CDS demonization watch, insurable-interest edition

By Felix Salmon
May 7, 2009

A common meme among CDS pundits is that since credit default swaps behave in some ways like insurance policies, they should be regulated as insurance policies, and no one should be allowed to buy credit protection unless they have an insurable interest in the credit in question — that is, unless they loaned money to it.

Nemo, however, turns that meme on its head, and has decided that if you do have an insurable interest, and then act to collect on your insurance, then you’re “a criminal enterprise”:

Morgan Stanley bought insurance against BTA’s default and then caused that default. If you are wondering how this could possibly be legal, then good.

When he says that Morgan Stanley “caused” a default, he just means that the bank called in its loan, as is its right. But because Morgan Stanley was prudent and bought insurance against the default, its losses won’t be as big as they otherwise would have been. In what way is this supposed to be even unethical, let alone criminal?

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20 comments so far

Rather than calling Nemo, who has a nice blog but is not the most respected economist out there, why not directly comment on Willem Buiter in the FT, who started with the accusation?

Posted by M | Report as abusive

felix, it may be unethical — and in time possibly criminal — because Morgan Stanley, as a lender to BTA, likely had information about BTA’s situation that was not available to other market participants.

in other words, just plain old trading on insider information. i think the traders call it “inside running.”

geddit now, felix?

Posted by Gao Zhi | Report as abusive

Gao- what are you talking about? Trading on inside information? How absured- if that is the case, any financial institution that hedges its loan portfolio is guilty of that. Are you suggesting banks should not be allowed to hedge their loans? Aren’t we trying to encourage banks to reduce their risk?

Felix, it is the hedging, not the calling, of the loan that is unethical, and for the same reason that hedging a bond is unethical–this is a rehash of the perverse incentives(a.k.a. empty creditor) problem.

Ray, I can’t speak for Gao Zhi, but /I/ am suggesting that banks should not be allowed to hedge their loans, or any other financial interest that carries potential control or similar rights that, by design, were intended to be linked to that interest (unless they forfeit such rights in so hedging). I am aware this is a radical view.

The problem with CDSs is not the purchasers of them but the issuers. If there’s one lesson from this financial crisis it should be that these banking institutions can’t be trusted to reasonably assess their own risks. Therefore, insurance regulation type capital requirements are clearly needed to avoid the collapses we’ve seen from happening in the future.

Posted by Kerry | Report as abusive

When buying insurance ( betting on failure) MS had a way to make it more likely that failure would occur and that the insurance policy would pay off. How can that be acceptable (i.e. allowed to go unpunished) behavior?

The folks selling that insurance didn’t know about that extra liability

Isn’t that like trading on inside information?

Or were the insurers responsible for understanding the risk they were taking? The game was rigged and MS collected and hurt the whole country (world?) by their actions.

And they come out whole in this mess? This is not right.

To make a loan at interest and fees then insure the loan so to be able to collect by calling the loan and forcing bankruprtcy is the kind of finance that Adolph Hitler rose up against. Perhaps by the look of it? Justifiably so! RDuane Willing

Well you aren’t generally allowed to buy insurance on say a racehorse and then shoot the horse and collect the insurance. Don’t know if this is the same but it appears the allegation is that it is the same.

so what kind of insurer would sell insurance to a customer who was able to create a cause for a claim at any time? How could any company be stupid enough to sell a CDS to a a lender, and give them the authority to decided when they should be paid?

We have lots of regulations that prevent people from causing themselves harm (like laws against using drugs), why can’t we have regulations that prevent companies from doing really stupid things?

Posted by KenG | Report as abusive

That’s the thing. If I buy a CDS, someone has to sell it to me. I can’t simply declare a CDS on X to be paid by ? That’s where price discovery comes in. There are two different assessments of the risk.

If I cause a default on X, I’ll be sued by X and the person who sold me the CDS, as well as probably be investigated by the govt.

i have a somewhat different question. Overleveraged Bank holds $100 in bonds from Struggling Car Company. Vulture Hedge Fund agrees to buy those bonds from Overleveraged Bank for 30¢ on the dollar, or $30 total. Vulture Hedge Fund then buys a CDS contract to insure the full $100 in bonds on Struggling Car Company. Vulture Hedge Fund then proceeds to refuse a government-sponsored bailout of Struggling Car Company, effectively forcing Struggling Car Company into bankruptcy. Vulture Hedge Fund is thus only out the $30 for the purchase of the bonds and whatever the premium on the CDS insurance was. Assuming that premium was $50 – which is probably way too high – the potential profit margins for Vulture Hedge Fund on the default of Struggling Car Company is still 20%.

How is this legal?

Posted by mercurino | Report as abusive

Banks should not use CDS’s or anything else to hedge against default. They should try to come up with some estimate of the risk and then either take on the debt and its risk or not.

Hey banks, assess risk. That’s your job. That’s why you get paid. Banks are the ones that meet with the borrower, they are the ones that can see on a case-by-case basis where they are making money or how they are using it.

Banks outsourcing risk assessment through CDSs is like a surgeon outsourcing the cutting and stitching parts, or a police department outsourcing the arresting part, or a fire department outsourcing the parts involving heat and smoke. Risk assessing and assuming is their main task.

The only reason banks earn the big bucks is to assess and assume risk. If it’s just about the mechanical processing of accounts and transactions, my Federal Employee Retirement System does that at a cost of a few hundredths of a percent per year.

Posted by Dan Hess | Report as abusive

Felix, your title shows you still don’t get it, or are trying to provoke. “Demonize” suggests that CDSs are being made out to be worse than they are. Poor CDSs are the victim here.

Felix, this is not a lunatic fringe. Have you taken too much of the KoolAid? Warren Buffett has been shouting from the rooftops on certain financial weapons of mass destruction for seven years and CDS have absolutely covered themselves in glory ever since.

An unsurprising headline:
“Berkshire’s Munger Favors ‘100% Ban’ on Credit Swaps”:
http://www.bloomberg.com/apps/news?pid=2 0601103&sid=aKIC60dEOH2U&refer=news

Posted by Dan Hess | Report as abusive

I guess when you land at Reuters you lose the sanity / intelligence of your old commenters. Anyone who suggests that it’s criminal for a bank to HEDGE THEIR RISK obviously has no idea what they’re talking about. And if you think we should ban hedging, I hope you’re excited to help make the 2008 credit crunch look like a lending bubble. No hedging = no lending. Enjoy.

Posted by ab | Report as abusive

Ab,

Your rudeness is only matched by your ignorance of history.

With all due respect, there was a time in the not-too-distant past when banks didn’t hedge their every risk. Banks still lent and the economy did just fine, better indeed, than it has recently.

These bankers need to man up like bankers of their father’s generation and assume some risk, after doing the boring work of analyzing things themselves.

How did anything of size ever get built or any product come to market over the last few hundred years?

Posted by Dan Hess | Report as abusive

Dan,

I recognize that there have been major changes in risk management in the past half-century, but I’d say that most of these had a very positive effect on the availability of credit. You can argue that we’ve overlended recently, but I don’t think you can claim that a prohibition against hedging wouldn’t create a major credit contraction.

More to the point, what would be the benefit from prohibiting hedging (other than to “man up”, whatever that means)? For every story of hedged banks refusing to cooperate with borrowers, I’d guess there are 100 untold stories of banks lending because they have that hedging ability.

Posted by ab | Report as abusive

A simple point: Given that CDS are bilateral private contracts it is entirely possible, and likely legal given the lack of regulations on CDS contracts, to create several hedges with several different CDS issuers wherein the issuers do not know about the other hedges and thus will agree to pay off the full rate.

Given that MS knew it could cause a default by calling their loan, hedging such as this would create a perverse incentive to make the company default and get paid several times for the same loan.

Though the CDS issuers might be able to call fraud, given the end result, but litigation such as that is expensive and piercing the corporate veil is always a pain in the ass.

Posted by Anonymoose | Report as abusive

I think we need to remind ourselves that credit default swaps have not been with us long at all. They were invented just in 1997 at JPM and only in Dec. 2000 when Clinton signed the Commodity Futures Modernization Act did they really start to take off. That’s just this decade. The wonderful 1980s and 1990s happened entirely without them. CDS’s have had a positive impact on credit but we mostly ended up with credit we did not need.

I think Pimco handling of bonds is instructive. The world’s largest bond fund uses virtually no CDSs (a miniscule amount in relation to their size). They just study like hell and if they like the risk/reward they buy. They earn their keep by their hard evaluation of risk. If there is a default, they absorb it and they are diversified. In 2008 they saw a positive return with on the order of a trillion dollars under management.

To say that lending would have collapsed were it not for credit default swaps is not accurate. Lending by the big players in swaps actually did collapse quite drastically and the ones who stepped into the breach were the US government and the unleveraged PIMCOs of the world.

Posted by Dan Hess | Report as abusive

From the PIMCO website:

The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.

http://europe.pimco.com/LeftNav/Bond+Bas ics/2006/Credit+Default+Swaps+06-01-2006 .htm

Sounds like they appreciate the benefits of CDS…

Posted by ab | Report as abusive

That’s a nice glossary page. It even says it came from a 2001 textbook; probably copied by an intern. If you want to find out how PIMCO actually feels about CDSs, see Bill Gross’s January 2008 Market Commentary.

http://www.pimco.com/LeftNav/Featured+Ma rket+Commentary/IO/2008/IO+January+2008. htm

Here’s one gem:
“Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant “black swan” run that might break them.”

The whole article lays out a hypothetical doomsday scenario with derivatives and particularly CDSs at the center. By the end of the year, it had played out and we found ourselves living in the People’s Republic of America.

Hello? The shadow banking system actually did collapse. By the middle of 2008, Uncle Sam, through Fannie and Freddy, was suddenly almost alone in home lending.

Posted by Dan Hess | Report as abusive
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