Felix Salmon

Why banks shouldn’t play in CDS markets

By Felix Salmon
May 29, 2012

There are a few different ways to look at the seemingly-unstoppable rise of the amount of “excess deposits” that JP Morgan ended up handing to its Chief Investment Office, rather than lending out to individuals and businesses needing loans. Maybe big corporations are flocking to deposit their billions at Chase because they know it’s too big to fail. Maybe Chase just can’t find anybody who both wants to borrow money and is likely to pay it back. Maybe — and more likely — Jamie Dimon funneled increasing sums to the CIO just because the CIO could generate a higher internal rate of return than his plain-vanilla lenders could.

But as Roger Lowenstein explains today, a large part of what we’re seeing here is the way in which lending has morphed into investing. All of us intuitively understand that there’s a difference between lending someone money, on the one hand, and buying a bond, on the other. The former is a bilateral contractual relationship which lasts until the loan is repaid; the latter is an anonymous purchase of securities which can be flipped for a profit (or sold at a loss) after weeks or days or even minutes.

The CIO, playing in the bond and derivatives markets, is very much in the latter camp rather than the former, as you can guess by looking at its name. It makes investments, rather than disbursing loans. But the danger here is not just that $400 billion of JP Morgan’s assets are being put to work gambling in the markets rather than extending loans to clients. The danger is that as the CIO gets bigger, it effectively turns the JP Morgan Chase loan portfolio into an investment, too.

It’s worth quoting Lowenstein at some length, here:

The new Jamie, and the people working for him, don’t have to worry quite so much. They know that if they become uncomfortable with the loans they can always hedge them in the derivatives market…

When JPMorgan hedges, it doesn’t get rid of the risk. That only happens when the customer repays the loan or, say, improves its balance sheet. JPMorgan’s hedges didn’t make the risk disappear; they merely transferred it to someone else.

Jamie had an escape hatch, but hedging doesn’t offer an escape for markets as a whole…

JPMorgan still issues loans but with half an eye on their “hedging” potential, that is, on the willingness of traders who may be halfway around the globe to assume the risk. These traders are less well-placed to evaluate the risk. They don’t know the customer and, of course, they haven’t the faintest concern for character. By habit and preference, their involvement is apt to be brief.

They assume risk by writing a swap contract in the full knowledge that they can unwind it via another swap days or even hours later. Someone may get stuck with the bad coin but, each trader is certain, it won’t be him or her. So the approach of these traders is inherently short-term — too short to invest the time and effort to evaluate the risk. Too short, we might say, to really care.

The plasticity of modern finance — the ease with which institutions can transfer risk — is a major cause of the heightened frequency of meltdowns and increased volatility.

To put this another way: liquidity is dangerous, because it breeds complacency. All you need to do is set a stop-loss, and you’ve protected yourself from large losses. Until, of course, the markets seize up and bids simply disappear from the market altogether. Or until your elaborate and complex hedging operations turn out to have been badly constructed, and you wake up in the morning with a loss pegged at $2 billion and growing.

Alan Greenspan famously said in 2003 that “what we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so.” In practice, if you look at the actions of the CIO, derivatives were used to transfer risk from those who should have been taking it — big lenders — to hedge funds who make money only when JP Morgan turns out to have fundamentally miscalculated its risk basis.

Entities who want to really take on credit risk are called banks, and they do so by lending. People who sell credit protection in the markets, by contrast, are traders and speculators who trust in the liquidity of the CDS market and who are sure that they will be able to get out quickly if things turn against them. And thus is the CDS market used shunt risks off, unseen, into the tails.

Liquidity isn’t just dangerous in the loan market. Look at houses, which used to be highly-illiquid investments characterized by a long-term relationship between a homeowner and a lender. When did things fall apart? When that relationship was replaced by a frenzy of securitization and refinancings, with even 30-year mortgages lasting for just a year or two before they were paid off by someone flipping their house or deciding they needed a cash-out refinance. The more liquid housing became — the closer it came to being piggy bank, to be tapped for cash at any time — the more dangerous it became, as well.

Lowenstein’s proposed solution — banning credit default swaps entirely — is not going to happen. But it’s a useful lens through which regulators should be looking at the banks they regulate.

Activity in the CDS market, on this view, is a sign of weakness, not strength: it’s a sign that the bank doesn’t have much faith in its own relationships and underwriting standards, and is reduced to having to buy protection from speculators in order to feel comfortable with the risks that it’s taking. Since those speculators, by definition, don’t have remotely as much information about the bank’s borrowers as the bank does, and since they certainly can’t put covenants into loans protecting them from profligacy at the borrower, such trades make very little economic sense in theory.

Regulators should remember this the next time a bank starts boasting about its sophisticated, state-of-the-art risk management systems. Most of the time, those systems involve complex bets in a zero-sum-game derivatives market, where the bank’s counterparties charge a premium for the fact that they’re on the wrong side of an information asymmetry. At best, in such cases, the bank is merely abdicating responsibility for its risks, rather than properly managing them. And at worst, it thinks that it has gotten the credit risk off its books, when in fact it’s just pushed that risk into the tails, where it’s bigger than ever.

Either way, regulators should have precious little time for such antics. They should force banks to go back to basics, instead, and manage their risks the old-fashioned way, by building strong relationships with their borrowers. Lending those borrowers money right now, when such lending is sorely needed, would be a good start.

8 comments so far | RSS Comments RSS

Ironic conclusion, given that CDS were devised, in part, to permit banks to do more of what they are good at (originate quality loans), and also maintain good diversification by transfering the excess concentrations to other entities.

Banning the use of CDS by banks could be just a step back in time to the days when banks blew up because they made loans that were too big (either to single obligor or industry) relative to their capital base.

Posted by BoringCanadian | Report as abusive

Indeed, your argument seems explicitly to imply that lending now would be even lower without liquid credit derivatives markets in which banks are hedging; that right now, they’re making loans that should not be made in addition to the ones that should, and that they should lose their ability to hedge so that they will only make the ones that are low-risk.

Posted by dWj | Report as abusive

It is no excuse for what JP Morgan did, but there literally are no safe places for the excess money in the market, except as low-interest deposits at the Federal Reserve. QE took away the bonds normally available, replacing them with a large quantity of money which has to be deposited at one bank or another, with nowhere else to go.

It is easy to say that it should all be lent out by the banks, but I suspect that the same people who are complaining now about CDS would be apoplectic if the banks made too many low-quality loans which resulted in defaults.

Posted by Hayes | Report as abusive

Swaps are nefarious instruments, they provide exposure at no cost, which is why so many flock to them, but make a mistake and wish to exit, the full present value of the mistake gets monetized. The argument that share-holders of tax payer took the loss is not valid here.. the loss could have been far worse or AIG sized.

Posted by Sechel | Report as abusive

The fact that there is excess money on deposit is proof that too much of it has been extracted from the economy. And for what purpose?

The economy is not in balance, and it isn’t because taxes are too high, or government spending is too high, or there are too many regulations. Too much money flows to too few people, who have so much of it, they don’t know what to do with it. They don’t want to invest it and they don’t want to loan it. They are going to lose it, because the economy that their wealth is based on and relative to will crumble.

I’m not suggesting that wealthy people should give away money (I don’t do much of that), but it has to be used somehow. And if you’re making so much money that you don’t know what to do with it, then pay your partners, the people who help you make so much money, more, so they can spend more of it, and need less help from the government.

I probably shouldn’t go off on a tangent here, but while I’m talking about paying your employees more so they don’t need government assistance, I think I should mention the most absurd government subsidy, which is the below market minimum wage. If the minimum wage is less than what can support an acceptable standard of living for a great nation, then the government ends up subsidizing those workers. What good are jobs if the government has to supplement the income? The workers end up paying little or no taxes, and need all kinds of help, because the job they took instead of unemployment or welfare won’t put food on the table AND a roof over their heads (we won’t even get into health care, because they don’t pay those bills, those costs are spread among everyone who can pay).

Anyway, if the distribution of income was less concentrated in a narrow silo, then the banks wouldn’t be stuck with the problem of how to use all that money – the money would be getting used by people working and buying things. Solve that distribution problem and the issue of what banks do with all of their deposits will go away. Money will be constantly in transit, rather than wasting away on a ledger.

Posted by KenG_CA | Report as abusive

I understand the instinctive appeal of your thinking here, but it is specious.

Consider the onion future. The trading of onion futures is banned in the US, that being the chosen remedy to a disgraceful episode of market manipulation during the 50′s. Ridding the world of onion futures has certainly prevented anyone from cornering the market in them, and at first the cost seemed low, for the volatility of onion prices during the 60′s was the lowest of any decade on record. Who needs to hedge a price that never changes? But in the current era, onions have become a riskier product to produce than corn, soy, or orange juice, all of which support traded futures. The fault lies in the remedy: making trading illegal instead of making predatory trading illegal.

There is more. What is the difference in principle between lending and equity? If the privilege of lending must be restricted to bilateral bank loans, why must not the privilege of investment be restricted to private equity? Why should the irresponsible hoi polloi be allowed to buy stakes in enterprises of which they understand little or nothing, merely hoping to sell to a greater fool?

Even by blogging standards, the ideas you have presented here are incoherent.

Posted by Greycap | Report as abusive

CDOs, the kind made up of home mortgages, are what turned lending into investing. CDS–and the awesome “synthetic” CDS–are what turned that defensible financial innovation into the finance neutron bomb and unprecedented profit machine for crooks.

The problem was always counterparty risk.

One may purchase a swap from someone in the market, but one cannot know if the company that sold that swap–and promised to take one’s loss–can actually do it.

The key innovation in the market? Neither side of the deal cares.

You pay them now for the swap. You book your “profit” and fee (and bonus) on the loan bundle. And when–not if, when–it blows up?


Big private profits today, guaranteed. Bigger losses tomorrow, also guaranteed. But the losses are guaranteed to be paid by the public.

Posted by Eericsonjr | Report as abusive

Commercial banks should never be allowed to use cds, or any other hedge instrument, to hedge their collateralized loan portfolio. For large banks, the size and diversity of its collateralized loans are the hedge. Bankers’ claims that additional hedges are needed are an indication that the loan portfolios are not healthy, and that this is fully recognized by the managers of our largest banking institutions. But how do you hedge against an overall collapse in the collateral (e.g. housing market collapse)? Well, the likelihood of such a collapse is greatly reduced if we don’t have a speculative bubble in the first place. Also, as we have seen, at that point your hedges blow up just as surely as your collateral, and you need to seek relief from taxpayers, who may or may not be in the mood to help you out, and recent banking shenanigans aren’t helping those prospects.

I am in total agreement with KenG_CA — we have way too much investment money chasing far too few investment opportunities. And we’ve had this condition for a long time. Too much of our productive capacity is being squirreled away as private investments (since so much of our output now goes to the wealthy) rather than public investments in infrastructure, education, public health, etc. This goes back at least as far as the dot-com bubble, and I suspect its roots lay partly in the tax restructuring that occurred under Reagan (although I believe there are other causes as well). In any case, the Bush tax cuts were gasoline on that fire, and likely lit the Great Recession conflagration we are now still trying to put out.

Posted by Sanity-Monger | Report as abusive

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