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.)
Most of the cash has gone to post collateral for CDS deals in which AIG was guaranteeing various bonds against default. As the risk of default goes up, counterparties demand collateral (cash, or cash-like securities); the amount of collateral they want goes up with the likelihood that AIG would have to pay out on a default. (The WSJ article sheds some light on the negotiations that other banks had over collateral; Goldman Sachs, when it couldn’t get as much collateral as they wanted, hedged themselves by buying insurance on AIG’s debt, which is a clever move I wouldn’t have thought of.) If AIG hadn’t been bailed out, its counterparties would be looking at tens of billions of dollars in losses in the form of write-downs on their CDS portfolios, because a bankrupt AIG could not be counted on to pay off on those contracts. Not knowing who was bearing those losses would have increased the fear that for several weeks was paralyzing the credit markets. So arguably, the potential damage of CDS was only contained precisely because the government elected to bail out AIG.
Now, how did the brilliant minds at AIG Financial Products – and they are, or were, brilliant – get into this situation? Like every other financial institution in these markets, they were using models – models, in this case, that estimated the probability of default on the various bonds AIG was insuring by “selling” credit default swaps. The WSJ article says that AIG was (a) using default-prediction models to determine the likelihood that it would ever have to pay out on credit default swaps, but did not have models (until it was too late) for two other risks: (b) the risk that increasing probability of default (as reflected in CDS spreads) would trigger collateral calls by counterparties, and (c) the risk that increasing probability of default would show up as write-downs on AIG’s balance sheet.
I don’t buy this distinction. Risks (b) and (c) occur precisely because the underlying bonds are becoming more likely to default. In order to distinguish risk (a) from risks (b) and (c), you have to have a theory that (1) the probability of default of the underlying bonds is separate from (2) changes in prices of the credit default swaps on those bonds – but (2) is nothing more than the market’s assessment of (1). This amounts to saying that your default-prediction model is right and the market is wrong, even when the market is composed of other banks with similar models; that’s not an argument you’re likely to win.
More fundamentally, there is a question about how valid even the best of these models are. In the last two decades, a new discipline of risk management has been developed in the financial sector. The basic approach is to estimate the variance of the values of the different assets that make up a portfolio, and the variance of the events that can affect the values of those assets, taking into the account the correlations between all of these values and events (that is, the chances of GM defaulting and Ford defaulting are not independent events). Once you’ve done that, you can estimate the likelihood of your portfolio losing X% of its value; if you don’t like the answer you get, you can use hedging strategies to reduce that likelihood. (This movement toward risk management modeling was so successful that the 2004 Basel II Accord recommended that banks be allowed to use their internal models in determining their own capital requirements.)
The problem is that, in general (most of these models are proprietary secrets, so I can’t speak with complete confidence), these models are fed by historical data – because, by definition, that’s the only data you have. So estimates of price volatility or of other events are based on past experience – experience that may only cover a very short period of time, especially where new and complex financial instruments are concerned. More importantly, even a long period of time is not relevant if there is a fundamental difference between the period your data is from and the current moment. To sum this up: Let’s say housing prices have never declined by 30%. You can’t assume they won’t fall by 30% in the future, for two reasons. First, it could be that they only fall by 30% every 100 years, and you only have 50 years’ worth of data. Second, it could be that in the past housing prices couldn’t fall by 30%, but the world has changed in a significant way, and now housing prices can fall by 30%.
As a result, early in the crisis (back in 2007), you would hear people saying that they were seeing “six-standard-deviation” events, or events that should only happen every hundred thousand years. This is just a silly thing to say. As a statistical matter, if your model says that some event was virtually impossible, it is generally more likely that you made a mistake than that an extremely unlikely event occurred.
In any case, the scale of the losses that have occurred in the last year and a half, and the pronounced failure of every financial institution to anticipate them – see the successive earning calls of every large US bank in 2007 – are as good proof as we will ever find that their risk management models simply didn’t work. If something called a “risk management” model doesn’t work under the the most extreme conditions, what’s the point of having it?
The Baseline Scenario 
Very interesting post.
My opinion is that I think it’s fine if a company or companies has a model that is unable to take into account the remote probability of an extreme, highly correlated credit event like the one we are going through now. The impact of having an insufficiently conservative model is that you will take extraordinary risks in achieving ordinary returns. And that appears to be what most companies during the real estate cum credit boom.
But the problem that causes so much upheaval in the markets especially around the time of the LEH/AIG bankruptcy/near-bankruptcy was that it became apparent that nobody knew what their counterparty risk was. CDS are completely bi-lateral agreements and not traded on any kind of exchange. Therefore, when a company enters into a CDS it is counting on the other party to pay in the case where a covenant is triggered. But what if that party is a hedge fund that has recently gone out of business? Or, more likely, what if that party is a hedge fund that “invested” its CDS payment in other high-risk derivatives and is nearly out of business due to the combination of investor withdrawals and reduced asset valuation? In the case of a CDS payment that could result in a payment of 90c on the dollar, that event itself could push some hedge funds under (which it likely did).
I am not trying to pick on hedge funds but rather making the point that the CDS “market” is, and continues to be, a house of cards just waiting for the next bankruptcy to come crumbling down. Investors and institutions of all shapes and sizes have used CDS to hedge themselves against all kinds of risk. But what happens if these hedges aren’t really hedges at all and, in the event of a CDS covenant being triggers, they find that their counterparties are not able to pay or, worse yet, non-existent.
This was the problem facing Treasury when it bailed out AIG. Although I have no first hand knowledge, my impression is that AIG had written CDS on debt of all kinds including Lehman bonds. When Lehman went under, AIG was forced to post more collateral (which we all know). Given that AIG didn’t have that liquidity available, it was close to seeking bankruptcy protection as well. And, if Treasury hadn’t stepped in, the house of cards would have come crumbling down as number of companies that had written CDS insurance on AIG bonds was apparently very large.
I am saying that I agree with Treasury’s action to bail out AIG as Lehman and AIG are two very big dominoes and that would have cascaded into something none of us would have wanted to see. At the same time, however, I think we need to look at the CDS market in general and implement some important fixes. Specifically, we need to get these bi-lateral contracts onto an exchange where prices, payments, and positions can be clearly identified and guaranteed. This would be similar to the options market (and I believe the CBOE is angling to be the clearinghouse for CDS.)
You see, there is nothing wrong with a company that has a faulty risk model. In the end, they will pay the price if it is sufficiently insufficient. But there is no reason why the folly of a few companies should bring down the entire financial system. And when a $60B market is being traded in back rooms and not on an exchange, that is exactly the danger we are facing.
The actions of the Fed and the Treasury have probably saved us from the Great Depression or worse. But unless CDS are moved to some kind of a clearinghouse or exchange, we have only postponed the crisis to another day. It is inconceivable to live in a capitalist society where no large institution is allowed to go bankrupt due to its impact on the financial system as a whole. That is not “survival of the fittest” – it is “survival of the largest” which is truly horrible foundation upon which to build an economy.
“…you would hear people saying that they were seeing ‘six-standard-deviation’ events, or events that should only happen every hundred thousand years. This is just a silly thing to say. As a statistical matter, if your model says that some event was virtually impossible, it is generally more likely that you made a mistake than that an extremely unlikely event occurred.”
The underlying assumption, that the process is gaussian, is where the flaw arises. In the kinds of probability distributions which properly model market behavior, the term “sigma” is meaningless.
See Benoit Mandelbrot, _The Misbehavior of Markets: A Fractal View of Risk, Ruin & Reward_ and
Nassim Taleb, _Fooled by Randomness_.
these companies are supposed to hire smart people. Yet none of them planned for an event like this? I know its a huge event and hard to plan for say like your car blowing up, but if you drive you at least have a spare tire in your trunk, seems like these risk managers did less than the bare minimum to cover themselves for a “just in cas” event. I now i hear the risk manager from Bear Sterns just got a great job, i forget if its with paulsons bail out team, but are you kidding me, I know nothing about wall street risk management, but i do know, Bear/Lehman, AIG, they all did a poor job. And to reward them, it just stinks
Jim:
I think your article was wonderful, especially your analysis of why AIG Financial Products’ models failed. You basically took the information contained in the story and turned it into useful knowledge, which we, your readers, can use in the future. (i.e. lessons learned from AIG’s mistakes)
Your analysis and conclusions lead me to the next question: What should “the brilliant minds” in these companies do in the future? – build better models which factor in the unforseeable or should the people using their models put less faith in these arcane models and use more of their own judgment in their decision making. (e.g. Jamie Dimon at JP Morgan Chase)
What would you recommend to the top-level risk managers of these financial companies? Is the mixture of complicated derivatives with arcane computer models toxic? And how will the regular investor be protected from these kinds of mistakes?
Add me to the list of those who are outraged about the risk manager from Bear Stearns landing a job with the Fed Reserve Bank. Have you no shame, sir??
Lester: That’s a good question. On thinking about it, I think I more or less agree with Eugene’s comment above. If you are a risk manager for an investment bank or hedge fund, you should be trying to come up with more realistic models. For example, if your historical data say that housing prices have never fallen by 30%, but Robert Shiller is telling everyone who will listen that housing prices are overvalued by 30%, maybe you should listen to Robert Shiller.
More importantly, though, we need better mechanisms to protect ourselves from companies that make bad decisions, because there will always be such companies. One way to do that is transparency. If everyone knew what AIG’s CDS portfolio looked like, maybe fewer companies would have been willing to do business with them. Maybe bond investors would have driven up the cost of AIG’s debt long before, forcing AIG to take more conservative positions. Maybe equity investors would have dumped their shares in fear, forcing AIG management (which, in all likelihood, only cared about their share price) to take more conservative positions.
There is a downside to transparency in a trading business, which is that it hurts traders if other people know what they are holding. But I think we need to move toward more transparency, because we should never be dependent on hoping that these banks and hedge funds know what they are doing.
Just a few technical points – great article!
You would probably be surprised how many banks still operate with “Default Only” as opposed to “Mark-to-Market” models which is the technical term for the distinction you are making. On a similar note you would also be surprised how that some companies still claim that Binomial Expansion Technique (BET) is an adequate method for assessing option-style-risk, but this is a different story.
— you have to have a theory that (1) the probability of default of the underlying bonds is separate from (2) changes in prices of the credit default swaps on those bonds – but (2) is nothing more than the market’s assessment of (1)
—
not quite; (2) is the current compensation paid by the market for taking on the risk of (1), but this usually does include a risk premium and that risk premium can be volatile (and is arguably so) meaning that (2) can vary independently of (1). What you are positing would imply the following statement for the equity and bond markets “whether I invest $100 in equities, or in long term bonds, or in cash, I will always expect to make the same amount” which very few people believe (to be precise: it is not exactly the same – what you are saying is that there might be a risk premium, but that has been the same from the beginning of time to the end of the universe)
CEJ: Thanks a lot for the clarifications. I appreciate it a lot.
So… what’s your view of the assessment now of AIG credit? Will the Govt ever let it go down? At 20%+ yields, does it make sense to consider sticking your toes in the water due to the cataclysm that the Fed/Treasury now wants to avoid in the form of an AIG default? They’ve already wiped out equity holders, but I don’t think there’s a way the Gov’t could restructure senior debt holders without triggering a wave of cross defaults among AIG senior debt and CDS holders.