Charles on... anything that comes along

I said I’d explain Credit Default Swaps. Just to give you something before it’s on everyone’s lips again. As it may be this coming week with the Lehman’s CDS auction. So here’s the reasons why they are toxic, with (hopefully) some simple-to-follow spin.

You live somewhere. A house or flat, say. You have stuff in it. Naturally, you take out insurance against your place burning down. You contact an insurer, who agrees to insure it, for a premium you pay. If it burns down, they’ll pay out.
Now, you can’t take out insurance against *someone else’s* house burning down – in law you don’t have any “interest” in it (and it might make people think you wanted it to burn down, because you’d get the big payout with no personal loss).

But with CDSs, anyone can play. They are insurance against any house (read: financial deal) burning down. You can get one, two, three, four, five, any number of people betting each other about whether this or that financial thing (company bond, mortgage-backed security, Treasury bond, etc) is going to turn into dust.

As long as you can find someone who’ll be a counterparty – that is, take the opposing view, and take the position of “insurer” – then you’re off and running.

And this market is completely unregulated. So to quote Dirk van Dijk’s explanation (at, I think, the original place it appeared):

If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don’t pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw).

With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like how a Life Insurance company has to have enough cash on had to pay off on your policy in case you die.

However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck.

In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members. In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can’t just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them.

This is not true for the CDS market. You are perfectly free to take out a “life insurance policy” on GM, GE (GE) or any other firm that issues a bond, and you do not have to be holding the bond. You can even take out a “life insurance policy” on the synthetic garbage the Wall Street has been pumping out.

And when people suddenly wake up and go “huh? Why did I think that people would pay out on policies on mortgages with horrendous reset payments?”, and those mortgage-holders default in huge numbers, your CDS suddenly comes due. Someone’s on the hook. Is it you? Is it that guy over there? How do you know? If they offer some financial stuff as collateral against a three-month loan they want of some money, how do you know which of its CDSs and so on are good and which are junk – or, worse, expose you to paying out on something that might happen in those three months?

The market in CDSs ballooned because, as van Dijk explains, hedge funds found them amazingly useful:

People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not.

However, suppose that the person who they made the bet with goes bankrupt themselves and can’t pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of “cascading cross defaults” comes in.

And that’s where we are. If you want a little reassurance, though, there’s Paul Kedrosky’s Infectious Greed blog: he used to be a broker/banker/on Wall Street, and writes a very informed (well, duh) blog.

For instance, you can stop worrying about CDSs on mortgages. They’re only 1% of the CDS market, which has been downsized! Yes, to only $34.8 trillion! Yes, I said trillion! So that’s.. um, 0.34 trillion of mortgage-based CDSs – or $340 billion worth. Come on, that’s just a rounding error, isn’t it?

As Kedrosky , points out: ”

The Deposit Trust & Clearing Corporation folks do some weekend working debunking myths about credit default swaps (or, as I like to call them, rodents of unusual size). Among other things, the DTCC says that net Lehman-related CDS fund transfers will be closer to $6-billion than the $250 to $400-billion figures that had been bandied about last week. It also says that less than 1% of the CDS contracts extant are directly mortgage related.

And as has been pretty obvious, the size of the CDS “market” has been wildly overstated, in many ways.

Reported estimates of the size of the credit default swap market have so far been based on surveys. These surveys tend to overstate the size of the market due to each party to a trade separately reporting its own side. Thus, when two parties to a single $10 million dollar trade each report their ‘side’ of the trade, the amount reported is $20 million, which overstates the actual size by a factor of two since both reports relate to a single $10 million contract. When examining the outstanding amount of actual contracts registered in the Warehouse (not separately reported ‘sides’) as of October 9, 2008, credit default swap contracts registered in the Warehouse totaled approximately $34.8 trillion (in US Dollar equivalents). This is down significantly from the approximately $44 trillion that were registered in the Warehouse at the end of April this year.

Hey, so that’s $10 trn we’ve pared off right there. Actually, the CDS market must be a lot smaller *in terms of the money changing hands* – rather as the options market is far smaller than the numbers quoted, because not all options are exercised.

The trouble comes though once securities start to fall, bonds turn to junk, and the CDSs come due. Then people are on the hook for money they may very well not have. It’s the whole margin call thing that magnified the 1929 crash – but this time, global.

Did I mention that unregulated selling of financial instruments is bad? OK, now I have.