A problem with credit default swaps

Once again a lot of dust is being raised over the fact that Goldman Sachs survived the crisis better than any other stand-alone investment bank in part because the bank took a large short position in subprime mortgages.  People are asking whether it was right for Goldman to sell subprime mortgages securities to clients at the same time that it was expecting them to perform poorly.

I think that framing the question in this way gets the problem precisely backwards.  Credit default swaps by their very nature pose a problem for the party that wishes to buy protection against a bond default:  the protection buyer has to find a counterparty who wishes to sell protection (i.e. take on the obligations of an insurer against the possibility that a bond defaults).

Because of the “cliff risk” built into these contracts, it’s not clear that there is any natural seller of credit default swap protection.  The monoline insurers, which used to specialize in municipal bond insurance, come closest — but even they were unwilling to write protection based on the standard CDS contract, which requires that the full value of the bond be paid to the protection buyer on the event of default.  The monoline CDS contract requires only that the insurer make the payments required by the defaulted bond as they become due.  This has the effect of pushing the “cliff risk” of being obliged to pay the notional value of the bond five, ten or even thirty years into the future.

Thus the protection buyers were faced with a challenge:  How do you create a marketable product that involves the sale of credit default protection?  This is precisely the kind of challenge that Wall Street’s innovative structured financiers specialize in.  The Wall Street Journal explains what happened:

Mr. Paulson and Mr. Pellegrini were eager to find more ways to bet against risky mortgages. Accumulating mortgage insurance in the market sometimes proved slow. They soon found a creative and controversial way to enlarge their trade.  They met with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create securities—packages of mortgages called collateralized debt obligations, or CDOs—that Paulson & Co. could wager against.

Synthetic and hybrid CDOs are designed to sell precisely the credit default protection that John Paulson, Goldman Sachs and Deutsche Bank were looking to buy.  Using both BIS and SIFMA data on CDO issuance, I estimate that from July 2006 through June 2007 at least $1.2 trillion in notional value of credit default swap protection was sold via synthetic and hybrid CDOs.*  I further estimate that CDS sold by CDOs from mid 2006 through mid 2007 accounted for between 30% and 100% of CDS protection sold by end users over this period.**

Thus we have reason to believe that CDOs were some of the most important credit protection sellers on the market when Paulson & Co, Goldman and Deutsche Bank were building up their short position in subprime.  While it is certainly the case that the banks that ended up with these CDOs on their balance sheets should have understood what they were investing in, it is far from clear that the CDO investors in tranches with investment grade and even AAA ratings that sit at the bottom of the structures — the ones in the second, third and fourth loss positions that protect the banks’ super senior AAA tranches — understood that they were selling credit protection to hedge funds and investment banks.  There is plenty of evidence that CDOs were marketed as bonds, not as packages of derivatives. And we, after the crisis, are left with the question:  If investors had understood that they were selling credit protection to sophisticated counterparties, would these CDOs ever have been issued?

Thus the problem with credit default swaps is that the market has very few, if any, natural sellers of protection.  This drives financiers who wish to buy protection to create products that make credit default swaps look like something that investors actually want to put their money into.  Given the consequences of generating supply in such a manner, regulators need to take a much more jaundiced view of the role that financial innovation plays in the economy.

* My estimate is derived as follows:  I use SIFMA data to generate the fraction of annual CDO issuance that was issued in each quarter of 2006 and 2007.  I use these figures to interpolate quarterly data from the BIS annual data.  Since SIFMA data only includes unfunded tranches of CDOs and BIS data includes all CDO tranches, I take the difference between the two data series as an indicator of the unfunded tranches that were issued.  Since the cash assets in CDOs must be funded, this is a lower bound on the notional value of CDS sold by CDOs.

**  The notional amount of CDS outstanding grew over the same period by $20 trillion.  Taking into account the fact that ISDA data tends to double count derivatives and that some derivatives expired, this probably reflects that over this period around $12 trillion in notional value of credit default swap protection was sold.  When we recognize that the difficulty of terminating these contract led to a situation where many dealer banks chose to offset exposures by entering into new contracts, we realize that most likely at least 2/3 of the CDS sold over this period reflects inter-dealer transactions and not end user sales of CDS protection.  Thus most likely less than $4 trillion of net CDS exposure was generated in the period from July 2006 through June 2007.  In fact, current DTCC data indicates that once offsetting dealer positions are taken into account the net value of CDS is only about one-tenth of the notional value.  This would lead us to estimate that about $1.2 trillion of net CDS exposure was generated from mid 2006 through mid 2007.  These figures indicate that CDOs sold between 30% and 100% of the CDS protection provided by end users in the market from mid 2006 through mid 2007.

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