Monday, March 16, 2009

CDS As Money In The Shadows

As of today I have changed the masthead of the blog to reflect my growing interest in monetary economics which, quite obviously to me, is at the very heart of the current financial crisis. There are certainly other critical influences shaping events (climate change, resource depletion and geopolitical tensions are foremost) but money clearly matters the most, day-to-day.

In fact, one could argue that every human activity ends up being factored into and reflected as money flows. If energy flow is the real (i.e. physical) manifestation of human activity, then money flow is its metaphysical - one could even say philosophical - equivalent. The funny thing about money is that, though it is ''unreal", even kids have a feel for it in daily transactions, whereas the "real" energy is completely nebulous in peoples' minds.

And yet, as befits any philosophic entity, few have a clue about what truly constitutes money - and this includes many so-called professionals. Most just think of money as currency in circulation: dollars, euros, yen and rubles in their pockets or in banks' vaults. Some take a further step and include deposits in banks, properly understanding them to be mere book entries. But it is very few who make the mental leap required to properly view debt as money - indeed, the very idea is antithetical to "common sense".

And yet, that's exactly what our current, fiat-issue money is. The acceptance of new debits (debt) by those willing to assume them creates equivalent new credits (money) and presto, new money is created out of, literally, faith. To paraphrase a familiar text:

Credo est fides omnipoténtem, factórem cæli et terræ, visibílium ómnium et invisibílium.
Credit is omnipotent faith, maker of heaven and earth, of all things visible and invisible.

I am sure that longtime readers of this blog are already familiar with all this stuff, Christian Credo in Latin and all. So I wrote the above as mere preamble to today's "out-of-the-box post".

Onwards, then..

The idea hit me as I was thinking more and more about CDS (credit default swaps) and their role in today's mess. I was quite surprised by Mr. Bernanke's repeated comments on how "angry" he was at AIG and their ruinous exposure to the CDS market. Now, a Fed chairman - the person most responsible for controlling our money - doesn't get "angry" in public, unless he has a very, very good reason and/or a serious point to make. To continue in the same vein as above, it's a bit like the Pope publicly denouncing one of his most important cardinals.


Because AIG and all other major CDS players did something very unorthodox, heretical even. They assumed monetary powers above and beyond those of a mere financial acolyte: they created money without having to submit to the prior omnipotent authority of the Fed.

I have previously discussed CDSs acting as phantom equity equivalents. But can they also be viewed as phantom money - indeed, very high-powered money? Yes, they can - and that's a key element to what has become known as "the shadow banking system".

The issuance of CDSs created obligations to pay pre-determined sums every year for, typically, five years - i.e. debts. They were created out of thin air and required no reserving at the Fed or anywhere else. There was no taxation, wage income, rents, mine output, oil wells or anything else tangible backing those debts. So what backed them? Faith, pure and simple. That's as close as we have ever come to creating the absolute faith-based financial instrument. The Dutch, those early tulip-bubblers, knew a thing or two about such instruments: windhandel they called it, or trading in wind.

A CDS Party Carried In The Wind
Flora's Wagon of Fools by Hendrik Pot (c. 1637)

There are several important observations and corollaries that can be drawn from viewing CDSs as uncontrolled money creation (see chart below). I will leave them to readers by posing this question: as CDS amounts outstanding now crash down through a combination of expiration, forced migration to regulated exchanges and negotiated settlement, what is the effect on money supply, the prospect for inflation/deflation and asset prices?

Data: ISDA


  1. I'm Dutch, and I was very pleased that you are crediting us with the invention of windhandel. We, as a nation, are extremely proud that we have given the world this important instrument for creating wealth out of nothing.

  2. Alas, Martin, the creation of windful and wishful finance cannot be properly credited to any one nation as it has been with us from time immemorial. There are in existence clay tablets showing contracts for the future delivery of grains going back to Sumerian times.

    But I'll give you Dutch credit for naming it!


  3. Nice post, and glad to see you linked from FTAlphaVille!

    CDS are even more high octane as money than you might imagine. CDS were used by banks to leverage their capital, allowing them to lend many more times their capital than they could have otherwise. This is why we see banks today with 20 to 40 times leverage, relative to the old fashioned 10 to 15 times leverage of the past.

    In the old days, a bank lending $100 had to hold reserves of $8 against that asset ($4 tier one, and $4 tier two reserves). With credit insurance in the form of a CDS from a AAA bank counterparty, they could hold just $2 in capital against that same debt.

    As a result, CDS were at the heart of the mammoth expansion of the money supply - and high octane money at that - at the heart of the asset boom.

    Thanks Greenspan and Bernanke! Thanks McCain and Gramm! Thanks ISDA!

  4. Hi Hell,

    As a regular reader of your site - and a poster at times - from 2006 onwards, I do appreciate that your attention is now specifically on monetary issues.

    My modest French-based site is called "Pour une épargne positive en période de crise monétaire". As far as I'm concerned, I believe the monetary crisis has started quite a number of years ago. We are simply getting to the crux now of a long and unstoppable event.

    Most people are regarding money as some kind of arbitrary tool. Of little value per se. To most, assets matter.

    Currencies are just the stick by which you measure them. Should the currency not exist, it would be up and running soon. Out of sheer necessity.

    Along with Von Mises and a few other illuminating thinkers, I believe that this is not the case.

    A sound monetary system has a value per itself. More significant that the TGV you seem to value: )

    As such a monetary system can be enhanced by sound practices à la . Or destroyed by shenanigans.

    Bernanke does not compare to Ludwig Erhard. Or Jacques Rueff.

    When a currency system is seriously impaired, you discover that long term ending is impaired.

    A robust monetary system offers sound borrowing as well as sound lending. It does not have to be international to operate.

    Once it breaks, there is little you can do to improve. Except at atrocious prices. That no politician will incur. At least now.

    On the list of broke monetary environments, will come the dreaded "runs to tangibles" and later swap-based commerce.

    We are alas certainly moving that way.

    You seem to believe the dollar will remain strong. I have overly serious doubts but will never bet against the Chinese government.

    That does not change the scenario. We are quitting the robust monetary environment that the US brought to the planet in 1944.

    This Bretton Woods event is something most forget. As some do forget what your country did in 1944-1945. I certainly do not.

    But times have changed. We may have to do without this solid monetary environment for a while.

    The credit crunch will be as long as this crisis. No robust currency no willing long-run savers.

  5. Hi LB,

    Interestingly, a bank can sell as much sovereign-risk CDSs as it wishes with ZERO (0%) reserves, as long as it is its own country, i.e. a French bank selling CDSs on French Govt. bonds.

    Fun, eh? But them's the rules...


  6. Hey, it is "Roth_s_child", with a "s" between the "h" and the "c". In german "das rote Schild" means "the red sign" and according to the german wikipedia, the Rothschild family decided to change to this name from "Hahn" wich means "rooster". And they took that name because of a red sign hanging above the entry to their shop in the Judengasse in Frankfurt-am-Main around year 1600.

    But that is not the most interesting in the story. What I find the most interesting is that two of the richest bankiers in the history are Germans. They are the Fugger family around 1500 who were maybe even richer than the Rothschild compared the world GDP of their times, and the Rothschild around 1800 of course. Strange coincidence.

    I would like to add that I prefer the american super rich from the 19th century (Rockefeller...) to (Ford...) today (Gates...) who are generally real entrepreneurs rather than "banksters".

  7. Dear Marin Belge,

    I am a very committed proponent of sound money. Because as Keynes said quoting Lenin, there is no surer way of overturning society than to debauch its currency. See my Greenback proposal.


  8. Hel, would you agree with Karl Denninger's position that CDS as credit insurance are inherently fraudulent because if the premiums were to properly price risk the returns on the bond would have a negative spread with comparable Treasuries? IOW the only way to make CDS worthwhile is to underprice risk systematically, collect the premiums, then go bankrupt when the claims come in (after you've pocketed your commissions of course).

  9. Dear yoyomo,

    Putting aside the fact that gathering pennies in front of steamrollers is inherently a rather unwise business practice, I don't think that MAJOR CDS market participants designed to go bust, a priori. (Some hedge funds funds, on the other hand..)

    Instead, CDS is just another manifestation of "new toys for tots",long a tradition with Wall Street denizens. You won't believe how common and persuasive such groupthink can be amongst otherwise intelligent people.

    They clearly had not thought of all of the ramifications, a process made very difficult as so many sugarplums danced through their heads.


  10. A really insightful post for those of us outside the industry, Hell!

    So if AIG stole fire from the gods (created money w/o Fed permission) why is the Fed helping them now? And looking at that hideous chart, can the Fed possibly do damage control on the amount of debt grown after 2004?

  11. Well, I find this blog more and more interesting, and attracting more and more interesting people by the day.
    A few comments on this post : my religious reading of Bernard Maris's Antimanuel de l'Economie a few years ago (I read the chapter on money three times and should go back to it again...) impressed a few facts on my mind : 1) classical liberal economic theory functioned for years on the assumption that money was of zero importance, only assets, or products, or whatever counted. Maris, who has thoroughly digested his Freud, found this rather unbelievable, and put it down to downright DENIAL.
    I agree with this analysis, and it is important in order to understand just why so many people really don't understand that money is "le nerf de la guerre".
    But the little act of positing that acceptance of debt can be overturned and renamed the creation of credit, thus creation of money, is just a little bit like...
    pulling a rabbit out of a hat.
    Magic and faith, although they resemble each other, ARE NOT THE SAME THING.
    And it's important to remember this, from a metaphysical standpoint.
    Because magic leads to charges of mystification.
    And the whole Wall Street scam is one big mystification.
    And we all know this. (Well, not all of us, but everybody here on this blog does.)
    Mystification destroys faith.
    And one BIG question : can we have faith in our money IF we have lost faith in other areas of our society, and specifically in our fellow man ?
    I think not, my friends.

  12. Dink asked:

    "So if AIG stole fire from the gods (created money w/o Fed permission) why is the Fed helping them now?"

    Because once money is created and channelled into the rest of the economy, letting it disappear would create the greatest bugaboo of US monetary authorities: deflation. So they had to bail them out - presumably doing so reluctantly.


  13. Dear Debra,

    I, for one, have faith in my fellow man - and woman! Not every single one of them, mind you, but very many.

    And I bet you do, too. Otherwise despair would have driven you away from the chattering masses of the blogoshpere :)


  14. So there was inflation in the CDS creation, now one of two or combination of things has to happen--deflation and devaluation of the currencies involved.

  15. In majority of cases, credit default swaps have an underlying bond that is secured by assets of the company. I don't think that it is just "faith" that backs them - so your classification is a bit off.

  16. we should pay attention to this kind of issues...the crisis will continuously affect us if this can't be solved or improved...

    - ledz -

  17. Belge:
    I agree, compared with Jacques Rueff, DeGaulle's money guy, Zimbabwe Ben is an amateur.

  18. Excellent. Now the real question is what does the Fed do to counter the CDS driven deflation. If it tries to backfill it all with "real" money the amount of money in circulation will skyrocket.

    A related issue is the digitization of money. Even though the dollar has lost ~95% of it's value since the gold standard has been abandoned, no new higher denomination bills have been introduced into general circulation. What happens when a $100 only buys a soda? When will we get the $1,000 bill? Or will this be a way to force everyone to use credit or debit cards? I bet some folks drool at that prospect.

  19. This morning in France all the commentators are smiling because both Trichet and Bernanke claimed in the media that the crisis will be over at end 2009 and the economy will grow again from 2010. Frightening.

  20. Dear Princeton squirrel,

    Even apart from the loads of CDS issued against indexes (eg ABX and CDX), corporate and sovereign CDS are credit insurance contracts between two parties unrelated to the issuer of the bonds. The bonds are used as reference, not backing for the CDSs.


  21. I say deflationary. We've already had the inflation.

  22. Yes, CDS provided the basis to expand credit without capital reserves and which is why in order to pay for the losses governments need to borrow money from future generations since the actual cash or productive wealth does not currently exist. The solution is default or BK by the major players which causes governemnts a great deal of pain since credit growth would thereby decline for years since the markets would need to return to orgranic growth to generate credit.
    Credit expansion has replaced energy as the key component for GDP expansion.

  23. Your new masthead quote exactly pinpoints the core problem of the crisis we are in today.

    The money-power-control-structure.

    I contend the Rothschilds are the alpha-male of TPTB because they have been in continuous power for 300 years.

    However, a funny thing happened in this decade, Universe has called these people out and their reign is over. The paper-control-paradigm is dead.

    We are headed to a new way of life and awareness.

    Joe M.

  24. "So they had to bail them out - presumably doing so reluctantly."


    Its almost sad to think of the Fed as being outwitted by these CDS punks. An analogy could be that we've been paying a little protection money to the mafia for a couple years. It wasn't ideal, but things were fairly stable. Then a new gang came to town, saw that the old mob had gotten complacent, and proceeded to shoot the town up.

    If there is no new CDS being issued and we just have to wait for the existing contracts to expire, I guess the old mob might be getting control back. If there is new CDS being issued (or other forms of non-Fed debt being issued) I guess the old mob has been outgunned.

    Hell's use of the word "presumably" brings up a third possibility. The old mob controlled the CDS punks all along and is using them as an excuse to charge higher protection fees.

    (Sorry for the drama, but I'm not in the industry so I have to learn by using analogies).

  25. Seems deflationary to me. How can there be inflation if wages don't rise and jobs continue to be lost?

  26. Yea, many new faces around. Cool, this is turning into sort of unofficial education center with everyone adding his cents.

    IIRC, inflation comes in two types - that driven by overeager buyers and the other, that of the supply side, caused by increasing cost of resources, and they don't neccessarily work in tandem. And then there is that very special kind of inflation that can occur if a government is unable to balance the books, borrow some more or somehow weasel out with dignity and has to resort to Unternehmen Weimar which has something to do with printing press.

    BTW, just did some research on some of the big bubbles of the past for the sake of education and fun, and while it's true that financial instruments tend to get more complicated, the human hype seemed surprisingly similar. Mix some lack of sound economic know-how with illusion of a new bull-on-steroids market that surely cannot falter, lots and lots of lust for easy dough and some delusions of safety, and voila, let's roll! And when those speculators are allowed to borrow en masse, then there is some serious damage waiting around corner.
    BTW, something fresh from good old Peter Schiff. The whole speech is rather long, and this is the segment about some faceoffs with stupidity:

  27. I thought the bank index was going back to levels of around 1990 because what they had used to create credit since then had failed. Tough going ahead. Bernanke might push the string so hard that we inflate, but it will come with fears of central bank insolvency. Without the derivatives market, I suspect we deflate for some time. There is a lot of supply of things out there looking for demand and there is a lot of money needed to pay on demand what is due.

  28. in majority of cases, credit default swaps have an underlying bond that is secured by assets of the company

    Many of the underlying issues of CDS's are illiquid or in limited supply compared to the notional amount of swaps written...

    So while there may be an asset it may well not be available during a credit event.

  29. I was particularly interested in your comment EEEngineer, about the digitalization of money.
    In the U.S. last summer I was completely flabbergasted at the number of times using PAPER money was just not an option : no checks (no faith...), no paper money for various reasons, and only card payment.
    And the number of ATM's cropping up in the most amazing places (in even the sleaziest little shops on the down side of Broadway in New York City...) leads me to believe that the nature of fiat money AS PAPER is already hurting, and that we (and the economists...) are way behind what our new representations of money are doing to the way we see money.

    Could we be collectively ONLY relating to numbers, and have completely forgotten the "support" (that's the French word, for clarification...) ?

    It almost makes me want to cut up my debit card...


  30. There are in existence clay tablets showing contracts for the future delivery of grains going back to Sumerian times.

    Not only that: When someone in Babylon got a margin call and could not pay he often chose to sell himself into slavery.

    In those times slaves were at least fed regular meals, beggars were probably run off by the hounds and thieves were made examples off.

    The Roman Gaius Cilnius Mæcenas (70 f.Kr.-8 f.Kr.) amassed his vast fortune speculating in grain; there were rumours of insider trading (not illegal then)

    Anyway, Having TARP'ed Bankers picking up thrash, fixing potholes in the roads maybe even maintaining public buildings would be some sort of justice.

  31. " majority of cases, credit default swaps have an underlying bond that is secured by assets of the company"

    Synthetic CDS is widespread and in fact may be a majority of the total.
    the industry is so opaque nobody knows but the investment banks were selling them like candy.

  32. Hell,
    Thanks for your great posts. Been following you since early 2007 and you opened my eyes and saved a lot of my hard earned money.

    In regards to the CDS problem. What would happen if the government just decided to declare ALL of them invalid. Cancel them out of the system - poof. Isn't it true that most of them is a hedge against own bets? And another big part of them would not be necessary because the companies credit they insure would be more safe if the company in it self hadn't made a lot of credit bets by selling CDS:s.

  33. Hel, Do you agree with:

    CDS increases the "quality" of a debt, thus also improves or creates liquidity.

    I am still have a hard time seeing the mechanism by which CDS created money. It definitely improved the liquidity of some otherwise illiquid assets.

  34. Hel, Do you agree with:

    CDS increases the "quality" of a debt, thus also improves or creates liquidity.

    I am still have a hard time seeing the mechanism by which CDS created money. It definitely improved the liquidity of some otherwise illiquid assets.