Wednesday, March 10, 2010

CDS Regulation At The OK Corral

I have been beating the drum on CDS for a very long time (well, "very long" in terms of the market's attention span, which has more in common with fruit-flies than normal human beings; scroll down to the January 16, 2007 post in the Sudden Debt link provided above). Thus, I am partly bemused and partly satisfied by the current drive to put some order - at long last - in the Far West saloon that is the credit derivatives market.

Because of what has happened to European PIIGS, and the vested interests of US-based investment banks and hedge funds, said drive has originated and gathered steam in Europe, as this NY Times article points out. The Europeans want outright bans, taxation and heavy regulation, while the Americans want the CDS market to move to an exchange/central clearer in order to impose transparency, capital adequacy and position/trading limit rules.

In a nuthshell, the Europeans want to kill the cow while the Americans want it moved to a supervised dairy barn where it can be milked in more sanitary conditions, open to periodic inspection by health officials.

No matter which option you prefer, however, the market has already self-corrected a large part of the excess it created during 2006-08, as the chart below demonstrates. Therefore, calls to corral the CDS market is a bit like closing the barn doors after the cows have gone (see chart below).

                                                              CDS Outstanding                                                 Data: ISDA

That is not to say that regulation is not necessary.  It is, and very soon - immediately, even. 

So, I have a question relating to sovereign-risk CDS (i.e. insurance written on government bonds).  Can a hedge fund - or anyone other than, perhaps, a supranational institution - write insurance on a country??  

Let's all be serious for a moment, eh?  Because my memory exceeds that of a fruit-fly and I distinctly remember investment banks begging - yes, begging - to be bailed out by national treasuries, just a few quarters ago.


  1. aw shucks. Your prejudices are showing.
    The Saloon is right to your right on the screen, after you dodge that irritating pop up for the books you want us to read.
    CDS market derivative SALOON ?
    What, pray tell, do I have in common with those COWS ? ;-)

  2. Hello,

    I have already posted this question 4 messages ago, here it is again.

    In this interview, Yves and Chris seem to agree that prior to Delphi's bankruptcy in 2005, in case of a default, CDS buyers had to show the underlying assets to be paid. But they write that this rule was cancelled because in Delphi's case there were more CDSs than bonds outstanding which was a surprise.

    It is the first time I read this story, and the Delphi bankruptcy is not that old! Does this make sense?

    Hellasious, do you have more informations about this? Indeed I think that it is not possible to improve rules for the future when history is not well known!

  3. Dear Arnould,

    The current discussion abt. CDS regulation goes even further: speculators should not be able to write credit protection (i.e. sell CDS) unless they already own the underlying assets (bonds), or at least show proof of equivalent risk.

    It's the "insurable interest" concept, common to all insurance policies.


  4. "insurance" is the dumbed down version used to explain CDS to people that know nothing about it. in fact, one can easily replicate CDS with tradeable instruments (borrow bonds and sell them short just like equities). CDS is not different from other futures that are also often explained to people as "insurance" against smth going up or down. and yes, ANYBODY, who can post a margin should be able to make any sort of contract with anybody else.

  5. Hello Anonymous,

    I have no problem with over the counter contracts, provided in the case of CDSs, the seller is bankrupted if he can not honour his contract. Thus the utility of margin. But are contracts that require margin still over the counter, ie in the "any sort of contract" classification?

  6. Anon,

    Actually, no, you cannot EASILY replicate CDS by selling the bonds short. The key word here is EASILY, and if you are in the bond market at all, you know why (repo, margin, short squeeze, basis, negative carry, etc.).

    The major problem with CDS is exactly that: they have made betting against credit-worthiness VERY easy - and profitable in ways that it shouldn't be (i.e. manipulation).

  7. Anon:

    If it's so easy to "replicate" CDS, per your statement, then why don't we just eliminate CDS altogether?

    It couldn't be because you just want to be able to lie to more clients, could it?

    From an anonymous pro-finance troll? I'm shocked!

    You're going to have to bring better material if you want to "defend" wall street on this blog, mr. anonymous.

    Hell, any chance you can grab the IP of our shy guest?

  8. The chart shows about 32T vs 62T in 07. That means that central bankers are holding aprox. 30T in liabilities on their balance sheets..... Probably, most of it off the books....

    Things are sure looking good.... ;-)

    Best regards,


  9. That last paragraph was poignant to say the least, congrats Hells! Great post and great discussion here as always.

  10. You heard the one about a lawyer who moved to a small midwestern town? He nearly starved to death, then another lawyer moved in, they both now have more business than they can handle.

    Similar to the finance and medical industries in this country: Scams protect by government payoffs. Now that is a real cheap insurance policy.

  11. Hellacious,

    Selling CDS i.e. writing protection is equivalent to buying the bond on a leveraged basis. So when you say one cannot write protection without owning the bond, you were confused.

    I think along the line of what you are thinking, you mean to say one cannot sell CDS without putting up the cash/collateral required to finance the payout in event of a default.

  12. About four minutes into this clip there is an interview with a professor from George Washington University. Somehow the blaring contrast of this very bright person calling Greece's economy "doo doo" makes it all too terrifyingly real.

  13. You really sound like one of these moronic regulators who has no clue about what is you're talking about. It wasn't single name CDS and CDX/iBOXX/iTRAXX that brought financial institutions to their knees; nor was exposing oneself to Greece's credit deterioration/appreciation potential that nearly lead the Olive to be forever squashed. I've traded these products since they've been in existence in buy and sell side roles and with appropriate controls and risk infrastructure in place, they are fantastic tools for promoting lending, transferring risk and economic expansion.

    Where the market ran into trouble was when it got greedy. CDOs, CSOs and other bespoke products on underlyings other than corporate issuers generate massive profits for sell side instituions. A $10mm CSO on corporate issuers could generate on average $4mm in "modeled or theoretical" trade date profit; the profit would ascend to $6mm if you change the underlying to asset back securities. With 20 sell side institutions buying protection from customers 100-150/year on the same deal structure with roughly the same underlying for 6 years while ignoring the screams coming from prudent risk managers who were alerting senior management to absurd risk concentrations but were drowned out by the Syndicate and Underwriting Heads, it was only a matter of time before the system collapsed.

    So please, next time you use the phrase credit derivatives, know what it is you're actually referring to. We have enough Nancy Pelosi, Barak Obama and Charlie Rangel types riding the popular "beat credit derivatives" down wave - we don't need idiotic bloggers like yourself twisting truth into falacy.

  14. The problem is...
    WHAT do we do with all those guys and gals who want to cut off the head of the goose that lays gold eggs ??

  15. Re: "Can a hedge fund - or anyone other than, perhaps, a supranational institution - write insurance on a country??

    I will say that all of us are really lemmings if we think using perfectly good brainpower and resources to buy and sell stuff like this is a good use of our time and energy.

    And Re: "they are fantastic tools for promoting lending, transferring risk and economic expansion."

    It seems someone has been treating his own toothache with a little bit too much nitrous oxide.

    What is the "alpha" for the entire financial services industry anyway?

    But whatever floats your boat.

    ... Kind of reminds me of how some people think spending more money on trauma care is a great way to improve the growing epidemic of disabilities related to childhood ATV accidents as opposed to not letting our 9 year olds get into ATV accident in the first place?

    But as I said before, it seems to me there are a lot of other problems I would rather spend my money on than regulating this. I am not sure throwing more perfectly good talent and resources after bad decisions to regulate this stuff seems any wiser of the rest of us.

    ... Though I guess I would not have a problem if you wanted to get the resources to regulate this nonsense from the CDSs themselves. At least it would be zero-sum in nonsense theater but the rest of us would not have to pay any more for this silly complexity.

    I am not in favor of using general collective funds for this purpose, that's for sure.

  16. Dear Anon,

    I will first use your own words:

    "...with appropriate controls and risk infrastructure in place, they are fantastic tools.."

    "Where the market ran into trouble was when it got greedy."

    "..ignoring the screams coming from prudent risk managers .. but were drowned out by the Syndicate and Underwriting Heads.."

    Now, how is that any different in principle from what I am saying and why am I a moron whilst you are a sage?

    CDS are indeed a valuable tool when properly used - and therein lies the rub. Nitroglycerin is invaluable in heart disease, but it can also be used to carpet-bomb cities.

    In my opinion, the CDS bubble eventually fed upon itself and not only contributed, but was a main facilitator of the Credit Bubble. Cheap credit insurance made lending to terrible credit risks possible - and momentarily profitable, as you pointed out.

    For heavens' sake, why was Greek CDS trading at 35 bp two years ago? The same baloney was going on then in the economy as now (300-400 bp).

    ..and, just FYG, I fist came into contact with CDS in 1998 at a London trading desk..

    Be well.

  17. This morning I listened to our national radio commentator talking about all the... finger pointing going on in the EMU these days over the Greek crisis.
    Our EMU leaders are accusing the Greek government and society of wanting to take us all down, and prescribing austerity with a vengeance.
    The Brits are morose, saying "bad boys for setting matches to property when we STOLID AND RESPECTABLE Brits are constructively commenting on Facebook". Finger pointing is just so... BOURGEOIS and unproductive. Such a waste of resources, as Thai says.
    Our government leaders better wake up quickly and NOTICE that the REAL economy is made up of FLESH AND BLOOD PEOPLE, and that these people WANT JOBS. (Indeed, I think that SOME of our government leaders are aware of just how dangerous it is to give precedence to (abstract) filthy lucre OVER flesh and blood men and women.)
    Otherwise, I am afraid that since WE on this blog luxuriate sometimes in scapegoating, OTHERS will not hesitate to make heads roll. And perhaps NOT FIGURATIVELY ??

  18. Thai,
    Since you brought up the topic of children's welfare and as a public health professional and father of four sons, I thought you might be interested in this article about child nutrition.

  19. Make a distinction between single credit default swaps or CDS as you refer to it and the product which brought AIG to its knees - incorrectly blended in with the aforementioned as credit derivatives but actually were CSOs and CDOs. AIG did not do ONE single name credit default swap trade. The sold protection on highly structured, highly leveraged, highly customized and highly illiquid collateralized synthetic and debt obligations for which there has never been, even in times of tight spreads, a remotely decent secondary market. These trades AIG did, and as you refer to in your preable as credit derivatives are NOT the same as single name credit derivative and CDX/iBOXX/iTRAXX trades - for which there is an absurd amount of transparency, market depth and liquidity.

  20. Why don't we regulate the democratic slimeballs in Washington. Bill Clinton, getting a BJ in the White House, Charlie Rangel - head of the tax writing Ways & Means Committee, who didn't pay taxes on income because he said he didn't know he had to, David Patterson, Governer of NY who help convince a battered woman not to press charges against his #1, Barak Obama, for spending tax payer dollars with a fever that crack addicts seek crack, Nancy Pelosi, who complains about the type of Boeing 737 or 757 taxpayers pay for her and her family to travel around the world on. I recommend everyone move out of the United States as soon as you can. Why the heck should I continue to work when I take home $80,000 for every $200,000 I make. So I can pay for crack addicts and welfare receipients including Obama's aunt in a Boston housing project. And by the Mr. Obaba, why haven't you produced a birth certificate and how, as an American citizen were you able to travel to Indonesia during your Black Panther college years when American citizens were prohibited from doing so? This country sucks, European regulators who want to ban naked CDS trading suck and I still think the person who wrote this blog is a MORON.

  21. "how, as an American citizen were you able to travel to Indonesia during your Black Panther college years when American citizens were prohibited from doing so?"

    Americans have never been prohibited from traveling to Indonesia AND Obama spent his childhood in Indonesia, not his college years.

  22. Anonymous, the mode d'emploi (instructor's manual) on this blog dictactes that we are too sophisticated to insult in the incredibly boorish manner that you just attacked this blog's author.
    Try acquiring some more advanced rhetorical skills before attempting to express yourself here again IF YOU WANT PEOPLE TO LISTEN TO YOU.
    And you should realize that PUERILE attacks DISCREDIT your point of view. Inevitable.
    That's NOT what you're looking for, is it ??

  23. Yoyo, totally off topic, but tonight I saw "A Serious Man". The dentist scene, the whole bit with the rabbi telling the story and the guy's reaction to it is PRICELESS !!! Have you seen the film ? Recommended specially for YOU.

  24. Do you think that (if we actually had the choice) we should utterly eradicate the small pox virus from the planet, or keep it around to study its DNA?

    I realize the example I am using to make my point is perhaps a tad extreme, but, there it is. I invite everyone, save for, uncivil, vulgar, dyspeptic, Rush Limbaughesque canker sores sporting the cowardly moniker anonymous, to answer the question.

  25. Edwardo, zero sum

    But if I have to chose- keep it

    PS- I thought you might get a chuckle out of this- knowing your views. It was kind of a bummer to read from my own views... Though I admit it did force a sardonic smile. :-(

    Yo, is there anyone else you also feel like keeping up to date on the latest skirmishes in The Forever War? I would most appreciate it. If I must play the role of defender of the faith, so be my lot in life. There are certainly worse roles I could play in life. AND it is getting a bit stale.

  26. Well, Thai, it appears that wind turbine supporters, and the turbines themselves, are full of hot air.