The NYT jumps the CDS shark

By Felix Salmon
March 7, 2010
Paul Krugman and others want the New York Times to be the paper of record, especially when it comes to matters economic, they're going to have to do better than this:

Like the credit default swaps that hid Greece’s obligations, the instruments weighing on our municipalities were brought to us by the creative minds of Wall Street.

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If Paul Krugman and others want the New York Times to be the paper of record, especially when it comes to matters economic, they’re going to have to do better than this:

Like the credit default swaps that hid Greece’s obligations, the instruments weighing on our municipalities were brought to us by the creative minds of Wall Street.

That’s Gretchen Morgenson, who ought to know better. The derivatives that hid Greece’s obligations were currency swaps, not credit default swaps.

But it gets worse. if you follow Morgenson’s hyperlink, you get to the Times Topics page on credit default swaps: the part of which is trying to compete with Wikipedia in terms of giving a clear overview of topics in the news. Columnists have some leeway to express opinions; the Times Topics pages should be assiduously accurate and impartial. Yet:

These instruments played a pivotal – and controversial – role in the financial crisis in the United States. Now, these swaps are emerging as one of the most powerful and mysterious forces in the crisis shaking Europe.

In essence, a credit default swap is a form of insurance. Its purpose is to make it easier for banks to issue complex debt securities by reducing the risk to purchasers, just like the way the insurance a movie producer takes out on a wayward star makes it easier to raise money for the star’s next picture.

I’m not even going to try to enumerate all the inaccuracies here. Were credit default swaps really pivotal in the U.S. crisis? They certainly brought down AIG, and a couple of smaller monolines. And they made synthetic CDOs possible — without them, the “unfunded super-seniors” which did so much damage to many huge banks could never have existed. But they weren’t pivotal in the sense that absent CDS, the crisis wouldn’t have happened.

But we’ll give the NYT the “pivotal role” bit just because it’s simply untrue that credit default swaps “are emerging as one of the most powerful and mysterious forces in the crisis shaking Europe”. (Even assuming there is a crisis shaking Europe.) In what way, exactly, are CDS emerging as particular powerful in the latest Eurocrisis? CDS volumes on Greek debt are a fraction of the total amount of debt outstanding, and certainly no sovereign has written huge amounts of credit protection, thereby racking up enormous contingent liabilities, in the way that AIG did. In fact, European sovereigns aren’t players in the CDS market at all.

In order to believe that CSD are “shaking Europe”, you have to believe that when one market player buys sovereign credit protection off another market player, in a transaction both sides think they’re going to make money on, finance ministries across the continent start to tremble. It’s silly. Sovereign credit spreads have moved up and down in sometimes-dramatic fashion for decades, long before CDS were even invented. And they will continue to do so even if CDS are banned. And there’s no indication whatsoever that volatility in European credit spreads is any higher now than it would have been absent the CDS market. Indeed, there’s a colorable case that the opposite is true, and that the ability to hedge one’s exposure in the CDS market has made the European sovereign bond market less volatile.

As for the NYT’s idea of the “purpose” of a CDS, all I can say is that I have no idea whatsoever where they got that one from. At least on the CDS/Greece connection, you can see how various European politicians love to be able to blame Goldman Sachs rather than themselves for their woes. But this just makes no sense at all. What “complex debt securities”, exactly, can banks issue more easily if CDS reduce the risk to purchasers? Presumably we’re not talking about simple bonds and loans here, since they’re not complex at all. Is the idea that banks somehow help companies issue debt bundled with CDS insurance? I’ve seen a few monoline wraps in my time, but nothing like that.

In any case, by putting all this garbage on its Times Topics pages, the NYT has pretty much given up any hope of having the tiniest bit of credibility in the debate over CDS. The WSJ might be sensationalist, but I haven’t ever seen it go this bad.

(A big hat-tip here to Anal_yst, who writes faster and meaner than I do, and to @taste_arbitrage.)


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Looks like you are fighting windmills. For some reason that I don’t understand, media (especially the New York Times, but not only them) love to bash CDS and even short-selling. Facts are just distractions anyways.

Of course you’re absolutely right though.

Posted by aristid | Report as abusive

“Were credit default swaps really pivotal in the U.S. crisis?”

Didn’t William Dudley note in a speech that the novation of CDS was part of the bank run that took Bear Stearns and Lehman Bros down?

See note 3 here: eches/2009/dud091113.html

Posted by csissoko | Report as abusive

Funny, she has a habit for this sought of thing. Just came across this:

Gretchen (Sept 13, 2008):

Here is a modest suggestion for James B. Lockhart, chairman of the F.H.F.A., to consider: Do the new owners — us deep-pocketed taxpayers — a favor, and open up Mac ’n’ Mae’s books so we can see exactly what we own.

Also, force both companies to disclose details on every mortgage they guaranteed or purchased in the last 10 years. This would include loan type, the year when the loan was made, the original rating on the security and its originator.

That way, the new owners would be able to see how deep into the subprime loan swamp Fannie and Freddie waded during the lending spree. After all, according to Inside Mortgage Finance, an industry publication, Mac ’n’ Mae bought almost $170 billion in subprime mortgage-backed securities in 2005, roughly one-third of the total issuance that year. And they bought an additional $120 billion in subprime mortgage securities in 2006, or 27 percent of the total amount issued.

Tanta (from CR):
I can’t even start with the fact that after all this time, Morgenson still can’t keep straight on the difference between the rating of a security (or a tranche of one) and the “rating” of a mortgage loan. She has been making that mistake for about two years now, as far as my memory serves, and she will apparently never stop.

Emphasis on the last part. Whether it’s ratings on loans thinking they are securities or CDSs vs. currency swaps. Some things never change.

Posted by duffsamoa | Report as abusive

Gretchen strikes out again!

But what of her point that municipalities are at the losing end of interest-rate swaps (which, though not actually named, are presumably at work here)? Not that she cites any convincing evidence, but it at least seems plausible to a laymen like me.

(Not that it is obviously the bank’s fault in any case).

Posted by cgotterba | Report as abusive

“Didn’t William Dudley note in a speech that the novation of CDS was part of the bank run that took Bear Stearns and Lehman Bros down?”

No he didn’t, actually. His wording there is of “novation of OTC derivative exposures”. There is no reference to CDS anywhere in the entire speech, and just one to CDOs. Since credit derivatives of all types account for only about 10% of the OTC derivative market by notional, one could not say that CDS novation played a significant role without knowing more details.

More generally, I think it is misleading to describe Bear’s troubles as a “bank run”, which suggests primarily a liquidity problem. In fact, Bear was insolvent, but was able to continue operations because it was able to meet its immediate cashflow demands (remember the “zombie bank” phrase?) The effect of novation was to force this insolvency to be realized. This occurred because collateral agreements between broker-dealers are symmetrical, whereas those between a broker-dealer and a corporate are often not. Novation moved underwater deals from agreements that required no collateral to be posted to agreements that did.

Posted by Greycap | Report as abusive

On the other hand, the only way to get any kind of reform done is to piss of the public to such an extent that Congress takes action. It works for the GOP on Fox News.

It would be nice if we had an educated public, something akin to basic ethics in business, and a Congress willing to “promote the general welfare”, but alas, we don’t.

In the same NY Times today, Frank Rich writes:

“Since Obama offers no overarching narrative of what financial reform might really mean to Americans in their daily lives, Americans understandably assume the reforms will be too compromised or marginal to alter a system that leaves their incomes stagnant (at best) while bailed-out bankers return to partying like it’s 2007.”

So Obama lacks an overarching narrative like “CDS are evil” so nothing gets done. What exactly, Mr. Salmon, is the right approach?

Posted by silliness | Report as abusive

“Were credit default swaps really pivotal in the U.S. crisis?”

Such a statement does not speak well of Mr. Salmon’s personal integrity. Of course the Mr. Salmon knows that CDSs were a significant piece of the puzzle. Mr. Salmon himself has acknowledged this many times in the past, so this is a strange reversal for him.

Would there have been a bubble and collapse without CDSs? Almost certainly. There were many other causes (huge financial inflows from abroad, dishonest borrowers, dishonest mortgage originators, weak of lending standards, Barney Frank and his drive to make every American a homeowner, rating agencies that were commatose at the wheel and poor integrity by investment banks assembling toxic MBS) but there can be no doubt that credit default swaps and especially those originating with AIG were a significant source of the crisis as well.

Mr. Salmon’s long-running thesis that much of the problem lay in the fallacy of a risk-free return is dead on. Many investors were looking for risk-free yield and thought they found just that. These risk avoiders that Salmon so clearly recognized would never have piled into mortgage backed securities but for the credit defaults swaps protecting them. (This is not mere speculation, for when the music stopped banks all over the world were seen to be holding a great deal of this toxic debt and a great deal of the corresponding credit default swaps.)

Without the continuous flow of funds into MBSs, strongly abetted by credit default swaps on those MBSs, the bubble would have run out of fuel much earlier. Correspondingly the subsequent collapse would not have been as severe.

Posted by DanHess | Report as abusive

Here are two blogosphere posts about this topic:
1. Rajiv Sethi (professor of Economics, Columbia University) says Felix Salmon should consider the possibility of multiple equilibria before dismissing the case for prohibition of naked CDS: efenders-and-demonizers-of-credit.html
2. The Money Demand blog tries to refute Rajiv’s argument: 03/naked-cds-market-efficiency-and-run-o n.html

Posted by TMDb | Report as abusive

DanHess, less of the ad hominem, please. But to your substantive point, the buyers of supposedly risk-free triple-A CDOs weren’t relying on CDSs for protection, they were relying on a combination of diversification and overcollateralization. The CDO tranches were triple-A *without* any CDS protection.

Felix –

Please forgive my enthusiasm! Your suggestion that CDSs were not a significant part in the crisis was too much for me to bear!

I agree wholeheartedly that the triple A blessing by the ratings agencies was a disaster. It is a good point that many investors needed no further safety net than that.

But the investment banks, the factories that were churning out these toxic CDOs, relied very heavily on CDSs to keep their operations humming. Goldman Sachs and others held enormous inventories of CDOs just as a function of doing business and the CDSs enabled them to do that.

All of the Wall Street banks churning out these toxic CDOs had a massively long position that was nicely balanced by CDSs.

Take the example of Goldman, purveyor of among the worst detritus among CDOs. They would never have tolerated such garbage on their books. Without CDSs, their garbage factory wouldn’t have worked because it would have required them to hold a lot of ticking bombs in their warehouse, so to speak. But with CDSs they could hold their hedges and churn away, spreading this garbage to the world. See? It was much bigger than the 62.1 billion in hedges at any one time because the inventory of CDOs kept churning.

Goldman was typical of the smart investment banks. The dumb ones ate the cooking.

Posted by DanHess | Report as abusive

I think the bigger argument about where our woes began in the USA should focus around the lack of moral responsibility and education on the part of homeowners who seem to be sorely lacking in Economics 101. Primarily, what goes up must come down (home prices, wages) in a cycle. Where’s the talk of the Sadek’s and the other unscrupulous ‘Mortgage Brokers’ and the part they played?

The same thing could be expanded to the whole debate with Gretchen, she seems to be missing the point that instead of trying to place blame solely on the banks, it takes two to tango with respect to the deals (whether it be CDS’s, Currency Swaps, Xccy swaps, take your pick).

Posted by chibondking | Report as abusive

@chibondking –

Homeowners got way out of hand, its true. But borrowers have been trying to get loans for homes since time began. And since time began, banks have been saying no, except when they could be convinced that the borrow was good for it.

Then with the passing off of risk via securitizations and derivatives, banks suddenly started saying yes to everybody, and often to the same people over and over again, one guy, no documentation, ten houses.

Borrowers were just acting rationally. Paul McCulley at Pimco talked about this ahead of the crisis. With no downpayment required, borrowers with no skin in the game were basically getting a free option at price appreciation.

No, for the case of housing crisis, blame lands squarely at the feet of the banks. Unqualified borrowers were always available.

Are borrowers different than they have always been? For a nice apples to oranges comparison, consider how in 1977 during a blackout, all of New York City was looted. In the 2003 blackout, nothing of the sort took place. If those 1977 citizens had been given the opportunity to get any house with no money down, do you think they would politely declined?

Posted by DanHess | Report as abusive

I respectfully disagree with DanHess and throw my weight behind the argument of chibondking. It does take two to tango. That lesson is critical to making any proposed regulation work. All the free money in the world isn’t going to create a crisis if, as chibondking pointed out, financial illiteracy and greed aren’t running rampant in society. Your neighborhood real estate agents, mortgage brokers, appraisers, developers, and condo flippers are as much to blame as the bankers.

If we are all to blame, then the fix is different than if only the bankers are to blame. If CDS are the wonderful innovation some claim, but our own weaknesses make them dangerous, then you ban CDS like you ban illicit drugs. If everyone can be trusted to act responsibly, then derivatives and the like are perfectly reasonable innovations.

Posted by silliness | Report as abusive


First I apologize for the delayed reply — didn’t get online til this morning.

What I left out of my quick blog comment was that after Bear Stearns the NYFed forced the dealers to jumpstart the move to central CDS clearing. And the infrastructure built in the six months after Bear is probably the only reason the CDS market was able to handle the Lehman collapse. Dudley’s comment together with the fact that the NYFed jumped on the CDS market point to its involvement in the Bear crisis.

Secondly you seem to be confusing notional values of OTC derivatives with their fair value (i.e. gross negative plus gross positive value). The OCC derivative reports make it clear that the fair value of CDS varied from 20% of the OTC fair value (Q1 08, Bear) to 33% of the OTC fair value (Q3 08, Lehman). Over this period the fair value of CDS increased by 20%, even as the fair value of interest rate swaps fell by 2%. Also because CDS values jump (unlike interest rate swaps), counterparties to CDS tend to be more concerned about holding an unmargined claim on a bankrupt counterparty — so they have a much stronger reason to novate their claims.

Posted by csissoko | Report as abusive

@DanHess -

I by and large agree.. There is definitely plenty of blame to go around on all sides. But securitization of risk is nothing new as you know. I’m not an expert on human psychology by any stretch of the imagination, but I would suggest that something drastically changed on both sides between the time the first securitizations came to market in the early 80′s and where we find ourselves today. Taleb, in his book Fooled By Randomness, put it quite succintly in explaining a story of traders (homeowners) being in the right place at the right time, riding a wave to riches and glory, casting aside any memory of recent financial pains. Those who lived during the recessionary periods in the early 80′s and with the mortgage crisis in the early 90′s should remember the pains of those crises. The same goes for the banks.

The instruments themselves are not what is dangerous, it is the people who overindulge in their use and lack the foresight, as silliness said. I would be willing to bet my lunch that if, in the words of Cher, we could ‘turn back time’ and have in place the risk management methodology that existed previous to the bubble created in the early 00′s, these instruments would have been helpful to a point, but not pose such a risk. Nobody had skin in the game, which is one thing that changed between then and now.

Apologies for the rant,

Posted by chibondking | Report as abusive

Oops. Careless math in post above. In terms of fair value in Q1 08 CDS were 18% of OTC derivatives and in Q3 08 CDS were 25% of OTC derivatives.

See Table 6 in the reports here:

Posted by csissoko | Report as abusive

cbk –

A nice discussion, thank you.

I just think of how Goldman and other smart banks played CDSs in a way that allowed them to securitize and sell vast amounts of the most toxic of CDOs to the world.

The thing is, these smart banks used CDSs perfectly. They have excellent risk management, they understood that they did not want to be long these awful MBSs, and they saw the bubble for what it was, and acted safely. If they could ‘turn back time’ their fixes might be mainly on the PR side.

I do actually agree with Felix that CDSs can potentially have positive value (price discovery, leaning against bubbles, etc), but three crucial and presently missing conditions would have to be met:
- real reserve (and not just margin) requirements for counterparties demonstrating an ability to really pay (because the market will surely sieze up for that CDS and some unlucky counterparty will have to ride that sucker down because the CDSs will be unloadable) if and when they are holding the bag in the event of a black swan
- an exchange for all CDSs, showing where counterparty risks are building. AIG was a terrifically wonderful company with one bad unit that ruined things for hundreds of thousands of employees and hundreds of millions of taxpayers.
- a requirement that bonds can only be insured once, corresponding to rules as old as insurance itself

These rules would bring safety to CDSs and transform them from liabilities to assets in our economy.

Posted by DanHess | Report as abusive

Yebbut, imagine how much better the NYT will be when they have a paywall…

Then imagine how much better CDS could be without regulation holding back the worst Yep, you’re getting warmer.

Posted by HBC | Report as abusive

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