Tag Archives: cds

“Appalled, Disgusted, Ashamed and Hugely Embarrassed”

No, that’s not someone talking about the banking industry. That’s Howard Wheeldon of BGC Partners (a brokerage firm) responding to Adair Turner’s statement last September that “Some financial activities which proliferated over the last 10 years were socially useless, and some parts of the system were swollen beyond their optimal size.” (Turner is head of the FSA, the United Kingdom’s primary bank regulator.) That’s from a recent profile of Turner on Bloomberg.

“‘How dare he?’ Wheeldon now says. ‘Markets will decide if something is too big or too small. It’s not for an individual, however powerful, to slam and damn nearly 1 million people.'”

Do we really need to point out that markets don’t always make the right decisions? Markets didn’t break up Standard Oil or AT&T–people did. And how is it wrong for public figures to be publicly stating their beliefs about what the objectives of public policy should be?

But the point of this post isn’t to single out another free-market zealot who apparently doesn’t think about the words he is saying. It’s to talk about John Paulson and Malcolm Gladwell.

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The Man Who Crashed the World?

Back in November, Michael Lewis wrote a great story in Portfolio on the financial crisis, focusing on the traders who saw that the housing bubble was going to crash, bringing mortgage-backed securities down with it – and made lots of money betting on it. Now Lewis is back with his article in Vanity Fair on AIG Financial Products (FP) and its last head, Joseph Cassano. This time, though, it feels like it’s missing the usual Lewis magic.

Lewis sets out to tell the untold story of FP, based on extensive interviews with people who actually worked there. He starts by laying out the conventional wisdom about FP, which presumably he is going to debunk. The conventional wisdom, according to Lewis, is that the problem lay in credit default swaps: “The public explanation of A.I.G.’s failure focused on the credit-default swaps sold by traders at A.I.G. F.P., when A.I.G.’s problems were clearly much broader.” Indeed, Lewis implies that the government essentially framed FP: “Why were officials, both public and private, so intent on leading others to believe all the losses at A.I.G. had been caused by a few dozen traders in this fringe unit in London and Connecticut?

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Conventional Wisdom About Credit Default Swaps

I originally published this post over at The Hearing on Monday, but it feels more like a Baseline Scenario kind of post.

One part of the Obama Administration’s financial reform plan is tighter regulation of credit default swaps – those previously unregulated derivatives that brought down AIG and nearly the entire financial sector with it. One of the problems with AIG was that its regulators were apparently unaware that it had amassed a huge, one-sided portfolio of credit default swaps that amounted to a massive bet the economy would do just fine; another problem was that, because credit default swaps were “over the counter,” custom transactions between individual private parties, they created a large amount of counterparty risk – the risk that the party you were trading with might not be there to honor the trade.

In response, the administration proposes to “require clearing of all standardized OTC derivatives through regulated central counterparties (CCPs).” In addition, “regulated financial institutions should be encouraged to make greater use of regulated exchange-traded derivatives.” Major players in the market will also be subject to conservative capital requirements (making sure they have enough money in case their trades go badly) and reporting requirements. These provisions aim to increase regulatory oversight and minimize the chances that a derivatives dealer will fail and take its counterparties down with it, and as far as they go they are a good thing.

However, there is one potential loophole that, according to UCLA law professor Lynn Stout (on Friday’s Morning Edition), is “potentially big enough to put the state of Texas into.” The loophole is that “customized bilateral OTC derivatives transactions” would remain out of the reach of both exchanges and CCPs.

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“I Have 13 Bankers in My Office”

The Washington Post (hat tip Mark Thoma) has a profile of Brooksley Born, who has been credited by dozens of commentators (including us) for unsuccessfully attempting to increase regulation of derivatives in the late 1990s while serving as the head of the Commodity Futures Trading Commission. There’s much to admire, including being the first female president of the Stanford Law Review, making partner while working part-time, and, most importantly, this:

Born keeps informed, but she has other concerns, bird-watching jaunts and trips to Antarctica to plan, mystery novels to read, four grandchildren to dote on. “I’m very happily retired,” she says. “I’ve really enjoyed getting older. You don’t have ambition. You know who you are.”

Then there are the frightening flashbacks to the regulatory battles we are sure to relive this fall:

Greenspan had an unusual take on market fraud, Born recounted: “He explained there wasn’t a need for a law against fraud because if a floor broker was committing fraud, the customer would figure it out and stop doing business with him.”

Translation: Imperfections in free markets are logically impossible.
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A Quick Note on Bank Liabilities

I want to pick up on a theme Simon discussed in his last two posts: the recent panic over bank debt, particularly subordinated bank debt. I’ll probably repeat some of what he said, but with a little more background.

Remember back to last September. What was the lesson of Lehman Brothers? The most important asset a bank has is confidence. If people are confident in a bank, it can continue to do business; if not, it can’t.

For the last six months, where has that confidence been coming from? Not from the banks’ balance sheets, certainly. And not, I would argue, from the dribs and drabs of capital and targeted asset guarantees provided by Treasury and the Fed. It has been coming from a widespread assumption that the U.S. government will not let the creditors of large banks lose money, out of fear of repeating the Lehman debacle.

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Whatever Did The CDS Market Mean By That?

The credit default swap market is a modern Delphic Oracle.  It speaks loudly and profoundly – these days at regular intervals – albeit using somewhat arcane terminology.  And after major statements such as yesterday (or perhaps this week in general), it’s worth pausing to reflect on, and argue about, what it really means.

Thursday’s statement, to me, was about US banks (graph).

The risk of default for US banks, according to this market, is rising back towards levels not seen since mid-October.  That is striking enough – but remember what has changed since then: (1) the G7 promised not to let any more systemic banks fail, (2) Treasury has provided repeated recapitalization funds on generous terms, and (3) the Fed offers massive, nontransparent funding to anyone in distress.  How can it be that the credit market still or again feels the risk of default rising so sharply and to such high levels? Continue reading

Dublin (and Vienna) Calling

If you think credit default swap (CDS) spreads are informative with regard to developing pressure points and issues that policymakers should focus on (or will likely spend hectic weekends dealing with), you should look at the latest CDS spreads for European banks.  The Irish story we have already flagged.  I’m also concerned that developments in East-Central Europe are starting to affect the prospects for West European banks, most notably in Austria. Continue reading

Credit Default Swaps, Herald of Doom (for Beginners)

No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!

As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default.

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AIG, Credit Default Swaps, and “Risk Management”

Since the Lehman credit default swaps settled without the sky falling, there has been a small wavelet of support for the once-obscure financial instruments that are widely blamed for amplifying the effects of the financial crisis, including a Forbes.com op-ed entitled “Credit Default Swaps Are Good for You.” I happen to agree that CDS can play a useful role in enabling bond investors to hedge against the risk of default, and thereby make it easier for some institutions to get credit. But it’s a bit premature to proclaim that all is well and good in swapland.

Most obviously, there is the troubling matter of AIG, which has recently received additional scrutiny from the likes of the New York Times and the Wall Street Journal (subscription required). AIG has already burned through most of its initial $85 billion loan from the government, has drawn down half of a separate $38 billion loan for its securities lending business, and recently got permission to sell up to $20 billion of commercial paper to the Fed. (And remember, when negotiations over the AIG bailout began around September 12, the company was saying it only needed $20 billion.)

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Lehman CDS Settle; World Doesn’t End

Yesterday was the last day for settlement of credit default swaps linked to Lehman debt. One of the fears raised in the dark days of September was that the failure of a bank like Lehman would create hundreds of billions of dollars of liabilities for companies that had sold insurance on Lehman debt, and that market participants had no way of knowing who was good for that money, because many sellers were hedged and might be counting on payment from another seller, who might be counting on …

Well, the financial system is still standing. While we won’t know who lost money until the next quarterly earnings are announced, no one defaulted on the CDS. In part, this was due to the fact that as Lehman bonds fell in value, sellers of CDS had to post collateral to buyers, so a lot of the losses had already been recognized. (I believe AIG was an exception to this, because they had a AAA bond rating and hence did not have to post collateral until they were downgraded.) Perhaps things would have been worse without the many liquidity-increasing steps the Fed took over the last month; if you have to raise cash in a hurry, it is far easier to get it from the Fed now than it was in the past. In any case, it appears we have one less thing to worry about, at least for now.