Sunday, January 9, 2011

CDS: Hedge Or Hog?

Are credit default swaps (CDS) legitimate hedging tools or just another way to bet the ponies?

I was there at the beginning, so I know that CDSs were originally designed to hedge or reduce credit exposure.  It was a highly specialized, custom-made and low-volume business stuck in quiet corners of trading floors, away from the glamorous hot spots of foreign exchange, money markets, derivatives and bond trading.  With trade documentation going back and forth, individual trades frequently took days to complete.

It was slow going for several years - and then everything changed. From a very modest $630 billion notional outstanding in the first half of 2001, CDSs exploded a hundredfold to $62 trillion at the end of 2007 (see chart below).

CDS Amounts Exploded 100-Fold Within Six Years

This mad rush into CDS was not caused by some pent-up craving to hedge credit risk  - quite the reverse, in fact.  Instead of seeking to reduce credit risk on existing bond portfolios, the new players who came into the market after 2004-05  used CDS as riskier and more volatile alternatives to straight bonds, viewing them as juicy income streams.  That's when CDSs ceased to be "hedges" and became "hogs".

This became very obvious with the issuance of synthetic and hybrid CDOs, types of second-order derivative products made up of a mixture of various CDSs, that acted like bonds on "speed".  In just three years between 2005-2007 a total of $160 billion of  purely synthetic CDOs (e.g. CPDOs) were issued globally, while cash flow and hybrid CDO issuance reached nearly another $1 trillion.  (All Data: SIFMA). 

Pointedly, a stunning 90% of all CDO issuance in this period was done for arbitrage purposes, i.e. to profit from the spread between the expected yield of the underlying CDO assets (e.g. CDSs) and the financing costs of the CDO tranches themselves.  This incredible percentage, more than anything else, reveals the true purpose of derivative finance: leveraged speculation.  It reveals that hedging - the usual excuse paraded out when credit derivatives come under criticism - was very far from the minds of those who dealt in them, since only 10% of the issues were "balance sheet" deals done to legitimately remove assets or their risk from originators' books.

It must be pointed out that CDS were not the only derivatives that went ballistic in that time.  Total derivatives outstanding reached a face value of $700 trillion in 2008 (see chart below).

Anyway, it takes two to do the CDS tango so there's an obvious question begging to be asked: Okay, greedy speculators and/or foolish pension fund managers knowingly or unknowingly sold credit insurance before the crisis on the cheap (see chart below) and by the boatload .....  But who bought?

 Chart: BIS

Who were so prescient and so smart as to keep buying the trillions of CDS that fools were literally giving away before the crisis hit?  Well, they didn't save AIG from collapsing into its CDS crater for the benefit of mom and pop policy-holders, did they?

The trouble with the property and casualty insurance business (and CDS are essentially P&C insurance products, no matter what bank traders say) is that it is very, very cyclical.  Competition increases and premiums  charged collapse when claims are low, but then a major disaster occurs and everyone scrambles to raise rates.  Sound familiar?

Right now, 9 out of the top 12 entities in CDS by notional amount outstanding are sovereign nations like Italy, Brazil, Spain and - of course - Greece (see chart below, click to enlarge).  Yes, it does make some sense as things stand right now with the CDS market, because nations are the largest debt issuers.  But how much sense does it make to allow  punters to go on betting on sovereign defaults, when it is the taxpayers who bail out the punters?  This is exactly like "Heads I win, tails you lose".

When you think about it, it's a paranoid/schizophrenic situation: paranoid CDS players have one personality that bets furiously against the credit of nations, driving up borrowing costs and forcing taxpayers to foot the increased bill.  Their other personality fervently believes that nations and taxpayers are the ultimate guarantors of the survival and smooth functioning of the financial system.  Can they have it both ways?  Well, sure - but only for as long as the sovereign CDS bubble lasts.  Because like any other bubble this too shall burst, and spectacularly so.  

Let me put it another way: how long can a dog keep biting the hand that feeds it?


  1. How long can a dog keep biting the hand that feeds it?

    How about: as long as it controls the levers of power.

    I think your analogy is wrong. How long can the dog's owner keep abusing it until it bites back? So far, the dog's owner (finance) has gotten the dog to fight other dog for scraps of food. Perhaps the dog will never know better.

  2. Actually, in the analogy finance is the dog and all the rest of us are its owners. We're feeding it and it bites us, the ungrateful mongrel. Pretty soon we're going to take it to the pound...

  3. A bit more complicated than dog (finance) and owner (us). The "us" is couched in and intermediary, the government, and people are focused on the mis-deeds of government rather than the source, finance.

    As long as the perpetrators are hidden and protected inside the intermediary the game will continue.

    That why it is so important to keep emphasizing the source of this problem.

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  5. Hell, would you be so kind as to comment on the zeitgeist movement? It seems to be that it's views and yours share some similarities. Thanks.

  6. Cottonbloggin:

    I watched a video at the Zeitgeist Movement's website regarding their belief system (all 97 minutes of it). It is a Utopian vision of a perfect society and ideology (politically expressing an almost anarcho-socialist vision of governance -- if not exactly that). I don't think Hellasious -- and certainly not I -- believes everything this group advocates. While it is true that we both would advocate a movement toward more alternative energy, there is much more to the group than a more efficient use of resources.

    What is it with all of these groups lately arguing for anarchy in one form or another? Has the whole world gone mad?

  7. Do you mind commenting on the buyers and sellers of CDS? You mentioned that sellers of CDS are generally property casualty firms.

    My question is, why is there not outrage towards the sellers of such instruments? So much has been said about how awful buyers of CDS are yet no comments are made about the sellers. Aren't they liable for poor decisions? I am not an expert about this nor do I run a fund. Just curious about your thoughts. Thanks, Mike

  8. I'm certain that CDS sellers are NOT mostly P&C firms. I was drawing a parallel with them. That said, AIG was one of the biggest sellers of CDS up until 2008.

  9. Okie--

    Hell and Zeitgeist both advocate for change in the monetary policy. And both seem to have come to their conclusions based on a reasoned analysis of the financial system: that money is debt, as well as the permagrowth v. a sustainable economic system where long term interests are taken into account argument

    It seems to me that Hell and someone advocating for zeitgeist would (probably) have a pleasant and agreeable conversation about the challenges and limitations of our current financial situation, which would continue until the conversation turned to the specific solutions on how to move forward with the information.

    Regardless... I thought Hell would be interested to see that the "money is DEBT" meme which he has drilled into our head, is now cropping up in all sorts of places.. crackpot and MSM alike-- FYI, i could also have pointed out one of "this american life's" most recent episodes where the byline reads something along the lines of, "the invention of money... you'll be interested to know, it's nothing but fiction"

    Anyway, I thought hell might be interested in commenting since its NECESSARY for the meme to propagate and become "common" knowledge before any change can be had, but... in the process of it becoming "common knowledge" there also runs the risk that humanity chooses to apply that information in ways that may not necessarily be any better for us. But, whatever...

  10. Cottonbloggin:

    If I heard it right in the video, it sure sounded to me like they were advocating the elimination of money altogether, not a change in how it is counted.

  11. Cottonbloggin:

    Perhaps this is a bad time to bring it up, but Zeitgeist now has an infamous connection.

  12. Re: Zeitgeist

    I think the best attitude to take in discussing monetary economics is to shrug and say" "It's just money. Now, let's talk about reality".