Credit Default Swaps: Yes, You Have to Think About Them
Brian Doherty | October 3, 2008, 7:16pm
Yes, ev'rybody's talkin' 'bout bagism, dragism, thisism, thatism, ism ism ism. And, of course, credit default swaps.
Arnold Kling over at Econlog has an interesting little exposition on why you should care, and connects them with some genuine fears about the possible effects of runaway short-selling (for more on which, see this piece from me from last month).
The key, from Kling:
A credit default swap is like insurance against default. If you want to buy a municipal bond or a corporate bond but not take default risk, you try to buy a credit default swap. You pay a fee, and in exchange for that fee the seller of the swap will make you whole if the city or corporation defaults.
The seller of swaps collects nice fees, and most of the time the borrowers don't default. But if borrowers do default, then the seller is like an insurance company in a town that was hit by a hurricane.
Sounds grim. How can the seller of such a swap hope to survive?
Suppose I have sold a credit default swap on Sallie Mae. That means that if Sallie Mae defaults on its bonds, I will have to pay some of the bondholders a big chunk of money. One way I can hedge that risk is to sell short Sallie Mae securities..... However, the more short-selling takes place, the closer they get to default. It is a vicious cycle. Ordinarily, I do not believe that short-selling affects the price, but when there is massive short-selling that is driven by dynamic hedging, I can see where the short selling would drive down prices.
So, does this mean that even the formerly soft on short selling Kling thinks there is a sensible place for short-sell bans or restrictions? It's a little more complicated than that, as are most things in the world of contemporary high-flyin' high finance. Short selling, after all, is a big way** the sellers of the swaps can hope to ride out the storm. Thus:
....if the government tries to curb short-selling, all that does is cripple the credit default swap market. It becomes costly to sell default swaps, so now creditors cannot get them at affordable prices. The only way they can reduce exposure is to sell their munis and their corporates and flee to Treasuries. I'm not saying that the curbs on short selling make things worse, but such regulations certainly don't solve the problem--at best, they shift it.
If my theory is correct, then the credit default swap protection is somewhat of a delusion....It is too late to undo the delusion. In the aggregate, markets under-estimated the risk of the bonds they were buying. The risk premium needs to adjust upward. That upward adjustment is not a credit squeeze--it's a return to reality.
See Kling talking general bailout horrors in this reason.tv clip.
**Amended from "only way" thanks to the totally justified comment from Gilmore.
Kant feel Pietzsche | October 3, 2008, 8:58pm | #
Fuck it! Let the apocolypse come. My peeps will do just fine.
{rant}
My paternal grandfather and his brother, although hardly educated men (8th grade), had great "native intelligence", work-ethic, and thrift.
During the depression, while everyone else was bugging out, they used their savings to buy up land at fire-sale prices in tax sales. They then worked hard, made do with used and homemade equipment, and prospered*. Eventually they jointly owned some 20 square miles of good farm/pasture land, made sound investments, and at their deaths, their estates were each around the $4M mark. The money went into family trusts.
*Of course, gas/oil royalties from a dozen or so wells didn't hurt the bottom line :-}
My maternal grandparents have a similar, though not as successful, story.
My parents, being depression kids, also know the value of thrift and work. Dad put himself through college, and worked for various railroads for 40 years. Mom went back and got a special-ed degree when I was a teen. They lived on dried beans, rice, garden veggies, and raised poultry for the first ten years of their marriage. We lived in a 8'x48' trailer till I was 12, drove used cars. They then built a beautiful, though certainly not palatial, 5 BR home paid for with CASH. I don't think they were EVER in debt for a penny.
They continued to save and invest, and lived within their means. They have a tidy net worth of their own now ($1M+), and combined with the income stream from the family trusts (which they are now in line for) are quite secure financially. Of course, being depression kids, they only draw from the trust if they absolutely have to, otherwise they revest.
I have a professional career, but NEVER forgot where I came from, or the lessons I learned from the grandparents and parents. I used to work summers for Gramps as a teen, 12 hour days for room/board and a whopping $500 because "it builds character". Worked with Dad weekends at various endeavors from age 10. (payed for family vacations and put money in my pocket to buy my first wheels)
My wife and I both put ourselves through college, no handouts from mom and pop (see a pattern here?).
Wife is a critical-care RN. I was a Paramedic and instructor of same for 25 years, taught myself computer programming just because it looked like fun. When an ugly auto accident put a serious "hitch in my git-along", I parlayed my knowledge of health care and insurance into an insurance brokerage for several years. I took that experience combined with my love of mathematics and 0's-1's, and went into risk management/analysis.
Well, that and on-line poker ;-}. I have a nice hedge fund that started before on-line gambling became evil. It keeps growing, sitting off-shore; but I may have to eventually expatriate in order to get at it legally.
I am quite happy to be self-employed as my love for certain herbs and organic compounds makes standard employment a bit complicated.
We rented for about 7 years and saved our chips. Although I would have saved long enough to buy with cash, a golden opportunity came up, and I ran with it. We took over roughly 1/2 of the back-end of a mortgage on a nice house from a "motivated" seller for a token $2K. (Presto! instant equity!) Paid off the balance 5 years early. Added 1,000 sq ft to it a couple of years ago with CASH.
(I politely turned down a horde of lenders with some pretty interesting re-fi offers with a smile instead of a kick in the nuts :-} )
Bills are all paid, cars are all owned outright, etc. When I hit the "Golden Years", I won't have to work unless I still want to. In my dotage, after my parents have gone on to their happy hunting grounds, my siblings and I will have access to the income stream from the trust if we need it.
Here's the main thrust of this rant:
1. I have absolutely no sympathy for individuals, companies, corporations, OR governments who are so enamored of the American Dream that they refuse to live within their means.
And before some redistributionist (you know who you are, Joe) makes the argument that "yeah, but you had advantages", I call bullshit. While my family has money, it's THEIR money, which they fucking earned. If they want to leave part of it to me in their will, great. If they want to spend it all on hookers and blow, (wow, thank me for a horrific visual!) that's their business. I'll be just fine. No one gave me shit other than the proper mind-set, and I am eternally grateful for that.
I recall a news story several years ago about a man who worked as a janitor all his life, and left close to $1M to a charity. There's NO excuse for leaving planet Earth with a negative balance sheet unless you are physically/mentally incapable of making at least a decent wage.
2. I sincerely believe that there are a lot of people like me in this country, a lot more than most of us think, regardless of their well-intentioned but misguided politics. If they had a family crest, it would probably look a lot like the "don't tread on me" flag from the LAST revolution.
They're not racist/sexist/homophobic, they're not heartless and unsympathetic to people less fortunate, they're just tired of crooked fucks (read politicians) who's only talent is selling bullshit to the easily confused, and then deflecting responsibility. Who's only ability is to convince backward people that their problems are caused by other people who are more advanced, and can convince same that they have a "right" to color TV, health-care, a "living wage", and housing.
They understand that if they want something in life, they might actually have to get off their asses and work for it. And they're tired of the criminal class (Guv'ment) stealing what they worked for, and squandering it on stupid shit, or giving it to others who don't deserve it.
3. If the whole damn system collapses, we'll still be fine. Don't forget that 20 square miles in the rural heartland. Good farmland/pasturage with a reasonable amount of timber, plenty of year-round clean running water. We all know how to build/maintain structures and equipment. We can grow/raise/shoot all the food we need. We have our source of power (the wells, man, the wells!!) Don't even need to refine the oil. Natural gas wells produce a fluid by-product which is an excellent substitute for gasoline.
It's remote enough that it will be a long time before our friendly representatives from NEW AMERIKA even notice our existance. And if they finally do notice us, we have lot's of guns 'n ammo, and can direct said ammunition quite efficiently. Perhaps efficiently enough that they will regard us as "not worth the trouble".
To many (but not all) of you on this blog: If the soup lines get too long or violent, feel free to look me up. We can start our own Galt's Gulch. :-} Even "city-slickers" can do just fine without infrastructure if they just have the desire to learn.
If you are willing to be self-sufficient, and pay your own way in whatever currency is in vogue, I'll be happy to sell/rent you whatever you need to get started. Otherwise.....STAY OFF MY LAWN!
{/rant}
John Thacker | October 4, 2008, 11:13am | #
Isn't the problem that credit default swaps make no sense at all? It's the LTCM risk model Ponzi scheme all over again.
The LTCM risk model is a not a Ponzi scheme. The LTCM risk model was similar in spirit to the martingale betting strategy-- the basic idea of "OK, I want to win $100. So I'll bet that, and if I lose, I'll just double my bet until I win once, then I'll start over again with $100. Since I'll eventually win a bet, I can't lose."
It's theoretically sound, so long as you have access to an infinite line of credit that no one will ever call in. In other words, not in practice. The problem is that while you will eventually always win, you also will eventually always have a long enough streak of bad luck to force you to get so highly leveraged (or temporarily down) that your credit will run out or someone will call in your debt, and the whole thing will collapse. Essentially you try to make profits as safe as possible by concentrating them into a event of probability epsilon.
the MSM still has not addressed that this whole debacle started with the last two Administrations--both parties--pushing Fannie and Freddie to make more loans to questionable borrowers. Everything else followed naturally from that decision.
Ehh, you can find lots of original causes. If you want to get technical, I'd go with
Ed Glaeser and note that everything else followed naturally from land-use and building restrictions that make bubbles inevitable and stronger. Anything that creates such a lag between price signals and construction makes bubbles inevitable, and the greater the regulation, the greater the bubble. That's why we've seen land bubbles in most European countries as well, but not in many US states (NC, TX, etc.) that lack such restrictions.
That said, the land-use restrictions explain why the housing bubble was inevitable, but there are other parts to explain. Certainly private industry did a bad job of determining the probability of rare events, such as a simultaneous housing price decline in many markets. Most previous housing bubbles were regional (such as in TX and LA when oil when it went up, and then bust when it went down); since regulations prevented S&Ls from operating in many states, this helped them go bust. Many believed that since previous bubbles had been regional, that greater diversification would help banks ride out the storm. However, there were quite a few banks that "diversified" only into those coastal states that saw the worst of the bubble, so they really weren't protected at all. Having operations in CA, AZ, FL, and VA didn't make for a hedge in this case. But note that some regional banks, like BB&T or Wells Fargo, seem to have pretty well escaped by operating mostly in less bubbly areas.
The existences of Fannie and Freddie explains why the government (and thus you and me) were going to be on the hook no matter what. I'm not sure I could go so far as to say that the bubble would not have happened without the government pressure towards increasing homeownership no matter what (and encouraging no doc, no down payment loans), but the government certainly made it worse. At the very least, it demonstrates that no push for greater regulation could have happened, since the vast majority of politicians were pushing for regulations that made the bubble worse, not better. (The Administration and some other Republicans including Sen. McCain deserve some credit for suggesting reforms that would have helped slightly with Fannie and Freddie, even while in general being, like all other politicians, part of the general cheerleading for homeownership. It at least makes them better than the ones who opposed that and were thus close to 100% wrong.)
Sonic Charmer | October 4, 2008, 9:57pm | #
Back to the subject of CDS, I'm having a hard time seeing Kling's point that the existence of short-selling to hedge CDS drives down prices. This seems to look at only one side of the equation.
Someone who has sold CDS protection is, in effect,
long the bond. If they short the actual (cash) bond in order to hedge, now they're essentially flat the bond itself (exposed to counterparty risk, and/or whatever basis exists between cash and CDS, of course).
In combo these two things should not "drive down the price of the bond" at all, because economically speaking he has bought 1 and sold 1. Kling seems to have missed that selling protection on a bond is going long. Look at it from the protection
buyer's POV: he's now
short the bond. If the bond defaults he gets paid; if the bond pays off and never defaults, he is stuck paying a coupon for the term of the CDS and gets nothing in return. So in order to hedge
his position, he has an incentive to
buy the bond. (Let's not get into squeezes resulting from the need for physical delivery...)
The point is that for CDS, as with bonds, there is a buyer and a seller. The seller may decide he needs to short a cash bond in order to hedge, but the converse is just as true for the buyer.
Whatever else their merits or demerits, the existence of CDS by itself should not have some sort of asymmetric effect that pushes bond prices down.
