainly substantially more value than the intrinsically worthless confidence game paper we call the U.S. dollar.

  15. Yoyomo,

    "freeze-dried provisions"

    Not yet, but I did try to order "Superpails" of organic legumes and grains in mylar balloons with the oxygen sucked out. They said they were backordered for three months so I declined. I found some place in Oregon that does custom lyophilization. I found another site that explained how to make your own mylar thingees. Then I got distracted by the election.

    <1/2 still not buying into the idea that the US dollar is not permanent. Soooooo there's that.

    Anything new with you?

  16. Dink,
    I only wish, can't convince anyone around me that the frame of reference has changed completely or soon will. The thinking around here is that, at worst, it might get as bad as 1981-2 and then things will turn around because, as everybody knows, they always do. My relatives and your <1/2 would get along nicely for the time being; not so much when TSHTF.

    Reading Don's comment on the prior thread was depressing, it seems every solution creates its own problem. Hopefully resolving the grid deficiency won't create its own set of new problems.

    Thanks Drake for the input. I'm thinking that an insurer can recoup most of its unhedged losses by demanding delivery of the defaulted bonds and selling them on to holders of naked CDS's at near par and shifting the loss to some other insurer.

  17. Interesting piece by Michael Lewis a bit and link below, this bit describes how Eisman who had been using CDS swaps to short BBB mortgage tranche's finally got why the investment houses were so interested in getting his firm to make these bets...


    The End: Michael Lewis

    "That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

  18. LineUp32,
    Long article but the implications are mind boggling, lots more people are going to be calling for Texas necktie parties for these guys. It was all so deliberate.

    BTW the link doesn't work, I found the article over at LondonBanker; HT Acrumb.

  19. Greenie,
    If memory serves me , I think it was you who called me an idiot for citing a suicide figure among Indian farmers of over 100K; well here is a link that doesn't come from CounterPunch (which you derided as leftist and unreliable):


    Happy reading.

  20. yoymo: It is a long article which is why I posted this one bit that focused on CDS. I think it points in the direction that Darth Toll was discussing in his post that is CDS is more then insurance and has a role that has not been discussed openly since the implications financially are extreme.

  21. yoyomo- that is a stunningly sad article. Thanks for the link.

  22. Occum's razor:

    Global wage arbitrage...this really has nothing to do with suppressing domestic wages in the spirit of competition.

    Global free market forces are much more compelling then your assertion and they are not one in the same.

    Think about it.