Stormy Weather in the Credit Default Swap Market

Credit default swaps (CDSs) – bilateral insurance contracts against bond default – are now in the eye of the storm. Worries about counterparty risk are mounting among market players and is multiplied by the lack of global netting. This column discusses lessons from the 2005 crisis in CDSs.

11 Responses to "Stormy Weather in the Credit Default Swap Market"

  1. CS   October 17, 2008 at 10:04 am

    Inneresting; what’s to prevent a party from buying up swaps on a company and then shorting it into bankruptcy (or ruining it in some other way) in order to collect. ie the financial equivalent of arson. ?

    • TooBigToFail   October 17, 2008 at 6:17 pm

      I read that this happens all the time, and you can buy these things on stuff you don’t even own. Plus this is insane. Banks lending to people that can’t afford to pay it back, and, it’s risk free? It’s this hell without the sin, goldilocks economy BS that is the problem. I have zero confidence that this will end nicely.

    • M   October 18, 2008 at 7:12 am

      You cannot short a company into bankruptcy using CDS, because a CDS on a company has no impact on the core capital of the company or its ability to raise additional capital, like with stock. If the CDS spreads move out, it will raise questions on the underlying company and people might react in panic to it and sell stock or so, but as such it has no impact on the company itself.

      • bill   October 26, 2008 at 11:55 am

        ya, I’m sure if all the panicking people ,sell all their stock incompany,that it does not hurt the company!!!!! ya O.K misterbernanke ha…ah..aaaa..ha!!!!!!!!!!!!!!!!

  2. Dan W   October 17, 2008 at 1:06 pm

    The LIBOR Illusion: Just WonderingMany economists today (these days) are pointing to the LIBOR as being a prime indicator vis-a-vis the current credit market freeze. LIBOR is high, and therefore credit is frozen. OK, I am simplifying the arguments grandly, but here is my point:Let’s say LIBOR comes down precipitously, as does the TED spread. These indicators would seem to point to an environment that is more conducive to risk-taking, and maybe would lubricate the credit market. I would posit, however, that risk aversion, per se, is no longer the primary variable/motivator effecting the credit/load marketplace.What this crisis has accomplished—more so than any previous crisis—is to bring into the light many of the fatal flaws that exist in the system of Fractional Reserve Banking. And these flaws have been underlined particularly by the current Credit Default Swap debacle. Let me expand a bit.As we all know, our system of banking is one in which MONEY IS DEBT. There are no longer minimum capital reserves that a bank must have on hand, as was the case, for instance, when a bank needed a 1:10 ratio of reserves to debt in its coffers. Unlimited fiscal growth, therefore, has, for decades, been predicated on the growth of debt (money) and on the ultimate servicing of said debt—which would then logically create more serviceable debt, and so on ad infinitum.But over the past, oh, 5-7 years we’ll say, banks and bankers and folks in the financial industry have, without any regulatory oversight, created and exploited a market of default “insurance” (called ‘swaps’, so that they appeared to fall outside of regulatory control) that has led to an exponential growth in the world’s overall debt. 50+ Trillion $$$ in worthless, unbacked, “assets” that financiers have used to become part of the mega-wealthy while leaving the planet in a huge economic morass.You see, since these Default Swaps are unregulated, unregistered, secretive, hidden transactions, no one really seems to know how much debt is out there, or who owes whom what, or when they themselves are all of a sudden gonna find out that their exposure in this market is way beyond their means to pay off their obligations. So all of banks and financial institutions are holding their collective breath, waiting to see what happens as these swaps hit the light of day.Now, add to this another variable. EVERYONE with half of a brain understands that Henry Paulson is a liar and a cheat. Everyone knows that he is an old Goldman Sachs guy who has a lot of self-interest when it comes to protecting this system and making sure all of the fraud that has taken place doesn’t become front page news. And no one knows this more than do other folks in the financial industry. Now don’t get me wrong: they may not all totally agree with how Paulson is “handling this crisis”, but they are silent and quiescent because they are terrified at what could happen if the truth really came out.OK, one final variable. Have you been listening to people like Nickie Sarkozy over in France? The European leaders are pretty pissed off at the U.S. for allowing this situation to evolve, and there’s a lot of sentiment out there that points to a little global game of “kill the carrier” once things settle down a bit. No, I don’t mean WWIII (literally), but I DO mean that the world is not going to let the United States Congress, banking industry and FED create monetary policy that is not subject to global oversight. Now, to this point, George Bush and his cronies have made it pretty clear that they think the United States is not beholden to the will of theInternational Court in The Hague—what will happen when an international monetary and financial regulatory body is created and the U.S. says it doesn’t recognize the authority of that body? You think the world is gonna shrug its shoulder and say—“OK”.So, 4 variables in totum:1. A growing lack of trust in the age old system of Fractional Reserve Banking2. 50+ Trillion $$$ in hidden, lurking worthless “Assets” and debt, ready to pounce like a cat in the night3. A core of economic and political leaders whose veracity is in question (put nicely)4. An international community that is finally ready to challenge the hubris and arrogance of the U.S.So back to the point of this post. As economists and would-be pundits wait for the LIBOR and TED spread to come in, and wait in turn for the concomitant loosening of the credit squeeze, one has to wonder why ANY bank or other financial institution would feel sanguine about lending anything to anyone!??!? The basic realities of a broken system, a dishonest and out-of-touch leadership, and a realization that the world is changing in ways that we could never have imagined (both economically and politically), and one has to wonder why—unless Paulson and Bush show up with guns and demand the banks lend out the $$$–why in the hell would any of these institutions loan these “monies” that they could, instead, simply sit on and use to feel a little better about riding out the storm.Just wondering.

  3. Guest   October 17, 2008 at 10:35 pm

    I don’t know why there is such a disconnect between the reality of the CDS debacle and the general public’s understanding of that reality. This is the mother of all financial storms, nothing in human history really compares to this because nothing like this was possible until you had the perfect storm of the last few years. 70 Trillion Dollars of Insurance was written without reserves or regulation, on an underlying insurable interest of about 5-7 trillion. Imagine have 10-12 fire policies on your house, and all 10-12 insurance companies having no reserves or regulation? The house will of course burn because the wild over insurance. At the same time we have a period of light or no regulation, so no one is watching this house of cards get built up.This is the PERFECT STORM. And we have only felt the first few breezes of this storm.

  4. Anonymous   October 19, 2008 at 11:01 am

    The Governments of the world have to just nullify these fraudulent CDS contracts and that would solve the problem. Those funds that bought CDS naked (i.e. without owning the underlying credit) will get screwed, but the financial system would be saved. And in fact, those that sold CDS can also make up for some of the losses of the naked buyers.After they nullify the CDS they can then make all CDS illegal (which they should), or just regulate it heavily.

  5. GreatFinn   October 19, 2008 at 5:30 pm

    I have seen several calls for “the government” or “governments” to simply cancel “all” CDS or “fraudulent” CDS. Is this actually possible? I don’t mean theoretically possible, I mean real world possible. And is there a down side to this? As in, such action making things worse?

  6. Wintermute   October 24, 2008 at 4:38 pm

    The CDS market can be made safe with one overarching regulatory principle: buyers must own reference entity paper (underlying bonds) equal to or more than their CDS purchases i.e. No “naked” CDS buying. This would deflate the CDS bubble to a 50th of its huge size. Once this is done – then transparency, exchange trading, central settlement – can all be made to work.The problem with cancelling all CDSs right now is the broader problem of monkeying with free-markets and destroying investor trust in them. Capitalism is getting bad press – but this is the engine of our high living standards. it must be defended. Bans on short-selling, mark-to-fantasy, lock-limits, market closures are all body-blows to the level-playing field of regulated market mechanisms. Wholesale annulment of legal contracts is another seriously negative action.I have often considered that the single most important reason that Africa is poor and the West is rich is that in Africa no-one takes the legal system seriously. So there is no protection of ownership and property. This is a foundation stone that must be protected – even it it means the credit crisis gets worse before it gets better.Free markets could be set back decades under such an attack against founding principles.

  7. Guest   October 24, 2008 at 6:16 pm

    Cancel all CDS’s unless the buyer can prove an insurable interest. As in life insurance, no one can buy a life insurance policy on John Smith unless the buyer has an insurable interest in John living. Buying such a policy without an insurable interest is called “against public policy”. If the insurance industry was run like the CDS industry, there would not be many John Smith’s in the world.

  8. bill   October 26, 2008 at 11:50 am

    CD’s should be illegal,and banned .PERIOD