What proponents don’t get about credit default swaps

In the Atlantic Charles Davi tries to argue that critics of credit default swaps simply don’t understand the market.  However, his arguments don’t show that he has a clear understanding of the market himself.

With the CDS market, we have a market-based measure of the credit quality of a wide variety of debt instruments outstanding for a given issuer. This makes the credit quality of an issuer more transparent, not less.

This is incorrect, because every CDS price necessarily includes not just a premium for protection against default by the underlying, but also some premium for the counterparty risk inherent in buying protection on derivative markets.  (The existence of negative basis trades where the CDS price is below the rate paid by the bond probably reflects the fact that the CDS market — for the limited group of people who are allowed to trade these high denomination products — is indeed more liquid than the bond market.  Note that as far as I am aware, there is neither empirical evidence, nor a theoretic argument that supports the view that more liquid markets produce better prices.)  As noted in earlier posts, the only circumstance in which an over the counter derivative does not involve counterparty risk is in the theoretic example where the derivative is written by a monetary authority.

Because CDS prices necessarily confound a premium for protection against default with a premium for counterparty risk, it’s hard to understand the foundation of the argument that CDS prices give a better measure of credit quality than a model based only on the bond yields themselves — which will as rule include no credit risk premia for parties other than the issuer.

However, even if we were to grant the argument that CDS prices give a superior measure of default risk, then that would immediately indicate that price disclosure in the CDS market must be improved.  While Davi claims that

the level of publicly available information from the CDS market is on par with that from the corporate bond market

as a small scale trader, I can assure you that this statement is incorrect.  I can access intraday corporate bond bids and offers whenever markets are open.  Davi links to the only public CDS pricing data that I know of — and this only gives end-of-day prices after the market is closed.  If Davi’s argument that CDS prices are “better” than bond prices is correct then the bond market is seriously biased against small traders.

In other words, if CDS price information is as valuable as claimed, then it is inexcusable to restrict access to intraday price and quantity information to insiders like the market making banks and their biggest clients.  In short, if the CDS market produces tradable price information, then as Gensler argued it’s time for CDS to trade on exchanges so that intraday prices and quantities can be made public in real time and everybody who trades bonds can benefit from the information created by this market.

Why collateral fails to protect protection buyers

Felix Salmon claims:  “Today, there isn’t a company in the world — not even Berkshire Hathaway — which can write CDS protection without having to put up collateral.”  Felix goes on to imagine a perfect world in which regular margin calls guarantee that CDS are fully collateralized and there is no risk of failure to pay.

Unfortunately the value of CDS contracts tends to move very suddenly and it is precisely when counterparties issue large margin calls that firms like Lehman and AIG are forced to declare bankruptcy.  Collateral posting regimes may work with commodities and interest rate swaps where price movements are far less volatile than CDS, but there are many reasons to be concerned about the success of collateral posting in offsetting the risks of CDS contracts.

The OCC derivatives report has data on the fair value of derivatives from bank call reports (Table 6).  The data does not include derivatives held by investment banks at the holding company level.  It also increases by over $2 trillion in December 2008 due to the movement by Goldman Sachs of many derivatives into the Goldman Sachs bank.  On the other hand it illustrates how much the fair value of credit derivatives can change from one quarter to the next.

The chart below illustrates the sum of the gross positive and gross negative fair value of credit derivatives (red) and of other derivatives (blue) held by banks (that are subject to call reporting).

The fact that the fair value of credit derivative contracts jumped from $186 billion in March 2007 to $1 trillion in March 2008 to $2.2 trillion in December 2008 should be a matter of concern to everybody.  (Note:  GS accounts for $276 billion of the December 2008 figure.)  Can we really be confident that margining requirements will (i) be sufficient to protect protection buyers and (ii) not have the effect of pushing some protection sellers into bankruptcy?

Addendum: Another problem with trillion dollar changes in collateral needs is that to broker-dealers only accept cash collateral (and more rarely Treasuries).  In Q4 2008, it is hard to imagine that collateral could have been met without extraordinary aid from the central banks — which (i) relaxed rules for commercial banks prohibiting them from financing the brokerage assets of affiliates, (ii) lent vast quantities of cash against brokerage assets and (iii) dropped interest rates to zero making it easy to finance the costs of cash collateral.  I certainly hope that in the next credit crisis, the broker dealers aren’t relying on similar policies to facilitate their need to post collateral.

CDS cannot eliminate credit risk

After the debacle of 2008, commentators still like to assume that CDS and other derivative contracts do not involve counterparty credit risk.  (See Greycap’s comment here.)  It is astounding that the near collapse of the financial system is not enough to make people realize that the best a CDS can do is transfer your credit risk from the underlying to a counterparty.  The only circumstance in which a CDS transaction can eliminate credit risk is if the CDS protection is sold by the issuer of the currency in which it is denominated (or in the impractical scenario that initial margin is the full notional value protected).  As far as I know the central banks aren’t in the business of selling protection.

Repeat after me:  Every CDS creates counterparty credit risk.  A CDS cannot eliminate credit risk.  For a given purchaser a CDS may serve to transfer credit risk from a less credit worthy borrower to a more credit worthy counterparty — but it is impossible for a derivative to eliminate credit risk.

I’ll comment on how collateral fails to solve this problem in a future post.

Worrisome CDS data in the broker dealers 10Ks (Updated)

UPDATE 3-4-10: There was an error in the chart on the dealers’ “matched books” that got JPM’s 2008 exposure  wrong.  It has been corrected.

The broker dealers’ 10Ks are all up on Edgar now, so I was able to update my file on the banks’ credit derivative positions.  What’s neat about the 10Ks is that all (except for Citigroup) reported not only the notional CDS sold and purchased, but also the dollar value of CDS bought that offset CDS sold.  This latter piece of information is very useful, because when a market maker keeps matched books almost all of the contracts will have identical (“matched”) underlyings and will offset each other.  Thus, we can use this data to see to what degree each bank is acting as a “matched book” market maker and to what degree each bank is taking proprietary positions in the credit derivatives market.  (As a reminder of why I am looking at only five banks please recall that according to OCC data the five banks in the charts below hold 95% of credit derivatives in the US banking system.)

For each dealer the first two columns of the chart below look at the net notional value of credit derivatives bought divided by the total notional value of credit derivatives bought at the end of 2009 (blue) and of 2008 (red).  Thus the first two columns are a measure of how much each dealer bank is using its role as a market maker in the credit derivatives market to buy protection.

For each dealer the third and fourth columns of the chart below use the banks’ reported level of offsetting derivatives to calculate the notional value of unmatched derivatives sold and of unmatched derivatives bought.  These two numbers are added and then divided by the total notional value of credit derivatives bought and sold.  For 2009 this fraction is green and for 2008 it is purple.  Thus the second two columns give a measure of what fraction of each bank’s credit derivatives book is “unmatched”.

The most remarkable thing to note about this chart is that only JP Morgan — notably the bank with the biggest credit derivatives book of all — falls below 5% on both measures.  Of JPMs $6 trillion credit derivative portfolio in 2009 only $98 billion is either excess protection on identical names or protection purchased on other names. The other $5.9 trillion in swaps are all matched trades.

In marked contrast, Bank of America bought and sold $2.8 trillion of credit derivatives (and thus has a $5.6 trillion portfolio and no net notional), but only reports $2.3 trillion in trades with identical underlying.  This implies that the bank has half a trillion dollars of unmatched trades both bought and sold.  It would be very interesting to learn what the explanation is for such a large number of unmatched trades — and how well Bank of America is managing these positions.

Morgan Stanley, like Bank of America, has a credit derivative portfolio with a remarkable number of unmatched trades.  Even though MS has only $69 billion in net notional value of credit protection bought, once identical trades are taken into account, we find that MS has about $600 billion in credit protection purchased but not sold and well over $500 billion in credit protection sold without an offsetting position and credit protection sold on identical underlyings that exceeds protection purchased on these underlyings.  Like Bank of America Morgan Stanley needs to explain why such a large fraction of its credit derivative portfolio is composed of unmatched trades and how it manages these trades.

Goldman Sachs has also taken large positions in the credit derivative market, although it is much more conservatively positioned than Bank of America and Morgan Stanley.  It has $217 billion in credit derivatives sold that are not offset by purchases and $381 billion in credit protection purchased with no offsetting trades.  Thus, Goldman has well over half a trillion dollars of unmatched credit derivative trades.

Off the top of my head I can see two problems with this huge overhang of unmatched trades.  First of all like AIG most of the market makers seem to be using the credit derivatives market to expose themselves to losses that are multiples of their equity capital.  While the expected losses on these contracts are of course significantly less than their notional value, the sheer size of the exposures is a problem.  The chart below illustrates this by calculating the unmatched credit derivatives sold divided by equity capital.

Secondly, the fact that these banks are relying on the credit derivative market to sell them protection is also a matter for concern — because, after all, what private firm is there in the current economic environment that can be relied on to honor these contracts?  The fact that the five dealer banks that account for 95% of the US CDS market have as a group bought $430 billion in credit protection from others is hardly comforting until we know who it is that sold the protection.

Data on the market makers’ CDS books

Thanks to the FASB’s September 2008 amendment of FAS 133, it turns out that all the market makers report the notional values of their credit derivatives positions bought and sold in their 10-Ks and 10-Qs.  So I was able to look up the positions of the five biggest market makers in the US.  These holding companies account for 95% of all credit derivatives bought and sold by holding companies in the US (per the OCCs data).

Here’s what I found.  (Blue is credit derivatives bought, red credit derivatives sold and green is the difference between the blue and the red columns):

Observe that because we only have aggregate data, the net credit derivative position in the chart above represents a lower bound on the unmatched portion of the bank’s derivative books.  It possible that when individuals companies and indices are taken into account, an accurate count of each bank’s net position would be much larger than the green column above.

To emphasize the fact that it appears that market makers are buying credit protection on their own account, here is a chart of the net credit derivatives as a fraction of the total credit derivatives bought.


We see that about 9% of the credit derivatives bought by Citigroup and 5% of the credit derivatives bought by Goldman Sachs are not matched.  Most likely these firms are using credit derivatives to protect themselves against losses.

Finally we can look at the net credit protection bought relative to the firm’s assets:

This chart just emphasizes the fact that the commercial banks have much larger balance sheets than the investment banks, and thus that even though a bank like JP Morgan has a net credit derivative position that is similar to that of the investment banks, it is relying less on the protection of credit derivatives once one takes the size of the bank into account.

Because only Bank of America/Merrill Lynch is now (this is a change from previous quarters) a net seller of credit protection, we find that in aggregate the market makers are buying at least $400 billion notional in credit protection from other participants in the market.  An interesting question is who is selling this protection:  foreigners, insurers, end users?

Do the market makers keep matched books?

I’ve been spending some time with the Office of the Comptroller of the Currency’s data on derivatives.  This is what I’ve found about credit derivatives:

(i) Commercial banks tend to buy and sell credit derivatives under the name of the bank, not under the name of the holding company.  The credit derivatives of the investment banks are at the holding company level although about one-sixth of Goldman Sachs’ credit derivatives are bought and sold by the Goldman Sachs Bank.  (In the chart below blue is the credit derivatives bought/sold by the holding company and red is the credit derivatives bought/sold by the bank.  Note that I did not actually download the data on Morgan Stanley’s Bank because its credit derivative positions were trivial.)

(ii)  Because the OCC collects detailed data about the derivatives bought and sold by banks we have extensive information on the positions of Citigroup and JPMorgan.  However, detailed information on the derivatives bought and sold by Goldman Sachs Group, Morgan Stanley and Bank of America (now that it includes Merrill Lynch) is not available.

On the other hand what we know about the derivatives held by banks is interesting in its own right.

(iii) Neither Citibank, nor Goldman Sachs Bank is running a very closely matched credit derivatives book.  (Note that for its size JPMorgan is reasonably closely matched, but the data simply doesn’t fit on the same chart as the other banks.  Also, in the chart below blue represents credit derivatives bought by the bank and red credit derivatives sold by the bank.)

(iv)  What’s more interest the difference between credit derivatives bought and sold doesn’t show up as much in the data on credit default swaps.  (In the chart below blue is now CDS bought by the bank and red CDS sold by the bank.)

(v)  The banks that are buying more credit protection than they sell  are not using CDS to do this.  (Blue:  credit options bought; Red: credit options sold; Green: other credit derivatives bought; Purple (not visible): other credit derivatives sold; Light blue:  TRS bought;  Orange:  TRS sold.)

While some of the market makers may be running matched books, it certainly looks as though others are using the credit derivatives markets to buy protection for themselves.  Given the pricing power currently in the hands of the market makers, it may be worth paying close attention to the trades of market makers who are trading on their own account in a big way, because there is no question that the market makers are well-placed to extract rents from end users if that is what they wish to do.

Of course, it would be far more interesting to have this data for the holding companies, because that would give us all a better idea of how the dealer banks are using derivative markets.  As things stand the claim that all the market makers keep matched books does not appear to be supported by the data that we have.

On the role of CDS in the Bear Stearns collapse

In William Dudley‘s very informative speech on the what and why of the investment bank failures, there is a very interesting footnote:

One final factor that was important in exacerbating the funding crises was the novation of over-the-counter (OTC) derivative exposures away from a troubled dealer. In a novation, a customer asks a different dealer to stand in between the customer and the distressed dealer. This process results in the outflow of cash collateral from the distressed dealer. The novation of OTC derivatives was an important factor behind the liquidity crises at both Bear Stearns and Lehman Brothers.

Dudley cites three sources of the failure:
(i)  withdrawal of repo credit backed by illiquid assets
(ii) loss of primary dealer accounts, and
(iii) drain on cash collateral via novation of OTC derivatives

Given the aggressive action in the credit default swap (CDS) market that was demanded by the NYFed after the Bear Stearns failure, I think that it is safe to conclude that the novation of CDS was an important source of cash outflow for Bear Stearns.  This is worth noting because one periodically runs into claims by financial market participants that CDS markets operated effectively throughout the crisis and that CDS are being unfairly targeted by people who don’t understand them.

I suspect that when the full history of the Bear Stearns collapse is written, CDS will play a non-trivial role in the story.

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.

What is a clearinghouse?

The discussion of clearinghouses appears to be missing some crucial elements.  From the latest Squam Lake Working Paper:

[There are] two important advantages of clearinghouses. First, by allowing an institution with offsetting position values to net their exposures, clearinghouses reduce levels of risk and the demand for collateral, a precious resource, especially during a financial crisis. Second, by standing between counterparties and requiring each of them to post appropriate collateral, a well capitalized clearinghouse prevents counterparty defaults from propagating into the financial system. Because of these advantages, the U.S. Treasury Department has announced that in the future all credit default swaps that are sufficiently standard must be cleared.

Clearinghouses, however, are not panaceas. In the fight for market share, they may compete by lowering their operating standards, demanding less collateral from their customers, and requiring less capital From their members. To ensure that clearinghouses reduce rather than magnify systemic risk, regulatory approval requires strong operational controls, appropriate collateral requirements, and sufficient capital. Clearinghouses should be subject to ongoing regulatory oversight that is appropriate for highly systemic institutions.

It strikes me as utopian to think that regulatory oversight could possibly ensure the solvency of a clearinghouse — especially of a clearinghouse for financial contracts that are subject to sudden changes in value like credit default swaps.  The reason that clearinghouses, like the New York Clearing House founded in 1853, were financially stable is because the clearinghouse liabilities were guaranteed jointly by the full faith and credit of every member of the clearinghouse.  In other words, if a firm wants to use a clearinghouse, it has to be willing to stand behind the liabilities of the clearinghouse.

Pushing derivatives onto clearinghouses without insisting on member liability for clearinghouse debt seems foolhardy.  When firms like Goldman Sachs and JP Morgan Chase are willing to put their shareholders on the line, regulators can be confident that clearinghouse policies are well designed.  Without such a seal of approval from the major derivatives dealers, how could regulators ever be sure that sufficient safeguards are in place for the clearinghouse?

And if the response is that the banks are unwilling to support a clearinghouse with member liability, that would imply that there is no way to design a sound clearinghouse for the derivatives under consideration.  This in turn has implications for the inherent stability of the derivatives market — and would immediately raise the possibility that the appropriate action for regulators is simply to shut the market down.