Here’s another easy way to tell the difference between a real swap and a financial guaranty: If it’s drafted by a junior banker with a B.A. in psychology who happens to be sitting at the swap desk this afternoon, it’s a swap. If it takes a team of economists, senior bankers and four Wall Street law firms several months to draft, it’s not a swap.

In any case, it makes sense to regulate financial sureties, however designated, with some consistency. Unfortunately for our economy, swaps were chosen for credit protection transactions precisely because they were an unregulated form, not because of the substance.

As you correctly point out, the financial insurance companies that got into trouble did so mostly because of unregulated CDS transaction, and not because of their regulated insurance policies. It was decision of the financial institutions themselves to evade regulation that got them into trouble, and their self-inflicted wounds can hardly be blamed on the authorities who lacked the power to regulate. AIG (regulated as a thrift institution) was profitiable in its regulated business, and disastrously unprofitable in its unregulated business. That is true of many, many financial institutions that got caught up in the crisis. You could make an argument based on the recent history of regulated financial institutions and CDS that regulation needs to be consistent, or over-exploitation of a loophole (like CDS) can lead to problems. But that’s an argument for consistency of regulation, not against regulation itself.

Your current article, abstracted, says “Who the hell can regulate these? Not NY! Maybe we should give the SEC another shot?”. The SEC?!? We have to wait around for a celebrity to make a false statement during an investigation about a financially inconsequental event tangentially involving CDS before we will get action? (SEC). We need to wait for a clear violation of a clear statute because there’s nothing else to our job but law enforcement (SEC). Financial knowledge is useless, and possibly a hindrance, because the time spent acquiring this could have been spent on your law degree (SEC). We are proven to be thouroughly corrupt, institutionally and individuals, but this is understandable given our motivation go get the high-paying wall street “compliance” job after we’ve payed our dues in “public-service” (SEC).

What you are saying more clearly is: NY can’t regulate these and you don’t have the faintest idea who was the remotest hope of doing so with any nontrivial chance of success. Which brings us around to: why do we tolerate these if we can’t regulate them other than a hail-mary pass to the SEC (the SEC! the SEC!!!)?

Now, if you want to distract the issue, you’ll refer to your various previous solid articles about how some CDS attackers are confused or misleading or sometimes even factually correct.
What we readers really want (ok, ok, maybe just me) is an affirmative defence of CDS vs what it has cost society. At this point – I’ve tried to fairly read everything you’ve written on this – my honest guess is that you know you haven’t begun to make one, and you are more motivated by a righteous annoyance at the more careless CDS detractors than you are to make a GOOD positive argument for why we collectively should bother with these for-all-*practical*-purpose-unregulatabl e risks. Please prove me wrong.

I’m annoyed. The CDS debacle has funnelled billions from myself and my children, through the AIG conduit, to Goldman folks who have just been told to expect at the least their second most profitable year and highest bonuses ever. I really, really, want to understand the upside here. Not the upside of this very particular situation, but the hundreds of billions of upside this particular finanical innovation has to offer in order to have made the cost even plausibly worthhile.

-axg

I think that Whalen’s point is that many sellers of protection on CDS markets are not actually setting aside the necessary resources to make payment when it is due. (See Dan above on this issue too.) If some firms are making promises that they are not prepared to keep, then Whalen is right.

In fact, a while back Paramax, a hedge fund, sold CDS to UBS and then argued that they had a side agreement that it was always understood that they couldn’t pay more than 3% of the amount protected (which was 6x their assets under management) and that UBS had promised never to mark contract in a way that meant Paramax had to pay, so when the bank actually demanded payment the issue ended up in court.
http://www.ft.com/cms/s/0/f34487e4-47d0- 11dd-93ca-000077b07658.html

Mark, would you agree that in this case, there was no exchange of value between the parties?

That could be the most idiotic thing I’ve ever heard. Yes, CDS are swaps. A swap is just an agreement between two parties to exchange sets of cash flows for a fixed period of time. The parties in a CDS are just exchanging a set of fixed cash flows (quarterly premiums) for a set of cash flows based on the daily replacement cost of the CDS (the mark-to-market). The idea that CDS involve “no exchange of value between the parties” is beyond ridiculous.

How do you still work in financial services?

If CDSs were viewed as traditional insurance, then setting the reserve requirements would be an a impossible task. Unlike, say life insurance, where one can make a pretty fair estimate of how many of your customers will pass away in a given year, it turns out to be quite impossible to put probabilities on so-called black-swan events, which are precisely what people want credit default protection against.

Making matters worse, unlike with life insurance or auto insurance, credit default events are highly correlated. Black swans, we have seen, travel in large flocks.

What’s more, the entities bearing the CDS risk will discover that their CDS obligations tend to pop during times of credit contraction and tightness, just as those entities are themselves under balance sheet stress.

The only reasonable reserve requirement would be that the risk-bearing entity holds some very high percentage of their theoretical maximum CDS liability available in ready reserves at all times. They certainly won’t be able to raise these reserves when their balance sheet is under duress.

The effect of any reasonable reserve requirement would be a dramatic curtailing of CDS activity as since CDS’s would require great pools of capital to sit in low return instruments awaiting their swans. Few would want that. Further, even if such contracts were deemed a good use of capital, proper reserving would lead to only a tiny dollar volume of contracts relative to today.

Any reasonable reserve requirement would therefore eliminate most credit default swaps.

Interestly, mere reasonable risk coverage take us a long way toward what has been advocated by Charlie Munger and George Soros, a world where all CDSs are gone.

http://dealbook.blogs.nytimes.com/2009/0 5/01/munger-of-berkshire-calls-for-ban-o n-credit-swaps/

http://www.dailyfinance.com/2009/06/12/g eorge-soros-wants-to-outlaw-credit-defau lt-swaps/

The fact that allowing CDSs while requiring reasonable risk coverage would dramatically reduce the use of CDSs shows that CDSs only thrive by leaving the risk uncovered. One big way that the economy became so highly levered was that CDSs allowed enormous amounts of risk to appear covered when it was not.

The AIG fiasco had nothing to do with selling “insurance”. The banks didn’t need insurance. The CDSs were just a way of boosting leverage beyond the legal limit. There was no economic purpose.

So, if we a large-scale derivatives market that is too complicated to regulate, my policy conclusion would be to shut it down. What’s yours?

1. The bank regulators had the authority to examine any aspect of a bank’s activities. They had the authority to figure out what was going on at the banks and to limit it. The regulators did nothing.

2. There are dim bulbs and deadwood at the top of the regulatory agencies and all of it needs to be cleaned out. A Herculean task if there ever was one.

3. We recently saw the regulators “stress-test” the major banks and compute the additional capital that the banks required to weather the economic turmoil. Then some of the largest banks complained vociferously about the additional capital requirements and the regulators backed off. More spineless regulation is not a solution.

After all, you BUY your chips at the casino.