“They did not have the funds because of the collateral arrangements in the CDS contracts. In terms of likely defaults, they probably did have the funds.”

JCH1952, AIG still owes the United States a bit more than $100 billion dollars in bailouts, including $70 billion in loans and interest, and $35 billion in relation to collateral the government accepted that proved to have a far lower market value.

If they have money somewhere, why don’t they pay it back? The answer of course is that they are broke. They are selling off their crown jewels and still can only pay a fraction of what they owe.

You are right that the collateral arrangements created an immediate liquidity crisis, but we have seen that many of those mortgage-backed securities really were worthless. Goldman and others wanted to be paid immediately because they saw or suspected that behind the facade AIG was insolvent, and they were right. They wanted to jump to the head of the line, before bankruptcy reduced their claim.

Indeed the default rate on subprime adjustable MBS has been running at close to 40% and rising! So these weren’t just paper losses! These MBSs have really been defaulting massively. Even prime fixed mortgages are defaulting massively.

“to use your own words, Felix.”

Yes, this is probably all very true, but you’re coming off like an axe-murderer staring into Felix’s eyes.

[insert brilliant analysis of the Libyan bond market here]

You too should be a CDS demonizer, Felix. It is the moral high ground.

The ultimate problem with credit default swaps, to use your own words, Felix, is that they can be end-of-world insurance. For the issuer, profits come now, and in the unlikely event that default actually occurs, well who cares, that is the end of the world anyway.

Writing credit default insurance without the ability to pay is fraud, pure and simple. It happened on a massive scale at AIG and there have been no convictions.

End-of-world insurance in the forms of CDSs on governments and government-backstopped institutions is a license to print money.

We are in the biggest debt bubble in history, particularly with respect to government debt. We are not getting proper market signals regarding the scale of the problem in the CDS market or the bond market. Yes they move in tandem, probably due to arbitrage, but neither properly accounts for default risk. If issuers were required to reserve appropriately and actually account for the end-of-world you speak of, things would reprice dramatically and become a market rather than a fraud.

Instead, under the cover of default insurance, sovereign debt towers to greater heights, putting off and worsening the ultimate reckoning.

We should therefore not be surprised if all these indicators show in the same direction. But one big difference is that in the case of CDS we have “off-market” values. And the CDS has no disclosure obligations. Meaning that derivatives are used extensively to circumvent investment restrictions, tax legislations etc, as Satyajit Das remarked recently in a newspaper essay. Therefore the derivatives market is now larger than the base market. The speculative market contributes to increase risk premia.

Check out the Chart of the Day on Bloomberg too, which shows that the European sovereign CDS market is tiny compared to the overall European sovereign bond market (i.e., less than 1% the size). The idea that the CDS market is somehow driving yields on Greek debt is really beyond ridiculous.

you might want to consider who -writes- PIIGS sovereign CDS protection. considerable risk there which no one is talking about.

you also might want to consider that in the event of a Greek default GS is likely to receive payouts on both its Greek CDS and the “balloon payment” on its currency swap with Greece. it would also get to stop making payments to the CDS protection writer. forget whether GS is “betting” on a Greek default (although I would not be surprised if they are); what would GS prefer to see happen?

CDS create perverse incentives. this is a problem.

I’d like to highlight the distinction between
- the existence of a CDS market is hurting Greece
and
- the widening of Greece’s spreads in the CDS market is hurting Greece;
in particular I’d compare this to
- international trade hurts the US
versus
- a rise in the price of imports on international markets hurts the US.
In both cases, the latter statement is probably true, while the former is probably false; the existence of the market in each case does the most good for the buyer when the prices are low, and what you’re looking at is not a change to where the market is imposing a net cost so much as a reduction in the amount of benefit from what it was able to provide under other circumstances.