A CDS Question

by publius

Dean Baker at CEPR has authored a short and helpful primer on the AIG controversy (pdf here).  One interesting question posed is how exactly the federal government is treating AIG’s massive credit default swap (CDS) obligations.

As Baker notes, most CDS’s were purchased by parties that didn’t own the actual underlying instrument (e.g., bond) being insured.  So these parties weren’t buying CDS's to protect themselves – they were essentially gambling on other people’s success.  Anyway, one burning question is whether the federal government is honoring all of the CDS obligations, or only those in which a party actually owns the instrument being insured.

The Treasury and Fed have not released the rules they applied in dealing with AIG’s CDS. They may have only honored CDS where the institution held the bond being insured or they may have honored all of AIG’s CDSs, regardless of whether or not the bank held the bond being insured.

This makes a big difference in terms of the purpose of the bailout. If a bank had bought a CDS to protect itself against losses on a mortgage backed security, and the CDS was not honored, then it would be an unexpected blow to its balance sheet. On the other hand, if the bank was just gambling that a bond that it did not hold would go bad by buying a CDS issued against it, it is difficult to see how a failure to honor the CDS would impose a serious hardship.

Anyone want to weigh in on that last part?  Agree?

Comments

[d'd'd'dave]

Chris Dodd said on CNN, "We originally directed AIG to honor the CDSs held by key political contributers but Treasury pressured us to honor naked CDSs held by Goldman Sachs as well."

[ed_finnerty]

This would be akin to 3rd party insurance - i.e. somebody else taking out fire insurance on your house. The boys at moon of alabama have been all over this story since september. I know some of them are a bunch of lunatic stalinists that forced Billmon to close the Whiskey Bar but the stuff on CDS's was pretty good.

[d'd'd'dave]

When confronted with Dodd's comments, Geithner defended himself, saying, "It doesn't matter what we do because Bush was bad and Cheney was worse."

[d'd'd'dave]

I'm an actual troll today.

[Bernard Yomtov]

I can imagine a reason for buying a CDS on a bond you don't hold. Suppose you own lots of stock in a company and you don't want to or can't sell it, for some reason, but fear a decline in its value.

I guess you might buy CDS on the company's bonds as a hedge. I have no idea if anyone does this, but it wouldn't be pure gambling, and I guess CDS could be used for other sorts of hedging as well. In those cases I think the failure to honor the CDS would hit the balance sheet - the real one at least.

What I've always wondered about is why buy CDS on bonds you do hold, as opposed to just buying less risky bonds in the first place.

[jrudkis]

I think a lot of CDS's that were not backed by an interest in the property were still bought as hedges against other investments that could tank in a major meltdown.

In otherwords, they were still insurance for real investments against a downturn if it happened, just not linked directly to the actual investments.

I think this could happen, for example, if you were a money managing firm with clients in the stock market, and as a hedge for them you bought into a Black Swan hedge invested in CDS's to protect against the the market plummet. It would be rational to beleive that once the home bubble blew, the market would follow, so as a fiduciary, you invest in insurance to cushion the blow.

So I am not sure that those who bought third party insurance on the home bubble are necessarily just gambling on the loss of others, rather than trying to insure their own investments once that bubble burst.

[Don the libertarian Democrat]

From The Economics Of Contempt:

http://economicsofcontempt.blogspot.com/2009/03/why-aig-was-rescued.html

"Why AIG Was Rescued
Felix Salmon argues that AIG was rescued because if it had failed, no one would have known who was ultimately bearing the losses, which would have caused financial markets to freeze virtually overnight:

[T]he web of connections between the thousands of counterparties in the CDS market is so complex that no one really has a clue who would have ended up holding the multi-billion-dollar bag.
...
But no one would have had a clue where in the financial system, exactly, those losses would have ultimately come to rest. And given the magnitude of the losses, you can be sure that no one would have wanted to have any kind of dealings with the poor schmucks who ended up on the hook for all those billions of dollars. And since those pooor schumcks could be pretty much anybody, no one would do any kind of business with anybody else: you'd get settlement risk run amok. The entire global financial system could grind to a halt overnight, due to the inability of any given institution to persuade any other institution that it was actually solvent.

I tend to disagree. Incidentally, I think this is more or less the explanation for why Bear Stearns was rescued, but not for why AIG was rescued.

The reason AIG was rescued was much simpler: regulatory capital relief. AIG's massive CDS portfolio was providing an enormous amount of regulatory capital relief at the time, primarily to the major U.S. and European banks. Had AIG failed, all the major banks—which were already engaged in mass deleveraging due to Lehman—would have suddenly lost most, if not all, of the regulatory capital relief that AIG's CDS contracts had been providing. This would have put the banks well under their regulatory capital requirements, and thus would have sparked a fresh wave of forced liquidations, depressed asset prices, writedowns, and yet more forced liquidations, as the banks scrambled to raise capital to meet their minimum capital requirements.

With the markets already convulsing wildly due to Lehman's failure, this would have been a devastating body blow, and I don't think the markets could have taken it.

From what I understand, this is the doomsday scenario that ultimately led Geithner to rescue AIG."

I hope this helps.

[Fraud Guy]

jrudkis,

The question is, then, could any insurer/writer of CDS really hedge against a Black Swan that would take down a large swath of the financial markets without being a vulnerable part of those markets itself?

This brings me to a point that I have heard made, which is that some of the CDS buyers felt that they were hedged, not by AIG or the CDS writers, but by the U.S. Government who could not allow them to fail.

The counter point is that all of the CDS buyers were ignoring or accepting the fact that their purchases were not really protection, but a legal shell game to allow them to increase leverage by claiming protection. (See Mr. Regulator, this CDS covers me for $50B in losses against these loans/positions, so I can count that against my reserve requirements, and lend out/use another $50B and keep my 10-1 leverage; really, I can.)(Uh, okeydoke.)

[ThatLeftTurnInABQ]

It is also worth noting that several of the recipients of AIG money were foreign banks. While the public has an interest in the stability of the world economy, which means preventing major foreign banks from going bankrupt, there is no obvious reason that American taxpayers should be forced to bail out foreign banks of wealthy countries. It is possible that there is some quid pro quo under which foreign governments are bailing out U.S. banks on losses suffered in their countries, but there has been no public acknowledgement of such an arrangement.

This sounds a lot like my hypothesis that they are doing it to recapitalize the European banks without causing too much of a ruckus here in the US.

There is a possible alternative explanation. The government may have made these payments in order to preserve the international reputation of the U.S. financial industry. If that is the case, then this is a rather expensive subsidy to the financial industry. To date there has been no explanation as to the reason for making these payments.

I think there is a third possible explanation – that AIGFP’s CDS contracts are collectively such a dense and tangled mess of decentralized and disorganized paperwork that it is taking Treasury months on end simply to find it all and dig through it to figure out just exactly who the counterparties actually are. Remember that back in 2005-2006 they didn’t think more than a tiny handful of these contracts would actually be triggered, so there was no reason to organize it all for the purposes of running a mass settlement. It wouldn’t surprise me if AIG had no central database of information summarizing all the counterparty relationships expressed via their CDS, instead individual traders and their managers were keeping track of the paperwork on an ad-hoc basis. Think of a mess like the Gitmo detainee files, only on a much, much larger scale.

If this sounds unbelievable or shocking, go read some of the insider accounts of what is was like working at one or more of the major investment banks and hedge funds (e.g. Richard Bookstaber’s A Demon of Our Own Design ) and note what a hodge podge of IT systems they were using.

[Bernard Yomtov]

If this sounds unbelievable or shocking,..

Not at all. Remember the stories of attempted home foreclosures where no one could find the actual mortgage documents.

You'd think with all the money floating around someone would have gone to Staples and bought a box of file folders, but I guess not.

[ThatLeftTurnInABQ]

You'd think with all the money floating around someone would have gone to Staples and bought a box of file folders, but I guess not.

That might have been better that what they appear to have actually done, which was to run daily trading operations on Excel spreadsheets

Departments and silos had to hedge their use of the banks balance sheet so invented elaborate and often useless hedges. Sometimes the hedges would be within the same bank or counterparty and their systems were so inadequate they had no idea what their true risks were. It wasn't just Deutsche Bank who had no systems to book its credit derivative positions; none of them had anything.

Trade first, book later was the motto. The products came out faster than the IT systems could be built and many banks were held together by Excel spreadsheets.

Years ago, a management consultant told me her firm tried to limit the use of Excel at a large insurance company (strangely the one beginning with A and ending in G) but was shot down for being a luddite. She knew that these shadow systems were unregulated and would cause long term problems. And so she was right.

So imagine (if you will) being the guys/gals from Treasury who walked into AIGFP on the first day and asked the manager of some trading desk "show me your CDS's", and were told "let me go ask Charlie".
...
Hours later: "umm I'm afraid Charlie's not here, he left a month ago. We think he was keeping some of his trades in a spreadsheet, but we can't find it on the network, and his workstation was wiped clean last week. Our guys from IT think they may have his files archived on tape, assuming he wasn't keeping them on his C: drive. I'll get back to you."

Lather, rinse, repeat.

[J. Michael Neal]

I can imagine a reason for buying a CDS on a bond you don't hold. Suppose you own lots of stock in a company and you don't want to or can't sell it, for some reason, but fear a decline in its value.

I can imagine another reason for buying a CDS on a bond you don't hold: you sold a CDS to someone, who may or may not hold the bond, and you are trying to lay off some of your exposure to a reinsurer. I've read some stuff, including the linked Felix Salmon piece, that indicates that this is a large part of what happened with AIG. They weren't so much the primary seller of CDS. Rather, they were the company that everyone went to for their reinsurance. One of the things that would happen if it failed is that a lot of folks who thought they were hedged now aren't.

My guess, and it really is just a guess, is that this is what is being discussed when people talking about hedge funds getting a lot of the AIG bailout. AIG probably didn't deal with the hedge funds directly; I'm willing to believe that Wall Street traders sacrifice live goats at their desks, but even I wouldn't guess that AIG was quite that brazen, though I could certainly be wrong. However, if the bailout money is going to AIG's institutional banking counter-parties, who then funnel the money to hedge funds that they sold protection to, that's exactly the effect that you would get.

[MarcinAsia]

The problem is that there is not a clear line between hedge and speculative purchases of CDS.

a) buy a cds against bond X owning bond X

b)buy a cds against bond X having sold a cds against bond X

c)buy a cds against bond x owning very similar bond Y (for which there is no cds market)

d) buy a basket of cds against a portfolio of bonds

e) buy a cds and synthetically short it through actively trading other securities

f) buy a cds as generic protection against a financial meltdown

g) but a cds because you have figured out that company X is the next Enron

h) buy a cds on a hunch

The first of these is obviouly hedging. However the next few arw also hedging, but much harder to define. Where do yopu draw the line? If you do so retroactively -- or even start to seriously consider it -- those with transactions just above your line will understandably get worried.

A second reason. Even if they bought the cds as a apeculation, this may be one of the few bright spots in a otherwise toxic portfolio. If an institution is in trouble any hit (no matter how deserved) will just make it worse. This is fundamental to the issue of bailing out failed institutions -- justice and the future economy may point in different directions.

[Fraud Guy]

Sorry, all of these wonderful comments about the trading systems is bringing back a fond memory.

Years ago, while job hunting, one position I interviewed for was as an ACH Analyst for an offshoot of a major regional bank (long since gobbled up by another major regional, and in turn gobbled up by some multinational "House").

The ACH network has been around for a long time, is well regulated and understood, and was at the time the standard means for banks to transfer funds to each other.

The position required taking turns on the overnight shifts, which could be the busiest.

Why? I asked.

Because you would have to reconcile errors.

What do you mean?

Since this offshoot of the bank handled ACH transactions for the region, the analysts were required to review transactions that did not have correct routing information, research to determine the correct destination bank (and sometimes origination bank), and forward the funds.

How many can there be?

Sometime dozens, and they all have to reconciled before banks open.

Why do they happen?

Sometimes the information is entered incorrectly, and sometimes its just not valid.

How much can these errors run?

Since these are bank reconciliation transfers, they can run to 8 or 9 figures.

You mean that people incorrectly send millions out from their bank?

Yes, all the time.

Remember, this was the basic system banks used to process funds transfers to each other, with many millions in errors nightly, that had to be manually reconciled nightly.

I went into internet fraud prevention, which was just going crazy at the time, instead of insane.

[John Casey]

It's not clear to me how AIG can distinguish between CDS obligations it will honor and those it will not. To get back to basics, a financial institution that does not honor all of its obligations when they fall due is described by one word: 'bankrupt'.

JC