Streetwise Professor

January 26, 2009

CDS Follies

Filed under: Derivatives,Economics,Politics — The Professor @ 8:24 pm

The NYT reports that the Obama administration is planning to require central clearing of CDS products:

The administration is also preparing to require that  derivatives  like  credit default swaps, a type of insurance against loan defaults that were at the center of the financial meltdown last year, be traded through a central clearinghouse and possibly on one or more exchanges. That would make it significantly easier for regulators to supervise their use.

. . . .

Officials said some credit default swaps with unique characteristics negotiated between companies might not be able to trade on exchanges or through clearinghouses. But standardized or uniform ones could.

“We want to make sure that the standardized part of those markets move into a central clearinghouse and onto exchanges as quickly as possible,” Mr. Geithner testified. “I think that’s really important for the system. It will help reduce risk and the system as a whole.”

The new trading procedures for derivatives could also enable regulators to impose capital and collateral requirements on companies that issue credit default swaps that would make them safer investments.  American International Group, one of the largest issuer of such swaps, never had to post collateral and nearly collapsed as a result of issuing a huge volume of such instruments that it was unable to support.

I’m tired of writing about why mandatory clearing and/or mandatory exchange trading is a bad idea, and perhaps you’re tired of reading about it.   Suffice it to say that it is possible to improve transparency to regulators without creating a clearinghouse and the associated risk sharing mechanism that can actually exacerbate systemic risks.   Moreover, I have yet to see any serious consideration from regulators about the effects of concentrating risk in a single entity that almost certainly has less information that existing bilateral market participants.  Nor have they presented any serious comparative analysis of the costs and benefits of alternative default risk sharing mechanisms.  The analysis presented in public, including in Congressional testimony, does not even reach the level of superficial.  

For those who want a more detailed analysis supporting my position on the undesirability of forcing clearing, I suggest my piece in the most recent issue of Regulation.  I’ll link to my gruesomely long analysis when I have a chance to move the latest version into my webspace.    

I should also note that this is only one issue among many that makes me less than impressed with Geithner.  His comments on China were foolish.  His behavior on his taxes was no mistake, and cast serious doubts on his judgment.  

But, perhaps we’ll be lucky to escape with only mandatory clearing, rather than something more draconian.  Also in today’s NYT, Gretchen Morgenstern  Morgenson [HT John M] argues for far more onerous restrictions on the CDS market, perhaps including its outright elimination.

Morgenstern’s  Morgenson’s “argument” and “evidence” in support of this position are seriously lacking, to say the least.  She completely misses the point on the role of CDS market in particular, and the operation of risk sharing (i.e., insurance) markets in general.   Consider this example of her clueless prose:

Normally, if a company goes bankrupt, a trustee steps in and helps it get back on its feet. The process can be brutal for creditors, suppliers and employees. But the ill effects of a bankruptcy are magnified if billions of dollars in insurance must also be paid out by companies that wrote protection on a beleaguered company’s debt.

To observe how idiotic this is, consider the following rewrite:

 But the ill effects of a hurricane are magnified if billions of dollars in insurance must also be paid out by companies that wrote protection on a stricken city’s property.

Uhm, Gretchen, babe, think of how brutal the process of a bankruptcy would be for, say, “creditors” if NONE of them can insure against bankruptcy.   Do you think it’s just possible that some creditors are better off because they are able to insure against the event of a bankruptcy by buying protection through the CDS market?  

Sure, it sucks for the protection seller–or the company that insures houses against hurricanes–when it has to pay out.  But the whole idea behind this market, and the market for property insurance, is that it would suck a whole lot worse if creditors/property owners had no ability to protect against such adverse events.  It’s an ex ante mutually beneficial exchange of risks.  It’s beyond weird to criticize these instruments because they perform their risk transfer function in the way the parties agree.  

Morgenstern  Morgenson cites two supporters of heavy regulation of CDS markets,  Sylvain R. Raynes and  Christopher Whalen.  Whalen argues for 50 percent margins on CDS trades.  Just where does that number come from?  Any thought to the possibility that excessive collateralization can be unduly costly?  No evidence of any thought, whatsoever. Raynes wants to euthanize all outstanding CDS contracts, effectively unwinding them.  That is, he wants to require termination of outstanding insurance contracts that consenting adults entered.  So, how is this supposed to make them better off? Moreover, the existing counterparties have the ability to reverse deals, if it is in their mutual interest.  The fact they don’t do so, tells you something–or should.  But apparently not Mr. Raynes–or Ms. Morgenstern  Morgenson.

Here’s another pearl of (populist) wisdom:

Obviously, something must be done to eliminate the possibility that taxpayers will wind up paying off entities that essentially bet against the American economy.  

Betting against the American economy!  How unpatriotic!  

Note the “essentially” in that sentence.  She had to say that because those buying protection didn’t ACTUALLY do any such thing–they bought protection against a bankruptcy in order to preserve their wealth in such an event.  But to make it sound really bad, she has to demonize prudent financial strategies.  

There’s an argument as to whether the government should make counterparties whole, or let them receive only incomplete coverage because the protection seller can’t perform.  You can make that argument without stupid BS about “betting against the American economy.”  I mean, grow up.

Here’s another howler:

Mr. Raynes’s proposal would treat hedgers — buyers who bought C.D.S.’s to protect themselves because they actually hold the underlying debt — differently from speculators who bought C.D.S.’s simply to bet against a troubled company.

Some basic finance here, people–derivatives markets are markets to trade risk.  Usually they REQUIRE speculators to operate effectively; without speculators, who will take the risk from hedgers?  (Insurance companies are “speculating” on fires, hurricanes, and other bringers of human misery.  Want to get rid of them too?) This demonization of speculators, and proposals to treat them differently, is more populist boob bait; various proposals to regulate energy derivatives mooted over the summer contained similar inanities.  

Moreover, it will never work.  I defy anyone to find a way to separate hedging sheep from speculative goats that a couple of lawyers won’t be able to circumvent in about 10 minutes.

I’m all for a serious debate about CDS markets, and ways to improve their efficiency.  Unfortunately, a serious debate has yet to begin–at least on the pages of the New York Times.

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2 Comments »

  1. SWP,

    You make a completely persuasive case!

    And yes, Gretchen is completely out of her depth but her name is Morgenson not Morgenstern.

    Just nitpicking—that’s all.

    Comment by John McCormack — January 27, 2009 @ 9:22 pm

  2. John-

    Speed kills yet again.

    Duly noted. . . will edit.

    Welcome back. Hope all’s been well.

    The ProfessorComment by The Professor — January 27, 2009 @ 9:45 pm

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