What’s the instability risk of CDS markets?

By Felix Salmon
March 12, 2010
Kevin Drum has a couple of good questions about credit default swaps, and the final link in his post literally made me laugh out loud, so I'll do my best to answer him.

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Kevin Drum has a couple of good questions about credit default swaps, and the final link in his post literally made me laugh out loud, so I’ll do my best to answer him.

If the bond issuer does default, and there are a hundred speculators who own CDS protection on one of its bond, you’ve gone from, say, a $10 million event to a $1 billion event. Basically, when things go bad — and eventually they always do — widespread CDS protection can cause things to spiral far more out of control than they would otherwise.

And what’s the upside of allowing this? The argument I hear most often is that broad market trading of CDS provides an efficient price discovery mechanism for the underlying securities. Moody’s may rate that bond AA, but the CDS market will tell you what traders really think.

I guess I have two questions about that. First, does it really work? Are CDS marks really reliable indicators of creditworthiness? That’s debatable. Second, even if they are, is this a big enough benefit to make the instability risk worth it?

The first thing to do here is to dispute the premise. Yes, things will always go bad. But when things go bad, is it true that “widespread CDS protection can cause things to spiral far more out of control than they would otherwise”? Kevin is honest enough to note that when things went bad in 2008, that didn’t happen. And conceptually, it’s not the existence of credit protection which is a problem. People who have bought protection make money, they’re happy. The problem is the people on the other side of the trade — the people who wrote the CDS, not the people who bought them.

Indeed, that’s exactly what we saw in 2008: the people who bought lots of credit protection made lots of money, while the big losers were triple-A-rated companies like AIG and MBIA which had written the protection and which, by dint of being triple-A, didn’t have to put up collateral against the CDS which they sold.

Today, there isn’t a company in the world — not even Berkshire Hathaway — which can write CDS protection without having to put up collateral. And even if credit default swaps aren’t moved to an exchange, they will likely move towards a much more centralized clearing mechanism, which will institutionalize collateral and margin calls and make sudden bankruptcies even less likely than they are now.

But the most important thing to note is that the true villain here is not CDS so much as it is leverage. If I buy a bond and it goes to zero, I lose money, but there are few systemic consequences. If I’m a leveraged institution, however, and I bought that bond with borrowed money, then the consequences can be dire. Writing CDS protection is essentially the same as buying a bond, and writing CDS protection while putting no money down — as AIG did — is just as dangerous as buying a bond on zero margin.

So now ask yourself exactly what’s going on in Kevin’s hypothetical, where there are a hundred speculators who own CDS protection on a single credit. As we’ve seen, the speculators who bought protection don’t pose a systemic risk, although they might alter the likelihood of a bankruptcy filing. The real risk comes from the people who are net sellers of protection on that credit. And who might those be?

Think about what’s going on here, for a second: we have a lot of speculators making a negative-carry trade, where they pay regular coupon-like insurance premiums and get paid a lump sum in the event of default. Negative-carry trades are almost exclusively the province of hedge funds: long-only investors almost never make them. Indeed, it’s the long-only investors who are on the other side of the trade — institutional investors who wrote CDS rather than buying bonds, because the yield was higher or because they simply couldn’t locate bonds to buy, or just because CDS are more liquid. For those investors, CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.

The middlemen in the picture, the broker-dealers, are leveraged, but they are nearly always pretty flat when it comes to their net CDS positions. Insofar as there’s a big net position in the market, with one group of people net buyers of protection and another net sellers, the net sellers of protection — the ones posing the systemic risk — are unlikely to be leveraged, and if they’re not leveraged, nothing spirals out of control.

Sensible CDS regulation can and should, then, put tight limits on how much leverage a net seller of credit protection can be allowed to have. And by all means, if you want to keep things symmetrical, apply the same limits on how much leverage a bond investor can be allowed to have. But the CDS market is more dangerous, just because it’s so much bigger.

As to Kevin’s two questions, the first asks what the upside of the CDS market is, and the answer is simply liquidity — which is much more than just price discovery. The CDS market worked, during the crisis, even as the market in corporate bonds failed: bonds weren’t pricing, and CDS were. Selling bonds is hard and opaque — that’s why bond traders make so much money. Buying protection on bonds you own is cheaper and easier and much more transparent. And don’t even get me started on loans. People will invest in bonds if they believe they can exit their positions when they want. And the existence of CDS makes exiting a bond position much easier than it ever used to be — which in turn makes the bond market much more efficient. If you banned CDS, the price of credit would surely rise.

And Kevin’s second question is whether this benefit outweighs what he calls “the instability risk”. I think it does, just because the instability risk is hard to quantify and easy to regulate. The bellyaching of the Greeks notwithstanding, there’s no real evidence that the existence of the CDS market makes credit markets more volatile. Indeed, I believe that it can keep primary credit markets open when otherwise they would be closed. So let’s consider the upside of the CDS market before banning it for no good reason.

Update: Kevin, clever chap that he is, sees a flaw in this argument:

To a large extent, the superior liquidity and price discovery of the CDS market is attributable to its greater size, which in turn is attributable to leverage. If you tightly limit leverage, don’t you also constrain the size of the CDS market? And if you do that, will it still provide any noticeable liquidity benefits compared to the market in the underlying securities themselves?

I have to admit I was wondering this myself, as I left the office this evening. And really, there’s only one way to find out. But I suspect that CDS will always be significantly more liquid than the bond market, just because most bonds are buy-and-hold investments which are very difficult to find or sell on the open market. You will always be able to find a broker-dealer willing to quote you a price on a credit default swap, because they can simply conjure one out of thin air by writing a contract with you. If you want to find a specific corporate bond, however, that can be all but impossible most of the time, and in any case it might well be trading well above par, or have some other attribute which makes it much less attractive than a CDS of the same duration. People who are used to the stock market are always shocked at the illiquidity and opacity of the bond market: insofar as credit default swaps are a positive financial innovation, it’s because they managed to bring equity-like liquidity and transparency to a market in desperate need of them.

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Comments
15 comments so far

“it’s the long-only investors who are on the other side of the trade — institutional investors who wrote CDS rather than buying bonds, … They’re not leveraged.”

Um, Felix have you heard of the Oppenheimer Core Bond Fund? (see here: http://news.morningstar.com/articlenet/a rticle.aspx?id=268433) Mutual funds were using CDS to leverage their returns in 2008. What data do you have that demonstrates that pension funds, mutual funds and other institutional investors don’t use CDS for the purpose of leveraging their returns? Isn’t that one of the reasons the returns on CDOs (which in the later years usually were leveraged with some CDS exposure) were so popular with institutional investors? It seems to me that nobody knows the full extent of the use of CDS to turn traditionally unleveraged institutional funds in leveraged investments.

“the broker-dealers, are leveraged, but they are nearly always pretty flat when it comes to their net CDS positions”

I think you need to set to work reading some 10Ks. Here’s my assessment of the broker dealers so-called matched books: http://syntheticassets.wordpress.com/201 0/03/03/worrisome-cds-data-in-the-broker -dealers-10ks/
Alternatively see page 9 of this Goldman presentation: http://www.scribd.com/doc/27796815/CDS-C onf-Call

And how valid are the prices generated by CDS if many sellers are highly leveraged and may not have the wherewithal to honor their obligations?

In short, I would agree with you if I thought that “the net sellers of protection — the ones posing the systemic risk — are unlikely to be leveraged” was an accurate description of the market.

Posted by csissoko | Report as abusive

“institutional investors who wrote CDS rather than buying bonds… For those investors, CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.”

They don’t “buy a CDS”, they write protection under a CDS. And “for the full cash value of the amount being protected” is an odd choice of words. It sounds like you’re saying that writers of protection are posting cash collateral to equal notional. This is untrue. Also, they are leveraged. They have no up-front funding cost to write protection (unless it’s a tight name trading on a 500bps running spread).

Otherwise, good post.

Posted by Sandrew | Report as abusive

I should add that I love your blog, read it regularly, and find your views on regulating CDS very sensible. I think it’s because I usually agree with you that I react strongly to your nonchalant approach to the current CDS market.

Posted by csissoko | Report as abusive

As Mr. Salmon continues his defense of CDS, Steve Pearlstein of the Washington Post writes a column on Friday about another innovation. His critique of all this nonsense is better than anything I could write.

“In many ways, the Hollywood Stock Exchange is simply the logical extension of the recent trend in financial markets, which have long since outgrown their original purpose — to raise capital for real businesses — and have now turned themselves into high-tech casinos offering endless opportunity for speculation.”

http://www.washingtonpost.com/wp-dyn/con tent/article/2010/03/11/AR2010031104794. html

I realize that the chances of returning to the original purpose of financial markets is nill, but must we invest so much energy defending the indefensible given all the evidence of corruption?

Posted by silliness | Report as abusive

Much of this post is very well written and you are spot on when you point out that the problem is really centered on the sellers of CDSs. You are also spot on in fingering leverage as the problem.

But at the core of your column is a bald-faced lie, backed up with no evidence.

“Indeed, it’s the long-only investors who are on the other side of the trade — institutional investors who wrote CDS rather than buying bonds, because the yield was higher or because they simply couldn’t locate bonds to buy, or just because CDS are more liquid. For those investors, CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.”

Alright Felix Glass. Or is it Stephen Salmon, I forget you . This is a quite a statement and you give no evidence to back it up. If you were writing for print media, Felix, you would have to have evidence to back up such a statement.

The statement is patently false, for the size of the CDS market is proof that counterparties are massively leveraged.

When you make false statements on financial matters of such importance, you contribute to the material suffering of millions of people. This is not a trivial matter.

Posted by DanHess | Report as abusive

“most bonds are buy-and-hold investments which are very difficult to find or sell on the open market”

Yes. When the spread between on-the-run and off-the-run treasuries blows out to 35bp you know that size of the market is not the only consideration.

Regarding the claim that broker-dealers are net flat credit exposure, this is basically true, not withstanding those charts of “unmatched” CDS. The first issue is that all banks are systemically exposed to credit; they are natural purchasers of credit protection. When the CDS market is considered in isolation, any bank that is not a net buyer is probably not being prudently managed. As for the “unmatched” CDS, that partly arises from the natural hedging above, but mostly from trading positions with basis risk. For instance, a position in an index offset with single names from the index. As mentioned, there is basis risk to this position, but it is nowhere near the “multiples of capital” claimed.

As for institutional investors “buying CDS”, my reading is that this is just slippery fingers, and that Felix was thinking of long-only investors buying credit-linked notes. These of course embed a short CDS position but are in fact fully funded.

Finally, while it is of course true that hedge funds who write CDS protection do not have to post the full notional as collateral, the collateral requirements are still pretty onerous. Prime brokerage agreements have historically been pretty 1-sided in favor of the bank and with the withdrawal of so many providers are not getting any better. It was the funds who were the main victims of the Lehman debacle, so they were in fact providers of systemic stability. Other buy-side players such as asset swappers also have to post a lot of collateral. On the inter-dealer market, agreements are symmetrical, but then on that market the players are net flat.

These are the reasons why the general CDS market functioned so well during the crisis – much better, in fact, than the cash bond market. The problem CDS were those written by monolines and the captive subs of insurance companies without collateral (but with ratings-based collateral triggers – a crazy idea.) The regulatory issue is not “why aren’t CDS treated as insurance”, but “why were insurance companies able to evade existing regulations so easily?” Why was AIGFP technically neither a bank nor an insurance company? How does that make sense?

Posted by Greycap | Report as abusive

“Selling bonds is hard and opaque — that’s why bond traders make so much money. Buying protection on bonds you own is cheaper and easier and much more transparent.”

I’m what you might call a lay reader of your blog — though a devoted one — and this brought me up short. There’s something simple I’m failing to understand here, and I would be most gratified if you could explain it — why is selling bonds hard and opaque? In terms of the initial issue, or in terms of the circulation of that which is already issued? If I have enough knowledge to bet on/price insurance against the liklehood of default though the means of the CDS, how would I not have the knowledge to know whether I want to buy the actual bond, and at what price?

Or do you mean by “opaque” simple that because of the buy-and-hold nature of many bonds, they are rarely traded, making them dfficult to price? That doesn’t seem to line up somehow — it seems like buying either the bond itself or the CDS would require knowing what odds I’m willing to take on default.

Posted by Anonymous | Report as abusive

“For those investors, CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.”

You mean they’ll write CDS.

And they’re always leveraged at the point of writing a CDS.

But they can eliminate that leverage on a net basis by holding a risk free asset as protection or self-collateralization against the full amount of the potential payout.

The net result is that they hold a risk free asset funded by their own equity (zero leverage), plus a written CDS position.

The risk free asset covers the cash for the payout; the equity position absorbs the liability prior to the payout.

Posted by Anonymous | Report as abusive

@Greycap –

Your explanation of what Felix meant when he made his incorrect statement does not comport at all with Felix’s own words.

He said “institutional investors who wrote CDS rather than buying bonds, because the yield was higher or because they simply couldn’t locate bonds to buy” — this doesn’t comport at all with the incidental CDS involvement in credit-linked notes you talk of.

Felix writes as if these supposed “institutional investors who wrote CDS rather than buying bonds” and who are supposedly fully covered in cash (according to him) are the deep source of funding underwriting CDSs. That is clearly untrue. There is not trillions of dollars laying around to “buy a CDS for the full cash value of the amount being protected, just as they would a bond” — and those are the types of numbers we are talking about.

Indeed, @csissoko and @Sandrew pointed out this incorrect statement before me.

To my way of thinking, one reason CDSs ‘functioned so well’ during the crisis is that the federal government intervened left and right to prevent large default events from actually occurring.

Huge potential defaults which were averted by bailouts including Bear Stearns, Fannie, Freddie, AIG, and others.

When taxpayers step in and make $62 billion of credit default swap counterparty payments, that to my mind illustrates a market that is not functioning properly.

Posted by DanHess | Report as abusive

Greycap:

Could you please explain how these two sentences are not outright contradictory?

“Regarding the claim that broker-dealers are net flat credit exposure, this is basically true, not withstanding those charts of “unmatched” CDS. The first issue is that all banks are systemically exposed to credit; they are natural purchasers of credit protection.”

If the broker-dealers are net buyers of protection, then shouldn’t we know who’s selling it to them?

Posted by csissoko | Report as abusive

I’m sorry, csissoko, I don’t fathom what you think is contradictory. Could you be more explicit please?

I have never said that we shouldn’t know who’s selling protection to broker-dealers. There is a reason for that: I don’t think it is true. That is, so long as “we” is interpreted narrowly as regulatory/governmental authority.

It is not possible to open the trading books of hedge funds in real time for general inspection without destroying the business. And quite apart from the investment value and liquidity provided by hedge funds, if they are going to write credit protection then destroying them would reduce the stability of the financial system.

Posted by Greycap | Report as abusive

@Greycap:
The problem is that CDS are tools for transferring credit risk. There’s no way for CDS to eliminate credit risk (unless they are being sold by a monetary authority). Therefore, if a bank that is systemically exposed to credit risk buys credit protection, it is still systemically exposed to credit risk — just the credit risk of counterparties rather than the credit risk of the underlying.

Collateral may offset a small portion of the credit risk, but the pricing of CDS moves around so quickly (unlike futures and IR swaps) that precisely when you most need the collateral (eg Sept 2008), your counterparty is likely to be bankrupted by the demand for collateral (eg Lehman, AIG) and you will find that a large chunk of your exposure is not covered. This is credit risk.

So … the brokers are not flat credit exposure, because their business requires credit exposure and CDS can only transfer, but not eliminate that exposure. Ergo, contradiction. Also note that you agree that the brokers are not flat CDS as Felix claimed, because they use the market to buy protection.

BTW, do you have any links to data showing that hedge funds are big sellers of protection? It seems to me that the margin call risks are so high that they’d tend to steer clear of that market. My concern is that the less well managed banks may still be selling credit protection to the well managed banks.

Posted by csissoko | Report as abusive

csissoko, you are quite right that CDS transfer risk from one player to another and do not destroy risk overall. However, they really can reduce risk from the standpoint of a single bank, and even for the banking system as a whole. Although the risk is not destroyed when it is transferred out of the banking system, safety is enhanced because the bank is systemically important whereas the end seller of credit protection is not.

It is simply not true that collateral offsets only a “small” portion of credit risk, at least not for a bank; your views are founded on a false premise. You are making life difficult for yourself by conflating AIG and Lehman because they are exactly opposite cases. AIG posed a systemic risk precisely because it didn’t post collateral; it already had large exposures by the time it was downgraded and collateral calls were first triggered. But by this time, it already posed a systemic threat. Why were matters allowed to reach this point? That is the regulatory issue.

Lehman, by contrast, was operating under standard rules and had to post collateral continuously as its positions moved against it. When it was unable to meet it collateral calls, bankruptcy was exactly what was supposed to happen, and was the reason that its broker-dealer counterparties escaped with so little damage despite recoveries of less than 8%. The collateral system functioned as it was supposed to (for the banks, that is.)

CDS pose jump-to-default risks, but plenty of IR and FX products traded in volume (such as barrier options) also have jump risk. For that matter, so does an ordinary loan. Such positions must be managed statistically, and just as no bank can afford to make loans to a single obligor or small group of obligors that would bankrupt it if defaulted, every broker-dealer monitors its positions in real time and places limits on the risk it will tolerate. Trust me, nobody delta-hedges a barrier option near the barrier, where the gamma is asymptotically infinite.

Finally, yes I have said that broker-dealers are not literally flat CDS, which is what Felix wrote. So we are agreed on at least one point! However, I think that “flat CDS” is reasonable shorthand for “flat credit risk”, and that if Felix had to explain every aspect of market mechanics in detail in order to make a blog post he would never post anything. That would be a shame.

Posted by Greycap | Report as abusive

Greycap:

I agree that if it is true that the end seller of credit protection is not systemically important, then CDS may reduce credit risk for the banking system as whole. But believing this requires taking it on faith that every one of our huge banks is going manage their exposure to the CDS market well.

You seem to have this faith, but I’d prefer to see all the banks with access to Fed lending maintaining CDS books that look like JP Morgan’s — just to be safe. On the other hand the new Basel seems to be designed to make this happen — which implies that the regulators don’t trust the banks to manage their CDS risks any more than I do.

I’d also geniunely like to know who is selling that CDS protection to the banks — because it basically means that some other part of the economy is doing the banks’ job of managing credit risk for the economy. Any entity that takes on this role will require close supervision by regulators.

Posted by csissoko | Report as abusive

Greycap –

So nice of you to mention jump risk. That is precisely the thing. It is not accurate to say that CDSs *have* jump risk. They *are* jump risk. A credit will either default or not, and if it does a counterparty will lose massively. As default looms, it is 100% certain that there will be a ‘jump.’ In other words, it is 100% certain that the market have a discontinuity because there will be nobody on whom to pass the counterparty role when a default is really coming.

And enough with the protestations that the counterparties are ‘hedged’ for if they are then that is not a true counterparty. For every true buyer of CDSs, there is a true seller that is on the hook.

You cite the Lehman example as having worked so well, because they went bankrupt. Care to go around saying that in polite company? For whom? For a few of Lehman’s counterparties? How about for Lehman Brothers itself? And how about for the rest of humanity? That those collateral calls were able to destroy it (taking your word that that was what did them in) is evidence that Lehman had written bogus CDS insurance without the ability to pay. This continues to be common now. If Lehman was surprised by the ‘jump’ they should not have been. CDSs, by their nature, become 100% illiquid in the end. The market of private entities that will become CDSs counterparties as default really arrives has zero members.

Regarding your other point, if Felix had to work things out in order to make a blog post that would be an big improvement, because his wrong statements are terribly troublesome. Reading his post, you would think that a big part share of CDS counterparties have covered the notional amount in cash. “CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.” Felix even italized that last sentence. If this were true, there is nothing to talk about and there is no risk at all. It is false of course: there are huge amounts of leverage on the counterparty side.

Posted by DanHess | Report as abusive
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