Sunday, January 17, 2010

CDS Counterparty Politics

Long-time readers of Sudden Debt (it was started on Dec. 2, 2006 with this post) know of my insistence that credit default swaps (CDS) pushed the current financial crisis over the edge of the precipice. This relative newcomer to the roster of financial instruments acted as a catalyst, much as a slow chemical reaction proceeds at explosive levels with the addition of even a tiny amount of the appropriate substance.

I posted many times on CDS, from Phantom Menace to CDS Factors In Equity Valuation (a four-part series: Part A, Part B, Part C, Part D.) and frequently commented on one aspect that made them truly dangerous to the stability of our financial system, i.e. counter-party risk. It didn't matter, I claimed, that a dealer's CDS book was "square", i.e. that he slept comfortably thinking his market risk was zero because he/she had offsetting positions with other dealers.

When I said that huge notional CDS amounts really mattered (see chart below) I was pooh-poohed as a Cassandra, particularly by those professionals who only saw as far as their "blotter" and who never worried what would happen if a major participant went belly-up.

Until it did.

CDS Outstanding (Data: ISDA)

The AIG saga is now unfolding in ways that "professionals" would not even dream of and is snaring past and present Treasury Secretaries who rushed to bail out the failed insurer's counterparties at 100 cents on the dollar, to the tune of $62 billion.

I must admit I made a big mistake three years ago: I thought no American government would ever dare to use such an enormous amount of public money to cover the private losses of the nation's wealthiest institutions. And I am once again amazed at these same institutions' hubris of paying record-breaking bonuses for 2009 results. If this isn't the stuff that makes for public uproar and revolution, I don't know what is...


  1. Hello Hell,
    In you opinion are these bonuses, paid in real dollar cash, still based on overvalued assets, as they were in the past?
    Or are they based on real assets which, if need be, could instantly be sold at the prices shown in the accounting books?
    If 2. then there would be an evolution, don't you think?

  2. I once posted here that your view was economy centered (and I learned most what I know about economy by reading YOU).

    In perilous times politics trumpets economy. In extreme perilous times politics might get violent.

    This all to say that your disbelief in the possiblity in hyperinflation might be ill placed. From an economic point, your view is the correct one, I believe. But don't discount the possility of printing money ad infinitum (ie political interference), and of some of that money actually ending up in the real economy (not in the funny Wall Street economy).

    In the medium run this might make people stop believing that money has any real value (and the problem here is not comparing USD with other currencies, but with real physical resources).

    Consumption might fall like a brick, but producers of real things might start to believe that money is not worth the paper where it is printed in (money being only fiat). Thus hyperinflation.

    I am not saying that this (hyperinflation) is going to happen, only that it became clear to me that you were not valueing politics and sociology correctly in your reasoning.

    Regarding the "revolution". People are starting to revolt. Not directly because of bonuses and such, but because they are starting to feel the pinch in their daily lives (unemployment and all that). They are able to support abstract unfairness, but when that unfairness is coupled with concrete suffering, that is explosive.

    It is not clear to me that, in the US, this anger will go in a productive direction. As far as I see, it will be directed mostly against the democrats in particular (lets see the midterms) and political pluralism in general.

    If it gets harsh, there will be lots of Sarah Palin look alikes ready to leverage it.

    I still would like to believe that you are correct. Especially because I believe hyperinflation is the harbinger of war.

    I would really be interested in seeing what are your short to mid term predictions now that you seem to be doing a nice internal and personal belief revision.

  3. "I thought no American government would ever dare to use such an enormous amount of public money to..." & "If this isn't the stuff that makes for public uproar and revolution, I don't know what is..."

    The govt no longer represents the public and is a captive of the Big Money Monopoly (banking-military-media); for those who still doubt Alex Jones.

    The rumors of a new final solution for all the useless eaters in the age of resource depletion begin to sound slightly more plausible, no?

  4. Except it doesn't make sense.

    For example, if you and I place a bet on the outcome of the super bowl, we don't affect the result.

    Same with a derivative, unless there is physical delivery, and then its only on the net result.

    The reason why physical delivery matters for CDS is when a bond has to be delivered. If there is demand for the physical bond, the bond's price will rise.

    Now if you are using that CDS as a hedge against the losses on the firm, the rising price of the bond means you aren't hedged. Big losses on the firm, small gains on the CDS.

    As for the volume graph, lots of other things have the same graph. The economy. Employment looks the same.

  5. Like Tiago I too want to thank you for showing me this.

    And re: "I thought no American government would ever dare to use such an enormous amount of public money to cover the private losses"


    I remember you once said long ago how you did not think the US was like Argentina and in that moment I suddenly saw where our different viewpoints split. We have different mental models of our nation effected by our different viewpoints/vantage points. You have the wealthy banker's macro vantage-point, I have the... I'll let you decide for yourself.

    ... And now your warnings on (well intended) the misuse of CDSs has come to pass, I suspect (but hope not) we will witness similar well intentioned misuse with human default swaps (HDS).

    We have become bailout nation and have almost reached that magical moment where 50% of our economy is under the control of one economic entity. Yet we will see if that one entity is as disciplined Ireland or Denmark.

    Or is it more like Argentinian or Greece? ;-)

    Time will tell

  6. HellasIOUS,

    Keep in mind that the bailout money was not just for national interests. European institutions were helped also. It was really an attempt to save the old world imperialist monetary system, US and London centric. Regardless, I feel it will eventually fail due to the corruption necessary for its own survival.

  7. The bailout isn't to do with CDSs.

    The bailout is to do with keeping the ponzi scheme going.

    The problem is that governments needs the banks to keep buying and selling government bonds for them. No more borrowing and it all collapses.

    The collapse is inevitable. The only question politicians ask on the quite, is can I pospone the collapse until I'm out of office.

  8. Don't forget that the bailout was sold to the American people as a way to get the economy moving to start the flow of credit to main street when in fact it had very different motives. Now various groups want to use whatever public anger can be generated by this lie to get TBF regulations passed or get elected.
    The American public is spoiled by its very expensive lifestyle and will find much to be angry about in the coming decade.

  9. I based in the UK, and the f-ups here are huge. The chief regulator was the prime minister.

    What happening in the US, is that all banks are being done over for the problems with a few.

    In the UK its the same, however they are hitting the employees of all banks.

    The common factor is the regulator. Brown in our case.

    Personally, they should have screwed the banks that failed. Instead they have bailed them out and are still pumping money in secret to them.

  10. Just a few questions...
    When did the government EVER represent the people ?
    Back to Howard Zinn, "An Alternative History of the U.S." to dispell those die hard illusions.
    The people are already figuring out ways to deal with "the system".
    Work is being done, and paid for in other ways.
    The real economy is being transformed, while the top heavy, bloated Wall Street illusion flushes itself down the toilet.
    Try not to panic, y'all.
    But it's true... déclassement is here to stay.
    The old non negotiable American lifestyle is going to get shaken up a little bit in the process.
    But... the good news is that people are going to start using their grey matter in meaningful ways again.

  11. "I must admit I made a big mistake three years ago: I thought no American government would ever dare to use such an enormous amount of public money to cover the private losses of the nation's wealthiest institutions. And I am once again amazed at these same institutions' hubris of paying record-breaking bonuses for 2009 results. If this isn't the stuff that makes for public uproar and revolution, I don't know what is..."

    My only real criticism of you Hel: Not cynical enough about American politicians and you overestimate the curiosity and awareness of the American people.

    There will be no revolution against the government, only divisive politics of something like the "tea-baggers v the "progressives".

    We live in a fascist regime, a dynamic of various corporate interests, health care interests v MIC interests v tele-communication interests... integrated into the government.

    There is no "promotion of the welfare of the people". The sooner people see the new regime the sooner we can start to unravel it.

  12. "They are able to support abstract unfairness, but when that unfairness is coupled with concrete suffering, that is explosive."

    Agreed. I'm stunned at the resiliance of the current social safety nets. How is it possible that they are still funded when the debt is so blatently unsustainable?

    Note: this is not some red state/blue state moral outrage. Just an apolitical observation on something that I don't understand number-wise.

  13. "How is it possible that they are still funded when the debt is so blat(a)ntly unsustainable? "

    Because the alternative might look like this.

  14. No fair, yoyo, for that Daybreakers review/link.
    You got me scrambling to find my favorite Lubitsch film, "That Uncertain Feeling".
    A taste of the world before decadence and cynicism set in...

  15. Sorry Deb,
    But that is where I think we are (metaphorically) headed, just a matter of time.

  16. @Yo

    At least the vampires let people procreate in your version. ;-)

  17. And Deb, re: "Work is being done, and paid for in other ways" coming from your particular viewpoint in Europe.

    I just came across the following which support your particular view.

    I remember how popular the black market was in Mexico as a child, perhaps it will also make a come back here? ;-)

    Be well

  18. Lol, Thai, your economist on the link is even better at generalizations than I am, and that takes some doing...
    It's true that France THEORETICALLY has (had) a 35hr cap on the work week for a while there, instituted by the Socialist Party, but it was always pointed at as being the ROOT OF ALL EVIL, naturally because we all know that there is enormous social pressure on the individual to work until he drops because otherwise he will be taxed as... lazy and immoral (from a "religious" viewpoint, remember, sloth is a deadly sin...) and... unproductive if you TRANSLATE religious moralism into an economic language.
    We all know that we MUST work to eat.
    We have decided NOT to be ducks, and let the water slide off our backs.
    We have gratefully embraced our own alienation, or voluntary servitude, if you will.
    Management works long hours, in a hypercompetive atmosphere in France. And people walk around wondering... will I be next to get the axe, in many workplaces.
    Remember that France Télécon is moderately upset about the still continuing wave of suicides brought on by forced attempts to make French people, attached to land, homes, and roots, little carbon copies of the rootless (some would say mobile..) American workforce.
    A certain number of workplaces in France, particularly the privatized previous government owned workplaces, function like the concentration camps (Buchenwald, not Auschwitz, gotta keep those distinctions, there, ask Yoyo, he must know.) Like... you take a pile of rocks, and move it from one place to another, and when you have finished, you pick it up and move it back to where it came from.
    Demoralizing, just to keep the concept of "work" alive, and convince everyone that we must "work" to eat...

  19. By the way, Yo, just for fun, type in "Hypervisor" and "Thales" on Google to get a look at where we MIGHT be heading.
    Isn't predicting FUN ?

  20. "At least the vampires let people procreate in your version. ;-)"

    Only to feed off their labors.

    @Work to eat and unproductive work

    When all the energy slaves western society has depended on for the past century begin to vaporize into smoke, there will be more than enough not only productive but absolutely essential work for all the human and animal beasts of burden to perform, idleness will cease to be a problem in search of a solution.

  21. "Hypervisor" and "Thales"

    Another attempt to breathe life into Big Brother? It can only succeed if the populace allows it.

    I saw in the UK there is a campaign to disable surveillance cameras on local roads; there was a web site with pictures of more than a hundred wrecked spy-bots.

  22. Oh, YO, I love you.
    The Brits will destroy those spy cameras.
    The French will continue... COMPLAINING about them.
    That's what we do best in France. Complain...
    It's a national sport.
    And the Americans ? Just WHAT will THEY do with those spy cameras ??
    LOL. The guesses are open.

  23. People put up posters around here that point them out to motorists.

  24. Oh goody, Thai.
    You can just tell how... placid the American people are.
    Don't mistake me. Every advantage has its disadvantage, and vice versa or call it zero sum if you like.
    Revolution definitely has its bad points, lol...

  25. The vampires are inside the gates of the citadel:

    "Just last week, Virginia's incoming governor, Robert F. McDonnell, announced that he will let his Cabinet secretaries have dual allegiances by serving on commercial corporate boards of directors. Virginia is one of the states that permits this in-built conflict of interest between duty to the citizens and loyalty to specific corporate profit.

    So his new Secretary of Commerce and Trade, Robert Sledd, will continue to sit on three corporate boards. In his day job, Sledd is responsible for 13 agencies that regulate business policy, according to the Washington Post. On the side, he sits on the board of a tobacco company and a medical supplies business."

  26. Geez, with a schedule like that, maybe Mr Sledd can become virtual to deal with it ? ;-)

  27. That is a vital question that begs to at least be explored if not answered, namely, why hasn't there been revolutionary upheaval in the aftermath of the multitudinous abominations committed by our (captured) government? The bogus Tea Bag Brigade don't count.

    I'd offer my two-inflation adjusted- cents, but it's a tad late.

    In the meantime, down with both political parties! A pox on both their (sub prime and Alt A mortgage compromised) houses.

  28. Great post Hell!

    Also enjoyed the comments from Tiago, Thai, and others.

    Speaking of revolt by the masses....steps have been taken and are being taken to ensure the rebellion is short and weak at best.

    latest specifics here -

    Also I've come across a possible solution that I find quite interesting and fascinating. An attempt to control one's destiny and set the timing rather than sitting around waiting to be acted upon...

  29. Thanks for the link, Yophat.
    You know, even without going so far as to pull all our money out of the bank, all WE would have to do would be to... suspend our automatic withdrawals on our accounts.
    At the same time.
    That would have the convenient effect of dealing with... Hypervisor AND the banks at the same time, lol.

  30. Your Welcome Debra!

    Interesting thought you provide there! If we don't do something quick the government will end up being the economy....just surpassed the private sector.

  31. Don't usually make a personal appeal to the banking/doomer class of the blogosphere but my group has sent a bunch of people down to Haiti and they are really getting their collective you know whats kicked. sWhile the rest of us back fill for them, if any of you also feel like helping them out (they badly need cash- thought not as much as the bankers)- here is the link to help.

    Be well all

  32. If you had enough knowledge of the CDS relationships between companies, it is basic graph theory to show how the net value of CDS contracts can explode towards the notional value of CDS contracts (higher than the GDP of the planet) if AIG failed causing a chain reaction of failures around the world.

    You can also use computational biology to do the same thing.

    Notional vs net: complexity is our enemy

    "Imagine removing -- due to insolvency, lack of counterparty confidence, lack of shareholder confidence, etc. -- one of the nodes in the middle of the graph with lots of connections. What does that do to the detailed cancelations that reduce the notional value of $45 trillion to something more manageable? Suddenly, perfectly healthy nodes in the system have uncanceled liabilities or unhedged positions to deal with, and the net value of contracts skyrockets. This is why some entities are too connected to fail, as opposed to too BIG to fail."

    Googling Food Webs: Can an Eigenvector Measure Species' Importance for Coextinctions?

    Can Google's page-rank algorithm help save endangered species and ecosystems?

    Stefano Allesina with the National Center for Ecological Analysis and Synthesis at the University of California, Santa Barbara, and Mercedes Pascual of the University of Michigan at Ann Arbor have come up with an algorithm to rank the importance of species based upon the extinctions they would cause if they became extinct themselves.

    Vote Summary: Confirmation Ben S. Bernanke To Be Chairman Of The Board of Governors of the Federal Reserve System

  33. Hell... look at the work of Steve Keen who does dynamic modeling of the economy with ODEs.

    After starting my education in physics and switching to economics, I was dismayed to see the level of math and modeling going on in this field. Recursion, learning, and dynamic systems were not embraced but simple linear models were.

    I switched out of economics to finance and now trade.