At $45 trillion, the notional amount of CDS in existence is now fast approaching the total amount of credit market debt outstanding in the entire world.. By comparison, the capitalization of the entire US stock market is $20 trillion. Sudden Debt, CDS: Phantom Menace
One major calamity on the horizon, and arguably what has spooked the bejeezus out of Paulson and Bernanke, is the unregulated nightmare of Credit Default Swaps (CDS), a derivatives market that includes mortgage-backed securities, their derivatives, and many, many other types of (generally safer) debt such as corporate bonds. The CDS market is huge. Like $45 Trillion huge. Essentially, a CDS is a contract that acts like an insurance policy (but isn’t) between two parties. The buyer owns an asset (well, sometimes, but we will get to that) and pays a premium to the issuer to insure the asset against default. The purchase of a CDS was yet another ‘magic’ solution to create the appearance of a safe asset, since the CDS could be used to improve the credit rating of the debt instruments (bond, etc.,) that the CDS’ were used to hedge (which is why you will hear more about fraud at ratings agencies in the future). In effect this allowed the purchasers of CDS to hold assets that might other wise have been too risky for them to keep on their balance sheets.
Unfortunately, those issuing the CDS (AIG, for instance), did so using massive leverage, so they are in no position to pay off these claims in the event of market wide credit events (e.g., a bankruptcy epidemic). Additionally, being unregulated made the counterparty relationships opaque, meaning none of the companies purchasing CDS insurance know how much or what type of exposure the firms issuing the CDS have to other firms or assets. This makes everyone a bit uneasy. Additionally, a lack of CDS oversight meant that these instruments could also be purchased by third parties for speculation purposes. You read that right, this scheme also operated CDS’s as a casino, with fantastically high stakes. To make matters worse, the vanilla story of how CDS’s CDO’s (derivative instruments packaged with, and hedged by CDS contracts) function isn’t the whole truth, as is evident from this inside account at The New Combat of the real purposes that these instruments have been put to.
To give you an idea of the potential for disaster here, several articles have appeared recently that hint at the nature and massive scope of this problem. For instance, CDS issuance and a lack of collateral by a small investment office of AIG led to their near collapse. This event has been documented in a suprisingly good article from the NY Times. The danger of a CDS ‘credit event’ cascade seems to have been the reason that the Treasury moved to nationalize AIG. This event would have likely precipitated the downfall of the investment titan Goldman Sachs which, due to its ties to certain government officials and NGOs, is among the sacrosanct institutions that will be saved at any cost (to the taxpayer).
So now we come to the current situation, in which the taxpayer is being asked to not only provide the backstop as the lender of last resort (Warning: PDF), but is asked to hand over tremendous authority to the Secretary of the Treasury in the process. How did we get here? The short answer may be that when Secretary Paulson let Lehman Brothers fail, CDS exposure triggered a number of credit events that resulted in a major crisis in confidence among the big players, and that led to a near seizure of the already strained credit markets. The result is a real danger that a tsunami of CDS unwind becomes necessary, and we are all expected to hand over an enormous amount of power to a small group of individuals who were complicit, or worse, in creating the problems to begin with. IMHO, this should make us very, very wary of the motivations of the individuals ‘managing’ the current crisis and the massive resulting consolidation that is taking place within the international banking industry as a result.
Note: This is my imperfect explanation of a market that only a few select economists profess to understand. Please click through the links above and below for a more thorough explanation, I guarantee you’ll be both informed and enraged.
Further Resources:
Hello there,
I was happy to see that you linked to my piece from August 2007 (seems like yesterday): What is a CDO (I mean really)?
I note however that the mention comes is in a sentence and a paragraph about Credit Default Swaps (not CDOs).
One should realize a CDO and a CDS are very different animals.
1(a) A CDO is a vehicle constituted by some seven to ten contracts, all knit together and working as a finely tuned (ahem) machine.
Often two or three of these contracts are swap agreements, appended to provide protections to the investors in the CDO bonds (tranches).
1(b) A Credit Default Swap, on the other hand, is a single swap agreement.
(Except in very odd cases, swap agreements are executed on a standard ISDA form, which gets tweaked in detail to serve its desired purpose.)
2(a) The point of a CDO is to press income and principal payments from a large underlying pool of other financial instruments through the risk-stratified tranches to produce stratified returns. The riskier tranches pay higher interest, but are the first to suffer losses when mishaps occur in the underlying pool.
Thus, the CDO looks like and functions as a diversifed investment vehicle — although (as the TNC piece explains) the genesis is likely to have been a particular guy’s problem.
2(b) The point of a CDS is to hedge against the future.
The prime party (the Protection Buyer) pays a small periodic fee to the counterparty (the Protection Seller). In turn, the latter pledges to compensate the Protection Buyer upon the occurrence of events specified in the contract.
So the Protection Seller is kinda like an insurer, receiving regular premiums in return for assuming a specified risk.
3. A last note: In the mainstream press, “CDO” is often erroneously used to refer to Collateralized Mortgage Obligations. But there are important differences between these.
(a) The underlying pool of a CMO consists entirely of mortgage bonds — or, to speak precisely, Asset-Backed Securities (ABS) the underlying assets of which are mortgage loans (and perhaps commercial leases). The acronym MBS is used (Mortgage-Backed Securities) for this subset of ABS.
In contrast, the underlying pool of a CDO (at least all I’ve ever laid eyes on) is diversified. E.g., often deals I worked on restricted MBS to 2 to 4% of the pool.
(b) The differences noted above are important when one turns to the now-crucial notion of “market value.”
(i) CMOs — because their pools are homogenous and because their raison d’etre is truly public (to distribute the risks and rewards of mortgage lending to the wide world) — trade (or used to) fairly efficiently in secondary markets.
That is: The mortgage loans under a MBS, and the MBS under a CMO, are packaged and rated in a roughly standardized way throughout the industry. They tend to be “cookie cutter” deals. One AA-rated midprime MBS was not thought much different from the next.
And so until summer 2007 they traded en masse without much trouble — and the notion of market value had some foundation.
(ii) In contrast, a diversified CDO is a more complicated, less generic beast.
And (to return to the New Combat piece you linked) the fact that a CDO was probably built to solve a particular guy’s problem, means that it is full of special detail — nothing like a “cookie cutter” deal.
Thus, CDOs are harder to trade interchangeably than CMOs.
And, indeed, all the deals I was close to were entered into with little notion of secondary trading.
The aim was to solve a guy’s problem, not to extend the credit business of a particular industry to the four corners of the globe.
And the third0party investors in the CDO tranches weren’t looking for liquid assets, but rather something like a CD. Something that would pay attractive interest for a fixed period of time and then expire. (CDOs were almost always wound up much much earlier than their long-term stated maturities.)
AND SO. Today, as investors and regulators worldwide demand to know the market value of their CDO tranches, the answer unfortunately is that they weren’t built to support the notion of market value, and never traded efficiently in the best of times.
They weren’t really bonds, one might say. They had the form of bonds, but the underlying economic reality was rather different.
4. This is why, in August 2007, the New Combat editor aired the notion of price controls on the wounded segments of the “structured finance” world.
It was clear then (in light of what was happening to MBS and CMOs) that:
(x) trillions of dollars’ worth of CDO tranches would soon be under pressure to be sold or even unwound (that is, the underlying pool dissassembled and sold piece by piece), and, yet,
(y) those tranches were not built to support the notion of market value. They were too idiosyncractic and complex.
It would have looked like panic, true, to institute price controls a year ago, when the wounded segments of the credit markets were largely confined to mortgage land.
Things are very different now. The entire system of credit is under pressure. No segments aside from sovereign debt are trading worth a damn.
5. To address the gist of your post above, let me refer you to a recent post at The New Combat –
http://newcombat.net/Conversation/2008/09/27/derivative-obligations-oh-what-a-tangled-web-we-weave/
– which in turn refers to a recent Times piece about AIG that focuses on your concerns.
The TNC post then goes on to talk in parallel fashion about the catastrophic effects of the Lehman bankruptcy, discussing swaps in the process.
(Comments can be posted at TNC without registration or other obstruction.)
October 4th, 2008 at 6:19 am
Mr. Kropotkin,
Thanks for keeping me honest. The article you commented on does link to the TNC story about Lehman as well as the NYT piece on AIG- indeed, these were the inspiration for my attempt to synthesize the implications and distill the CDS issue for a wider audience. I’ve tried to clarify the content regarding your TNC article on ‘What’s a CDO, really?’, but I welcome any further comments or corrections you might have the time to provide.
October 4th, 2008 at 6:12 pm
Hello again,
This is just a housekeeping note to the editor — not for publication.
1. Aha — I’ve found the links you mention.
But they are not showing up with any typographical distinction. Thus most people (like me) will not know they’re there. ??
2. Would you like to swap official Links between your site and The New Combat site?
October 4th, 2008 at 7:31 pm
Mr. Kropotkin,
1. The links are faintly underlined and darken when you hover, I do agree they can be difficult to see.. I will fix them up.
2. Yes, I’ve added TNC to my blogroll, thanks!
October 4th, 2008 at 10:55 pm