Friday, April 3, 2009

CDSs Crash Land On Planet Gamma

In the preface to a previous post I mentioned the concept of correlation, denoted by the Greek letter γ (gamma). There is an excellent Wired magazine article by Felix Salmon that goes into significant detail on how a simplistic and short-sighted approach to correlation "sunk" Wall Street's CDO industry and precipitated today's crisis - or at least was its proximate cause. I highly recommend reading it.

Today, a bit more on my current view that correlation madness has ran its course and will fizzle back into obscurity.

First, a bit of background: I have in the past posited that CDSs are responsible for the lightning speed with which the crisis has spread from real estate to money, credit, equity and commodity markets. In chemistry terms, credit default swaps catalyzed a financial critical reaction, making it run faster and more destructively. They turned what could have been a severe - but otherwise normal - crisis into a runaway market meltdown.

[Note: Some think that all financial derivatives are bad - this is simply not so. According to the Bank for International Settlements as of June 2008 there were $683 trillion in nominal value of over the counter derivatives outstanding (OTC: not traded on regulated exchanges). Seventy five percent were interest rate swaps, forward rate agreements and foreign exchange swaps, i.e. run-of-the-mill instruments used in the daily operation of bank treasury departments. But the $57 trillion in CDSs are another species altogether.]

It was the newly created CDS market that provided the "toxic" structured product manufacturers (CDO, CDO squared and cubed, CPDOs, etc) with the ability to use and abuse low correlation values, and thus vastly expand the amounts of highly rated (AAA and AA) marketable tranches they could create. For example, a low gamma of +0.2 for a pool of mortgages would allow 70% of the pool to go into the AAA tranche, while a gamma of +0.5 would allow only 50% (all numbers hypothetical).

Once it was shown that actual correlation was higher when the real estate bubble burst, all hell broke loose. Every trader in the money and credit markets started plugging higher assumed correlation values into their spreadsheets, resulting in higher presumed risk and thus lower prices for everything from CDOs and equities to government bond spreads. The loop fed back into itself via - what else? - the CDS market, which now produced even higher gamma values. In other words, after a point the crisis was not only self-made but self-sustaining, too.

Understanding this "technical" cause of the current financial crisis leads us to conclude that part of the damage done to some credit and equity markets is pretty much artificial, i.e. not due to underlying economic fundamentals. That's why I have been saying recently that things are overdone on the downside.

The way out of this hole is pretty obvious, to me at least: use a modicum of common sense in evaluating risk and not exclusively arcane mathematical formulas that end up in the GIGO dustbin. In gamma terms, just as +0.2 was way too low for reality then, a gamma of +0.8 may be way too high now.

There are other necessary steps, too:
  1. Reduce the nominal amount of CDS outstanding. Demand that every major counterparty comes to a "netting conference", where they will be required to drill down to the final customer level.
  2. List all remaining positions on regulated exchanges that provide central clearing, position and margin limits, tight regulation and better transparency. This is harder than it sounds for the single name business (i.e. CDSs written on individual companies or entities) but should be very doable for the index business which constitutes a large portion of CDSs in existence.
  3. Have all new business conform to standard futures exchanges policies that already exist regarding customer risk and disclosure, margin, position limits, etc.
I am pretty sure that all of the above are getting some attention from market participants, regulators and even some market-savvy politicians. And this is - partly, at least - why we are currently experiencing a rally in equity and credit markets. Let's call it a "relief rally" for now and leave it at that...

PS: In view of the above, I agree with FASB's recent ruling on mark to market.


  1. Regulation and transparency would be a big improvement, but why can't CDSs simply be made illegal instead?

  2. "...but why can't CDSs simply be made illegal instead?"

    Because they are a fine instrument to USE, but not to ABUSE.


  3. Heroin was a fine cough suppressant yet we could not control its abuse so it was made illegal.

    Ether if handled properly is a fine general anesthetic but the potential for explosion makes it impractical.

    Are CDSs are the Corvair of tomorrow? A Sweet but dangerous ride?

  4. We can analyze what brung us here till the cows come home, it matters not.

    We are at the end of a cycle compounded by debt saturation. As such, the only way out is to cleanse/collapse. Then start over.

    Before this year is out everybody will surely understand this.

    Joe M.

  5. Hell:

    What does "drill down to the final customer level" mean?

    How bout rating agencies that understand what they are rating and have no vested interest in the rating?


  6. E.of Obvious makes a good point regarding heroin. Pleasure/greed trumps reason...and even self-preservation. Anything that can make a person or company that rich that fast will be abused.

    These financial vehicles have reached a level of complexity such that they inherently can't be transparent. They're self-obfuscating.

  7. I agree with dink. And I like the earl of obvious's comparisons (as you would all guess that I would).

    I don't believe in independant rating agencies.
    They are contrary to human nature...

    And I don't believe in insurance either.
    Will you tell me how you can have insurance and solidarity AT THE SAME TIME ?
    They are antithetical.

  8. One small point to the Earl of Obvious :
    making heroin illegal did NOT take care of the problem of substance abuse...
    No more than making alcohol illegal during Prohibition took care of THAT problem...

  9. Agreed Deb. But IMO making something illegal is effective in curbing its use even if it is not effective in curbing its abuse.

    This seems to be the crux of the CDS issue (or as close as my simple mind can interpret it). Social acceptance (via unrestricted legalization) of these products led people to believe they were not only harmless but even necessary?

  10. Debra,

    We liberals like to think that making things illegal doesn't curb their use.

    But, if you compare, say, tobacco versus heroin, you will see that making things illegal actually curbs their use.

    Also think about the usage of alcohol in Christian countries versus Muslim ones.

    Legality normally entails more usage.

    Note that I am not defending making tobacco illegal or even that illegal heroin is a good thing. I am only noting that the argument of more usage when illegal is moot.

    Anyways, back to the original topic, one thing that crossed my mind is that CDSs could me made illegal.

    One thought experiment that crossed my mind was the idea of making existing CDS contracts void (while returning fees). This would avoid a possible future avalanche of CDSs triggering. I am far (very far) from being a specialist... but it seemed a way to clear short term CDS armageddon.

  11. CDSs without such and such warrants or collateral will be illegal as of this future date.

    Short term speculation before said date increases value before legitimate market devices increase long term viability.

    Just need a definition of legitimate market device...

  12. Hell, Dink, Deb, Earl of Obvious, Tiago, etc...

    I would suggest the issue is really about the integrity of individuals in the system rather than endless processes to protect us from those individuals as Hell rightfully points out.

    We endlessly try to make processes to protect us from a few bad actors, e.g that old (fractal) rule of thumb- 20% of the people create 80% of the problems for the rest of us. I realize it very much brigs back the old tribal village issues of "excluding those who are different", but I might suggest a little more of this would go a long way to solving our problems- especially where we can get reasonable agreement on what is a "no no".

    And the processes don't work in the end anyway.

    Take the nut who just killed all those people in Binghamton NY (I am sure there are those readers of this blog who somehow fail to see the connection between this nuts behavior and their diminishing retirement and/or education and/or child care and/or health care, but most of the rest of us see the connection).

    Anyway, I bet you 10 to 1 the guy's craziness was well known by many many people for quite some time before he decided to kill those people. Yet some kind of reverse civics/civil rights "bubble" prevented us from stopping him long ago- we have already done the same with letting the mentally ill out of institutions because they don't want to be "locked up". And now the costs/tragedies of their homelessness are a daily occurrence.

    And Tiago, FYI- Heroin is a so so drug (at least for medicinal purposes). Its short (but sadly not super short) half life limits any real value vs. other options available. My grandmother's hospice used heroin in Britain to treat her pain when she died from metastatic breast cancer. It worked fine but there really are better options out there... On the other hand Cocaine really is still the best Ear Nose & Throat drug we have- we try to approximate its "perfection" by mixing several other compounds together but they never work quite as well and it slows providers down (costs productivity) as we spend all the time getting different drugs and mixing them-a total pain in the a@$$. But we use the multi-drug option as the "control" procedures around storing cocaine are so onerous.

  13. Sorry Tiago (some kind of switch in my mind made me switch your names as I was typing), I meant Earl of Obvious.

  14. Thanks Thai. Might I also add that it was also a far better treatment for E.D. than Viagra.

  15. Now you'll get me talking shop about the significant number of times I have had to directly inject epinephrine by syringe in "you know what" in order to control their priapism (you can look that word up).

    A VERY bloody and rather uncomfortable mess which definitely has a tendency to make "large" men faint.

    You don't want me talking shop



  16. I happen to know someone who is good friends with the woman who devised Credit Default Swaps. Let me just cut to the chase and say that in Blythe's view the vast majority of those who traded in CDS did not know how to use them properly. A self serving view to be sure, but just because it's self serving doesn't mean it isn't correct.

  17. Thai said: I would suggest the issue is really about the integrity of individuals in the system rather than endless processes to protect us from those individuals as Hell rightfully points out.

    Hi Thai, I hope you are not suggesting that just because the system ain't perfect we should then have less of the system and instead reply on individuals. That sounds like a major step backwards.


  18. Fully collateralized, risk-priced credit insurance would cost more than the spread on the underlying security and no one would buy it. The only way to maintain the CDS market is through misrepresentation and eventual inability to pay claims.

    Re: William Black, some people will never see conspiracy especially if it is conducted in the open.

    Re: priapism & epinephrine, do un-"large" men have less tendency to faint?, less blood perhaps?

  19. There's one little significant point about making things illegal to control their use/abuse.
    It pushes the economic exchanges into that no-man's land that we all wish would go away... (ORGANIZED crime that functions like banks, for example...)
    I agree with Thai that if we stopped concentrating so much on finger pointing and wrist slapping, we might actually be able to COOPERATE to do something about all of this.
    But I have also abandoned all hope and desire to get things done in an INSTITUTIONALIZED framework (and yes, one of those BIG institutions among others, is the governmental bureaucracy...)
    Talk to Arnould. Over here in this very very bureaucratic country, lots of business gets done...UNDERCOVER.
    Bureaucracy ends up killing our economic life.
    And Thai, I don't agree about locking the people up to protect society.
    I think if we actually did this, I would probably be locked up, and I don't relish that perspective...

  20. Forgot the link on CDS pricing:

  21. Thai,

    I would suggest the issue is really about the integrity of individuals in the system rather than endless processes to protect us from those individuals as Hell rightfully points out.

    You are mostly right: excess regulations are no substitute for integrity and excess rules only creates opportunities for well-connected and well-informed participants to take advantage. Actually excess rules breed corruption.

    But, the other extreme will be no rules at all. And I would imagine that you agree that killing/robbing should not be allowed.

    So this becomes an engineering question: What is the right ammount of rules?

    I would argue, that any rule on this issue (or many other subjects) should be made as simple as possible.

    Any rule should also try to strive to low complexity in the system (as I see it, CDSs - at least as they were in the past and now - are mainly a massive introducer of complexity and opaqueness in the system).

  22. I looked up priapism


  23. Posted by Jesse and it lines up exactly where we are headed, a USD/USG collapse.

    Joe M.

    "If Democrats were trying to create a new Weimar Republic it would be hard to imagine a more sincere and effective effort. The problem is that the shadow of what comes next looms over the world like a dark cloud of misery brought about by the madness of men."

  24. "letting the mentally ill out of institutions because they don't want to be "locked up". And now the costs/tragedies of their homelessness are a daily occurrence." (Thai quote)

    There was an article on CNN about an Austin hospital that had racked up 3 million in unpaid expenses on 10 people. The ten were homeless, mentally-ill drug abusers who were brought in over 2500 times over a couple years.

    " if we stopped concentrating so much on finger pointing and wrist slapping, we might actually be able to COOPERATE to do something about all of this." (Debra quote)

    Can't cooperate with the crazy (Austin). Can't cooperate with the evil (Third Reich, Wall St.). Unpleasant consequences must be in place or else the crazy and evil will destroy The Commons.

    "directly inject epinephrine by syringe "

    i AY CARUMBA ! (Secretly we all love macabre shop talk). Memory from an organic chemistry lecture: "If it ends in "-ine" it has an amine functional group. These are important for drugs and explosives". Interesting class; nearly sorcery.

    @Joe M
    "a USD/USG collapse"

    My ears always prick up over USD talk since I've been hiding out in cash. Do you have a time frame? Milestones to watch for? Like Edwardo's gold talk, I may not always agree, but I am curious.

  25. Dink,
    You may want to check out Mike Panzner, he's been spot on:

  26. dink,

    Timing the event or even how long it plays out is impossible. However, I have become convinced that when TPTB lose control of Gold it is game over.

    I am looking for a 100-200 dollar up move in Gold, over a matter of hours, which will indicate something very bad for the paper-paradigm has occurred.

    Additionally, we have Martin Armstrong, a cycle master, that has indicated a turn date of April 19th.

    Personally, I think we will see a very, very bad Summer/Fall that will make people/masses start to question whether TPTB can even keep the whole system together anymore. We shall see.

    Joe M.

  27. @Yymo, Joe M:

    (Sorry if this is messy; I'm making it up as I go along)

    An advanced civilization requires specialization. Specialization requires a stable currency to exchange with. The USD has served as that currency all my life.

    The USD is getting put at risk of destabilization. I don't know if the process can be stopped. I don't know how fast a new currency can gain global, or even local, trust.

    So I equate the destabilization of the USD with reduced civilization. Maybe its bad logic driven by reptilian fear, but there it is.

    If civilization reduces just a little bit, I can see how physical gold would be handy. But I guess I see civilization as "all or nothing" so we either have an agreed upon currency or we have canned food/ammo.

    "a very, very bad Summer/Fall that will make people/masses start to question whether TPTB can even keep the whole system together anymore"

    Ah, man. I was hoping for at least another couple of years of civilization. Surely we'll experiment with various levels of communism before a full crash?

  28. Dink said:

    "I don't know how fast a new currency can gain global, or even local, trust."


    So, I've just flown back from Europe, and I found myself in the newly renovated terminal 5 (the old TWA terminal at JFK) catching a connecting flight back home by way of JetBlue.

    As it happened, security stole my toothpaste, and after a gazillion hours on the plane, I was really, really hard up for any sort of minty breath freshening anything.

    But I didn't have any dollars on me.

    So I decided to try to sweet-talk some giftstore employees into giving me free stuff. So after shmoosing for a bit, I sob that all I have on me are Euros.

    -- and they gave me one of those looks-- They're local NYers, from queens maybe, and not only did they not know what Euros were, they also weren't quite sure what or where Europe was... But they thought they'd heard of it.. maybe.

    Now since I had time to kill, I pulled a national geographic off the rack, found a map of the world, and pointed to places using the miniature torch of a Statue of Liberty.

    And after a few minutes, I'd successfully convinced this trio of ladies that other places exist, and that these other places use NON-dollars to pay for stuff.

    And then they wanted to SEE some.

    And then they just WANTED some.

    So we made a deal. I gave one of them twenty euro cents, and she gave me a pack of stale mentos from the display. (i don't think it crossed her mind that she'd actually STOLEN them).

    I think the point of this is twofold:

    first-- people are like magpies. Many just need to see a shiny something with a clever story attached to it in order for trust to develop.

    Second-- "Ahhhh... America!"

  29. Oh, come on now Cottonblogin. No reason to insult them. They were just harmlessly flirting with you. I know there are many intelligent women who play dumb just to attract the guy. I guess it backfires on them sometimes

  30. Where to start ?
    SECRETLY I don't exactly relish shop talk (sorry Thai...) because my daddy was a forensic pathologist and I heard those stories of coke bottles in the most unbelievable places in people in emergency rooms, and now I find all that rather... HO HUM. (Been there, done that, I guess...)
    Sorry Dink. You CAN cooperate with the crazy (and the evil, but I don't believe in evil people, I believe in circumstances that bring out the worst in people, that's really a different ballpark), YOU JUST HAVE TO CARE ENOUGH TO BE INTELLIGENT AND TACTFUL ENOUGH TO DO IT. And I repeat that I am saying this as someone who COULD be considered a nut case (but think about it, in the same way as there is always someone out there who is more "con" than YOU are, YOU are also somebody elses' "con". Believe me on this one. I think that it is a universal truth.
    And the same thing is true for "craziness".
    I heard this morning that the G20 agreed about just about everything, BUT NOBODY MENTIONED MONETARY REFORM.
    Could it possibly be that the G20 agreed about everything just so that they could push monetary reform under the carpet ? Sounds probable to me.
    The behind the scenes show for the G20 was even more interesting : Strasbourg was looted and burned in places... (But maybe I'm getting my metaphors mixed and Strasbourg was for the Nato meeting, who knows ? I kind of don't pay too much attention to the news flashes these days...)
    Hmm... wonder what THAT could mean ?
    And I repeat, punishment does not work with human beings. Making them afraid to make them behave is setting society up for future chaos.
    We actually had managed to figure this out at the end of the 60's, when the U.S. prison population was at an all time low, and we were even considering giving up on prisons ! (yes, yes, I'm not joking...)
    And welcome back Cotton, I'm sorry I missed your bartering in JFK. Were the ladies flirting ? Are you really as cute as that ? I'm sorry you didn't show up at my place... (But I'm really off bounds anyway...) : )

  31. Cotton,
    Reminds me of a conversation 30 yrs ago with a friend from Brooklyn who said he wanted to go to Europe and buy a cheap used bike and ride around the French and English countryside. I told him to make sure he would be allowed to take the bike on the ferry and he asked, what ferry? He thought that Britain was attached to Europe.

    Before $ loses currency in the US, it will have crashed and lost convertibility on the FX mkt. I think that will take a few years as China/Japan/OPEC can't afford to lose their reserves before an alternative is set up but that is something that is in the process of happening:,0,865582.story

  32. As for CDS being the only "dangerous" derivatives, it seems it is not quite true. The last report from the OCC said that bank losses from interest rate swaps last quarter were the largest ever by a large margin. And interest rate swaps are how many trillion dollars in notional value? ;-)
    Go figure the rest of what will happen to that nearly 700 trillion dollar derivative market... we do not need many percent of losses for them to be HUGE.