Brent Nyitray
Fairlington Blade
Let the mutherfuker burn!
jnc4p
Kevin S. Willis
Michigoose
lmsinca
markinaustin
Arcanaut
novahockey
quarterback
ScottC
yellojktVital Statistics
| Last | Change | Percent | |
| S&P Futures | 1363.5 | 2.9 | 0.21% |
| Eurostoxx Index | 2518.8 | 4.6 | 0.18% |
| Oil (WTI) | 106.65 | 0.1 | 0.07% |
| LIBOR | 0.4736 | 0.000 | 0.00% |
| US Dollar Index (DXY) | 79.665 | 0.526 | 0.66% |
| 10 Year Govt Bond Yield | 2.04% | 0.03% |
Markets are rising this morning after Greece successfully completed its sovereign debt restructuring and the BLS released its jobs report. Over 95% of bondholders tendered after Greece said it would trigger a collective action clause compelling participation. This should pave the way for another 130 billion in aid. While the market clearly does not consider the crisis solved – the new bonds are trading at a 22% yield in the when-issued market – this should at least put Greece on the back burner for a while. The 10-year is down 6 ticks, while mortgages are flat.
The BLS released its February Employment Situation report at 8:30 this morning. Feb payrolls came in a bit higher than expected – 227k vs 210k expected. The unemployment rate was flat at 8.3% and in line with expectations. The labor force participation rate edged up slightly from its Jan lows. Earnings and hours were up a hair. Professional and Business services added the most jobs, along with health care. Government and construction were flat.
CoreLogic released its monthly Market Pulse yesterday (you need to register to get it, but it is free). They note the building economic strength and signs of improvement in the real estate market. They note that the recovery was initially driven by productivity-increasing capital investment, which allows companies to increase output without increasing hiring. Productivity growth is tapering off, which suggests that business has pretty much extracted all it can from existing employees and will need to start hiring to increase output.
The report notes that 25% of MSAs are now experiencing price increases. The ones that are lagging the most are the ones with clogged foreclosure pipelines – for the most part judicial foreclosure areas. Just more proof that politicians who want to slow foreclosures in the hopes that keeping supply off the market will stabilize prices are shooting themselves in the foot. Of course some politicians are incorrigible. To be fair, most of these measures are small-ball things that won’t change the dynamics of the housing market, but will allow the administration to say they are “doing something” about the housing crisis. For some reason, letting the market clear does not constitute “doing something.”
Do you look at Zillow to get an idea of what your house is worth? The Washington Post dissects the Z-estimate and its accuracy. Punch line: Neighborhoods with high turnover tend to have Z-estimates closer to actual sales prices than neighborhoods with lower turnover. While it can be a useful (and fun) number, take it with a grain of salt.
Filed under: Uncategorized |
All Things in Moderation 
“Greece said it would trigger a collective action clause compelling participation.”
So does this count as a CDS triggering event?
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jnc:
So does this count as a CDS triggering event?
That’s the question, isn’t it? ISDA has previously said no, but it keeps returning to the issue, even as recently as this morning.
[the link may require registration, but this is the gist of it:
“A special committee of the International Swaps and Derivatives Association will meet at 1300GMT Friday to consider a question from a market participant on whether Greece has suffered a credit event, ISDA said in a statement…
In January, ISDA said the inclusion of collective-action clauses in Greek-law bonds “would not, in and of itself, be expected to trigger a credit event.” But it added that “the use of such a clause to effect a reduction in coupon or principal” could trigger credit default swaps.
ISDA’s Determinations Committee for Europe will have the final say about whether holders of CDS can be paid based on losses investors will take under the restructuring. There is no opportunity for CDS holders to appeal if the 15-member committee of dealers and investment firms rules against them.” ]
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“ISDA’s Determinations Committee for Europe will have the final say about whether holders of CDS can be paid based on losses investors will take under the restructuring. There is no opportunity for CDS holders to appeal if the 15-member committee of dealers and investment firms rules against them.” ]”
So in short the ISDA can vote that in fact the Emperor is indeed still wearing clothes.
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jnc:
So in short the ISDA can vote that in fact the Emperor is indeed still wearing clothes.
Yes.
The issue of what exactly constitutes a credit event with regard to any particular CDS has been a thorny issue for some time.
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Back from MedPAC. You’ll be happy to know that we’re are totally FUBAR when it comes to entitlements. A day and a half of, “we can push this lever, tweak this, blah, blah, blah.”
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basically.
One of the biggest things what the desire for fairness. I’ll post about in depth later. but essentially, in a discussion on FFS reform, there’s a desire to add an out of pocket maximum. but if you introduce a budget neutral out-of-pocket max on Medicare FFS, those costs have to go somewhere — namely other benes with lower OOP. apparently, this won’t be popular.
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I’m pretty sure this won’t come as news to anyone here, but it’s still worth a read:
“The government has recouped TARP money by accepting other government funds
Posted by Suzy Khimm at 12:42 PM ET, 03/09/2012”
http://www.washingtonpost.com/blogs/ezra-klein/post/the-government-has-recouped-tarp-money-by-accepting-other-government-funds/2012/03/09/gIQAHgdT1R_blog.html#pagebreak
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jnc:
“The government has recouped TARP money by accepting other government funds”
Unfortunately the article isn’t particularly edifying, and seems to me to be trying to hype up a relatively minor issue.
While it says that “40 percent of the 341 institutions” that have gotten out of the TARP program did so by borrowing from a different government program, it doesn’t tell us how much of the $384 billion that has been paid back came from that 40 percent of institutions. But a little investigating is revealing. The article does say that the new loans came from a $30 billion small business loan program. So at most, less than 10% of the repaid TARP funds could have come from this other government loan program. However, if you click on the link provided in the article about this $30bn SBLF loan program, you find out that when the program was closed down:
The SBLF is returning $26 billion to the government’s coffers. According to the Treasury Department, just 933 out of the country’s 7,700 or so community banks applied to the program. They requested just $12 billion in loans. And one-third of that sum got approved.
So, doing the math, at most $4bn, or 1.04%, of the $384bn in repaid TARP funds could have come from this program. And it was almost certainly less than that, since it is highly likely that at least some of the $4bn went to banks that did not owe TARP funds. That’s not to justify it, but it is not the stuff of headlines that the 40% figure suggests it should be.
As an aside, I hate when journalists do this kind of thing, hyping a factual but irrelevant statistic (40% of TARP banks re-paid with government funds!), while ignoring or obscuring far more relevant, but much less sensational, data. And they do it all the time. Suzy Khimm, whoever she is, should be taken with a grain of salt in the future.
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Scott,
Do people still engage in CDS even though what triggers a credit event isn’t settled? Seems kinda ballsy, no?
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McWing;
Yes, there is still a lot of trading in CDS. In many, probably most, instances what constitutes a credit event is not that controversial, so there isn’t that much interpretation risk to buying/selling CDS. But the instances in which a non-standard credit event occurs (or doesn’t, as the interpretation might be) are not outrageously rare, so there is a real, if small, risk to be considered. And, as an asied, from my limited experience the lack of clarity almost always revolves around some kind of government action, as both the Philippines and Greece cases illustrate.
BTW…lots of rumors flying around at the moment that ISDA has declared a credit event. No one can confirm, but the journalist who originally claimed a decision has been reached is standing by his story.
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Elliot Spitzer on the Greek CDS
“Credit-Default Hypocrites
How Wall Street is gaming the Greek bailout.
By Eliot Spitzer|
Posted Monday, March 5, 2012, at 2:39 PM ET
A funny thing happened on the way to the Greek bailout: Credit-default swaps involving Greek debt—the same kind of financial instruments that triggered the 2008 fiscal cataclysm—were set aside, once again protecting big financial institutions from their own irresponsibility. ”
http://www.slate.com/articles/business/the_best_policy/2012/03/credit_default_swaps_how_wall_street_is_gaming_the_greek_bailout_.html
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Spitzer:
In Greece, any such problem was magicked away. A special committee that governs credit-default swaps got together and said: The Greek bailout—a write down of 50 percent of the value of Greek debt—is voluntary and thus does not trigger the contractual terms of credit-default swaps.
Um…seemingly not.
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What’s the take on spitzer’s analysis?
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bsimon:
What’s the take on spitzer’s analysis?
It appears to be founded on a false premise.
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Spitzer’s column for next week: How criminals on Wall Street conspired to have a voluntary Greek bond deal magically declared a credit event.
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Greece Deal Triggers $3bn in Default Swps
Why this is a big deal:
A swaps trigger “raises the question of which country is next and which banks are most exposed,” Hank Calenti, a bank analysts at Societe Generale SA in London, wrote in a note. “Less than six months ago we had the head of the ECB exhorting that there must be no credit event on Greece,” he wrote.
A settlement may bolster confidence in the $257 billion government-debt insurance market after Greece’s restructuring tested the viability of default swaps as a hedge. Greece reached its target for participation in the debt restructuring after using CACs to force the hand of holdouts, with investors in 95.7 percent of the bonds taking part.
Policy makers including former European Central Bank President Jean-Claude Trichet opposed payouts on Greek credit- default swaps on concern traders would be encouraged to bet against failing nations and worsen the region’s debt crisis.
“It’s important to keep investor confidence in this instrument as it will affect the ability of sovereigns to issue bonds,” according to Alessandro Giansanti, a senior rates strategist at ING Groep NV in Amsterdam, who said the decision will “restore confidence” in the market. “If you want to attract investor demand, you have to offer them an instrument that will allow them to hedge exposure, and CDS is the best instrument for that.”
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Damn, missed some good talk with a cell phone problem that three places couldn’t fix.
So, much like Greek bonds, they are replacing my non-functioning model with one arriving by mail in the next few days. Length of time before that one too is declared in default, unknown as of yet.
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jnc says it’s a credit event. Yay!
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For those with a long memory, Generalissimo Franco has finally been declared dead!
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Interesting speculation:
“Bank of America In Trouble?
POSTED: March 2, 10:44 AM ET
Matt Taibbi”
http://www.rollingstone.com/politics/blogs/taibblog/bank-of-america-in-trouble-20120302
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“If you want to attract investor demand, you have to offer them an instrument that will allow them to hedge exposure, and CDS is the best instrument for that.”
Why hedge with a CDS vs pricing risk into what you’re willing to pay for the bond? I must be missing something.
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I am more concerned about whether folks who have not bought these bonds can buy CDSs on them. If we think of a CDS as insurance against a calamitous event outside the control of the debtor, Brian, then there is a place for them outside the pricing structure, I think, because the pricing structure will take into account the debtor’s ability to pay and good faith, and “ordinary” commercial risks. But if people bet against the debtor who are not actual creditors than the CDS market is artificial and speculative and in the common parlance of insurance law, we do not allow folks with no insurable interest in a person or a transaction to buy insurance on that person or transaction. We fear they will skew the risk [odds]. Imagine if I could buy insurance on the lives of aircraft passengers with whom I have no relationship.
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sorry about not posting here, been too much going on to try to keep up. will try to do better. i still do not understand cds and how it works, anyone care to enlighten me in words of 3 slylables or less?
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Ticktock, hi. Try this, s-l-o-w-l-y, because the first paragraph is very easy but then it gets harder. This is from Simon Johnson and James Kwak.
A credit default swap (CDS) is a form of insurance on a bond or a bond-like security. A bond is an instrument by which companies raise money. A company, say GE, issues a bond with a face value of $100 and a coupon of, say, 6%. This means that if you hold the bond, they will send you $6 per year (6% of $100) until the bond matures (say in 10 years); at they point, they will pay you $100 (the face value). To buy that bond, you pay them about $100. If you pay exactly $100, the yield is 6% ($6 divided by $100). If you pay less, the yield is more than 6%. How much the bond actually sells for depends on how risky you think GE is (the chances that they will go bankrupt and won’t pay you) and on what interest rates you can get for other, similarly-risky bonds in the market. Bond-like securities, like CDOs, are similar in these basic respects.
When you buy a bond, you are taking on two types of risk: (a) interest rate risk and (b) default risk. Interest rate risk is the risk that interest rates in general will go up. If interest rates go up, the value of your bond goes down (bonds are traded in the secondary market), because you are still only getting $6 per year. Default risk is the risk that the bond issuer goes bankrupt and doesn’t pay you back. A CDS is called a “swap” because you are swapping the default risk – but not the interest rate risk – to another party, the insurer. The bond holder pays an insurance premium – typically quoted in basis points, or one-hundredths of a percentage point, per year – to the insurer. In exchange, the insurer promises to pay off the bond if the issuer goes bankrupt and fails to pay it off. At the time the CDS goes into effect, the expected value of the premium payments (a small amount every year) should exactly equal the expected value of the insurance payments (a large amount, but only if the issuer defaults).
This sounds pretty simple, right? So how did CDS become a dirty word? There are two main wrinkles to be aware of.
First, in order to buy a CDS (I call the bondholder in the above example the “buyer,” and the insurer the “seller”), you don’t actually have to own the bond in question. These are over-the-counter derivative contracts, which means they are individually negotiated between buyers and sellers. As a result, CDS became the tool of choice for betting on the likelihood of a company going bankrupt. If you thought the chances of company A going bankrupt were higher than everyone else thought they were, you would buy a CDS on company A. Three months later, when everyone else realized company A was in trouble, the market prices for CDS would have gone up, and you could either sell your CDS to someone else at the higher price, or you could sell a new CDS at the higher price. (In the latter case, you still have your original contract, and you write a new contract with a new buyer.) As a result, there are a lot of CDS out there; estimates are generally around $60 trillion, which means the total face value of the bonds insured is $60 trillion.
Second, CDS are not regulated, and in fact there was a measure inserted into an appropriations bill in December 2000 that blocked any agency from regulating them. Traditional insurance, by contrast, is highly regulated. Insurers have to maintain specific capital levels based on the amount of insurance they have sold; certain percentages of their assets have to be investments of specified quality levels; and, for personal insurance and workers’ compensation at least, private insurance companies are generally backed up by state guarantee funds, which charge a percentage of all insurance premiums and, in exchange, pay off claims for bankrupt insurers. The CDS market had none of that, so a bank could sell as many CDS as it wanted and invest the money in anything it wanted.
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Mark:
I am more concerned about whether folks who have not bought these bonds can buy CDSs on them.
Two points. First, one can have credit exposure to a given entity without having bought its bonds. Banks lend directly to companies, or have established credit lines, both of which represent credit risk without a bond purchase. And there are all kinds of contracts and agreements, for example interest rate swaps and foreign exchange swaps, that produce credit risk which one or the other counter party might want to hedge via CDS. The absence of a specific bond position does not indicate that a CDS contract is mere speculation.
Second, speculating by buying naked CDS protection is no different to shorting a stock. Both represent a negative outlook on the future prospects of a company. And both are valuable tools for providing information to the market. Just because one does not own a bond or a stock does not mean that one cannot have valuable insight and analysis into the value and future prospects of a company. The price of anything ultimately represents the sum total of all information and opinions in the marketplace of the thing being priced. Preventing anyone who does not already own a stock or bond from expressing a negative view of that stock or bond is simply preventing valuable information from being factored into the market.
To give you an example, think about what happened in the housing bubble. As the bubble grew, how could a non-lender and a non-owner express an outlook that the market was over bought? The only way was to buy naked protection on mortgage backed securities. A few brave souls did exactly that, and have reaped huge rewards as a result because their analysis was correct. But if there were more such brave souls, they would have sent an even bigger signal to the market, and may well have pricked the bubble sooner, with less damage than was actually caused. If these people were prevented from expressing this view, valuable information and views would be lost from the market.
There is certainly a legitimate argument to be made that there needs to be more disclosure on CDS positions held, and perhaps some better capital requirements associated with them. But I don’t think it makes any sense at all to prohibit trading in CDS outside of as a hedge to existing bond positions.
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Mark:
We fear they will skew the risk [odds]. Imagine if I could buy insurance on the lives of aircraft passengers with whom I have no relationship.
How would taking out insurance on the lives of strangers alter the risk/odds of those people dying in a plane crash?
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Scott – I’m watching the Big 12 semis on TV – no more thoughts tonight. We used to call the separation of the insurance and the insurable interest an invitation to a positive incentive.
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Mark:
We used to call the separation of the insurance and the insurable interest an invitation to a positive incentive.
If that means that the guy who buys insurance on strangers on a plane is incentivized to blow the plane up, sure. But how would, say, a hedge fund which bought protection on Greek debt go about bankrupting the country? Or how would the same fund go about tanking the real estate market in order to collect on a synthetic CDO payout?
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BTW Mark, suppose buying crash insurance on strangers on a plane was allowed. (Is it really not legal?) Don’t you think that might prove to be a valuable source of information? Imagine a particular flight suddenly has activity in non-passenger purchase of passenger insurance. That would be an indicator that someone has information about that flight that might be of use to others. Or suppose there was large activity in non-passenger purchase of passenger insurance for a given airline. That would be an indication that someone has information about that airline.
And speaking of flight insurance, if you have never read Michael Lewis’ first book, Liar’s Poker, you should. It’s a great read about Salomon Brothers during the go-go ’80’s, and includes an anecdote about flight insurance. Apparently a young analyst was taking his first business trip, and before he left one of the traders on the desk threw him a $100 bill and told him to buy some flight insurance on himself in the trader’s name. “Why?” he asked. The trader replied “I’m feeling lucky.”
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Scott, your anecdote indicates the historical problem addressed by the doctrine of the insurable interest. To have an insurable interest, one must have a direct benefit in the continued survival of the person or the property. Thus I have a direct benefit in the existence of my homestead, but not in yours. I have a direct benefit in my wife’s long life, but not in yours. If I am insuring against loss of my direct benefit; I am not gambling, rather, I am protecting my value.
If I have no direct benefit in the continued existence or success of a life, or property, or a business venture, then I can only gamble on its success. Pari-mutuel gambling sets odds at the racetrack. How the bettors favor the horses changes the odds minute to minute, sometimes. This is valuable information about how the bettors feel, because the track owner can adjust the odds so as to always make a profit. It is irrelevant to which horse will actually win the race.
I analogize selling naked options and buying CDSs on bonds one does not own to parimutuel betting. G-S, for example, is like the track owner, or the house in Lost Wages, NV. The information obtained from the herd of bettors does not actually “prove” the health of the subject, it only provides for high dollar speculation, which appeals to the most irrational of emotional demands, the thrill of gambling on the unknown [“I feel lucky”].
You did give an example in your first reply that I will consider longer:
“… one can have credit exposure to a given entity without having bought its bonds. Banks lend directly to companies, or have established credit lines, both of which represent credit risk without a bond purchase”.
I am guessing this is legitimate by insurance law standards from the short description.
In the end, Scott, I do not understand how naked speculation can help the economy because I think it is a force for bubble-and-bust. I think it can only generate vast profits for the house, and everyone else is a sucker. No increase in productivity seems to be involved.
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Mark,
In the end, Scott, I do not understand how naked speculation can help the economy…
As I mentioned, it provides potentially valuable information to the market. Prices are information conveyors, and represent the collective wisdom of all market participants regarding the thing being priced. By restricting the market in a given thing to a certain, limited demographic, you are necessarily restricting the amount of wisdom and analysis that goes into, and is conveyed by, prices. As I mentioned, our recent experience with the real estate market is instructive on this point.
Do you think that shorting stocks should also be illegal?
…because I think it is a force for bubble-and-bust. I think it can only generate vast profits for the house, and everyone else is a sucker.
Again, our recent experience with the real estate market suggests exactly the opposite. The bubble was being inflated by actual lending of real dollars to buyers of real property, not by “gamblers” speculating in the the MBS derivatives market. And, in fact, the only warning signals that a bubble was forming were being sent by buyers of naked CDO protection, ie “gamblers” or “suckers”, via the use of synthetic CDO’s. What we needed was more, not fewer, people actively buying this naked protection, which would have forced credit spreads to widen and thus blunted the growth of the bubble.
Recall also that, to use your metaphor, AIG was “the house”, selling huge amounts of credit protection to “suckers”. Those suckers are now very rich, while the house is surviving on a taxpayer bailout, not vast profits.
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I think AIG was a “dumb” house. It believed in the bubble.
I have no problem with selling short against the box.
You know more than I about market responses. I would be amazed, however, if the lenders who were packaging in a frenzy and the Fed, with its loose money policies, and the FanFred, with its EZ loans, and [from my perspective the biggest problem I saw in my backyard] the mortgage brokers with no skin in the game encouraging liar loans, and the appraisers with their optimistic valuations paid any attention to CDSs. I doubt they would have no matter how many people bet against the loans.
It really was nuts. Probably tight money would have stopped it, but none of the other pieces were big enough, alone.
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Mark:
I have no problem with selling short against the box.
If you have no problem with selling short equity securities, I don’t see why you should have a problem with selling short fixed income securities, which is essentially what buying naked CDS protection is…shorting the credit quality of an institution.
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I am confused by your analogy. If I owned fixed income securities I could hedge them with CDSs. If I buy a naked CDS what am I hedging against? If I own stock, and sell short against my position [against the box], I am hedging my position. If I sell naked options, what am I hedging against?
As to fueling the bubble, I think I agree. As to the breadth of the explosion when the bubble burst, I think naked CDSs did contribute. If the only CDSs floating were directly related to the defaulted mortgages the sums involved would not have threatened cataclysm.
From your perspective, what am I missing? Everything?
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Mark:
Sorry….when I asked you about shorting a stock, I was referring to an outright short, ie selling stock you don’t own. Shorting against the box, from what I understand, is just a tax strategy. An outright short is not a hedge to anything. It is an outright position on the future direction on the price of the stock, just like buying naked CDS protection on a bond is an outright position on the future direction of the credit quality of the issuer. Selling a naked option is similar, and perhaps an even better analogy.
From your perspective, what am I missing?
It is difficult to find information on just how much protection was purchased as a hedge vs as an outright position. However, what we do know is that between 1999 and 2007, total issuance of synthetic CDOs comprised 31% of all CDO issuance. (See chart 4 on page 33) Since the purchase of naked CDS protection on mortgage backed securities could only occur via a synthetic CDO, we know that such activity could comprise no more than 31% of all CDO issuance over that time. And since we know that some portion of those CDOs were used as hedges to market exposure, we know that the actual percentage is even lower than that. We have no way of knowing the exact percentage, but we can say that, whatever it was, losses related to such derivative, speculative activity were dwarfed by losses related to actual, hard investments in a collapsing real estate market. I don’t think there is any way around the fact that the bubble was fueled not by derivatives but by way too much hard money being put into real estate, and that a threatened “cataclysm” was the inevitable result regardless of any derivative activity that accompanied it. Our widespread economic woes came as a result of real wealth destruction, not because some clever hedge funds made money at the expense of AIG.
But beyond that, whatever role synthetic CDO speculation played in the threatened cataclysm, it resulted not from people buying protection on bonds they didn’t own, but rather from people selling protection without hedging the resulting exposure. AIG was selling protection, not buying it. All the monoline bond insurance companies that collapsed (ACA, MBIA, FSA) were selling protection, not buying it. Which is why I said that there is a legitimate regulatory argument to be made regarding disclosure of and capital requirements associated with CDS positions, particularly on the sell side which is where the huge downside risk lies. But to argue that anyone who wants to buy naked protection shouldn’t be allowed to do so seems, to me, to misunderstand where the actual risks involved are coming from.
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BTW, AIG may have been a dumb “house”, but the point remains…buying naked credit protection did nothing whatsoever to fuel the bubble, and the “suckers” turned out to be the smartest guys in the room.
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@Mark,
Generally speaking a healthy market requires a mix of hedgers and speculators. As a matter of fact, the commodity exchanges go so far as to require a certain percentage of hedger and speculator open interest in their products and will put limits on how many contracts can be on one side of the hedger / speculator side of the ledger. All of this is to maintain an orderly market – if the market is dominated by one or the other, you are prone to violent moves and / or very low volume.
The problem with the CDS market (and the AIG problem) was due to (a) no central exchange controlling position size and disclosing open interest and (b) the fact that CDSs were too cheap. Here is why they were too cheap:
AIG was selling protection on bonds in huge size. Why? Because credit default swaps were a cute way around Regulation T, which governs the amount of leverage people can use. Reg T was a Depression-era law which limited the amount of leverage an investor could use to 50%. So, consider a bond which pays 6%. AIG could borrow 50% and pay LIBOR (3%) to do it. So, on a million dollar position, they get $60,000 in interest (1M * .06), pay 15k in interest on the borrowed piece (500k * .03) and put up 500k. So their return is (60-15)/500 or 9%. But remember, AIG actually owns the bond in this case.
Sellers of protection don’t actually own the bond in question, so Reg T doesn’t apply. And the banks don’t require 50%. It was more like 10%. So in the case above, AIG would be receiving the 6% yield on the bond and paying LIBOR. No notional (the actual bond price) actually changes hands. So in our bond example, every quarter AIG gets a check for $8,250 (the quarterly 15k coupon less the quarterly LIBOR it owes) on an investment of $100k. And our banking friends across the pond were doing this as well, so their 100k “equity” is really levered 20:1. Credit default swaps allowed AIG and the euro banks to invest without putting up any money. Neat trick, eh?
Since AIG was willing to do that all day long, buyers of protection could bet against the bond in question very cheaply. Which they did.
Regarding the cascading counterparty problem, I would force CDSs to an exchange with a central clearinghouse that controls the amount of open interest, position limits and regulates the amount of margin on positions. And while the investment banks would complain about losing a lucrative business, investors (hey, remember them?) would be delighted.
That would go a long way towards preventing another AIG from taking down the financial system. I would do that instead of outlawing CDSs or prohibiting naked speculation.
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Brent and Scott, thank you very much.
I get some of this, with your help. I understand that the problem was in the selling of the unregulated, unbacked, and unhedged CDSs, not the buying, per se.
I see how the reforms Brent suggests should work.
I still do not understand why a “healthy market” requires naked speculation/naked hedging. A healthy market to me means one where stocks and commodities are traded subject to full disclosure and “perfect” information, whose primary purpose is to raise capital for business ventures in the stock market or to facilitate a world market in commodities for consumers and users as well as producers and sellers. I don’t understand why I should be able to buy gasoline futures if I cannot take delivery of gasoline and have no use for the commodity itself in vast quantities. In short, I do not understand naked speculation as related to “healthy markets”.
Scott, selling short against the box was a safe way to earn 30% annually on your money during the declining markets of the late 70s and early 80s. You could own solid blue chip stocks and sell and resell short options every three months against them and never have to convey the stock, riding it down the bear trail. When the market turned, you could buy back your option [one time] and hang onto your stock. This worked great back then. I did not do it or track it 2007-09 so I don’t know if it worked as well, this time. People were always more willing to buy a short [bargain! bargain!] then to sell it, I think, so there was a bias in favor of making money on the sell side.
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Mark:
I don’t understand why I should be able to buy gasoline futures if I cannot take delivery of gasoline and have no use for the commodity itself in vast quantities.
I don’t understand why you think you shouldn’t be able to do so.
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Mark:
I still do not understand why a “healthy market” requires naked speculation/naked hedging.
Who do you think the hedgers are going to hedge with? Hedging means laying off risk to someone else. Necessarily, then, someone else must be willing to take that risk on.
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Obviously, naked speculation requires naked hedging. I thought by now I had made clear that what I do not understand is the insistence that ordinary gambling – bets on someone else’s success or failure – is of any use to providing more investment capital for business growth, or a stable commodities market.
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Mark:
Obviously, naked speculation requires naked hedging.
I’m not trying to be difficult, but I don’t know what this means. The term “naked” generally refers to an uncovered or unhedged position. For example, selling a naked option means selling an option on something that you don’t already own. So I don’t know what you mean by “naked hedging”.
My only point was that hedging involves transferring risk. An airline that is at risk of future changes in the price of oil can use commodity futures to hedge that risk, but necessarily that requires someone else who is willing to take on the risk that the airline is looking to get rid of. Hence the necessity of including in the market speculators willing to place bets on the future price of oil. Without them, the universe of people with whom the airline can hedge is drastically smaller, making the market illiquid and hedging that much more difficult to execute.
I do not understand is the insistence that ordinary gambling – bets on someone else’s success or failure – is of any use to providing more investment capital for business growth, or a stable commodities market.
In terms of market stability, speculators provide liquidity, and liquid markets tend to be less prone to violent moves than illiquid markets.
In terms of providing investment capital for business growth, only initial public offerings or debt issuance does that. Once the stocks or bonds are issued, even trading in them directly (as opposed to via derivatives) is all speculative and provides no new investment capital at all. It is simply a measure of market sentiment about how much growth has occurred or is expected to occur in the future.
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I understand what you are saying about each point.
My naked-naked reference is to the transaction whereby someone buys, for example, a swap on a bond he does not own, which someone else must sell to him.
I see that from AIG’s perspective it does not matter whether the buyer is hedging or gambling. It is that whole transaction I am questioning.
I think the airline illustration is the classic example of the good hedge as opposed to the speculation that I question. I see that you are suggesting that good hedge might not be available if not for speculation on the other side of the transaction.
I see that more investors imply more liquidity in the market, but I do not understand how shadow markets of synthetic derivatives affect the primary market. I believe that part of what Brent was addressing to me was that making that market transparent and regulated would have a beneficial effect on the primary market.
The legal consequence of making stock alienable is the market for stock. Without alienability of stock no one can be expected to become a passive investor. Thus the stock market is a necessary function for capital creation. I believe that you are arguing that by extension, naked transactions will create more stable markets and encourage more capital formation, perhaps. It is this last I would like to have evidence for.
BTW, I thought selling naked options on the NYSE was barred.
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Mark:
I think there are two questions here that might be getting meshed into one.
First, are derivatives useful financial products, and do they add value to the economy? To be honest, I think this is a question best left to individual market participants to decide for themselves (just as i think, for example, that the question of whether a university major in art or women’s studies is useful and adds value to the economy should be left to participants.) But, objectively speaking, I think there is little doubt that they are useful and they do add value. So there is no reason one should want to eliminate derivatives markets in general or any one market in particular.
Assuming we agree to that, the question then becomes should participation in that market be limited to certain kinds of people motivated by approved, “proper” ends. I think not, partly for reasons already stated (markets function better when there are more, diverse participants pursuing their own, diverse ends), but also because I don’t think it is the proper role of government to be involving itself in the thought process of why a particular transaction was undertaken. All the government should care about is 1) did the contracting parties agree to the contract and 2) did they do so under some kind of coercion or fraud.
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“All the government should care about is 1) did the contracting parties agree to the contract and 2) did they do so under some kind of coercion or fraud.”
To that I would add that gov’t should care about “3) what kind of damage can the parties do to parties that are not participating in the transaction?”
Freedom within markets is great, until market participants start taking bets that affect the rest of us; for instance AIG’s apparent inability to cover all CDSs they wrote. If I choose to take a risk, I should be able; but my risk taking should not put others in danger.
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bsimon:
Freedom within markets is great, until market participants start taking bets that affect the rest of us; for instance AIG’s apparent inability to cover all CDSs they wrote.
I agree. Which is why I suggested that there needs to be more transparency and capital requirements for writers of CDS protection. Or, perhaps, as Brent suggested, clear them through an exchange with margin requirements.
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I agree. Which is why I suggested that there needs to be more transparency and capital requirements for writers of CDS protection.
I’ve always tended to believe that regulation should be prejudiced toward enforcing transparency (that disclosure allows every one, in theory, to know what they are buying, and from who, and perhaps what it might entail), rather than micromanaging every little bit of every transaction. Similarly, campaign finance shouldn’t be about who can buy how much of what when, only that we get to find out which people bought what politician and for how much. Thus, if I am pleased to vote for a politician purchased by Apple, and distrust politicians purchased by Microsoft, I can take that knowledge into the voting booth with me.
It’s why I generally don’t have much trouble with regulation requiring reasonable product labeling (caveat: some of it is absurd). It’s good to know what you’re buying and what it does.
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