THE BEAR'S LAIR
One casino too many
By Martin Hutchinson
Wall Street over the last generation has been a prolific generator of casinos,
in which the dealing community can make a very nice living indeed by providing
investment and "hedging" services to outside investors. Of all these casinos,
the credit default swaps (CDS) market has been among the most lucrative. As the
credit crisis has unfolded, however, it has become increasingly apparent that
the CDS market's damage to the global economy is sufficiently severe to justify
closing down or at least sharply restricting Wall Street's favorite sandbox.
During the surge in size of the derivatives market in the early 1980s, in which
I was an active albeit minor participant, we looked extensively at the
possibility of designing credit derivatives. The
need, after all, was obvious: there were banks excessively exposed to
particular borrowers and equally other banks and insurance companies with
appetite for credit and no exposure to those borrowers. Credit derivatives
could allow participants to buy and sell credit risks, aligning their exposures
with their beliefs about the market.
There were always two problems. First, there was no obvious way for credit
derivatives to settle; the process of bankruptcy was sufficiently fuzzy and
differed sufficiently from case to case that there was no watertight way of
calculating when credit derivative buyers should be paid and how much. Second,
the credit exposure taken on through trading credit derivatives was huge; the
cash flows were hugely asymmetrical, with a certainty of modest annual payments
going in one direction and a low probability of a massive cash settlement in
the other. In that sense, they were like life insurance policies, but life
insurance policies where the sum assured was not hundreds of thousands or a few
million, but hundreds of millions or even billions.
Those problems were never solved. Instead, from the middle 1990s, a market
grown crazy through never-ending expansion and excessively cheap money simply
started trading credit derivatives without solving the problems underlying
them. No watertight settlement procedure was ever designed; the current
standardized settlement procedure involves a mock auction of a few million
dollars of credit exposures, with the prices reached determining the settlement
of exposures involving billions, or even hundreds of billions, of dollars.
Needless to say, the temptation to cheat is overwhelming. Nor has there been
any central clearing mechanism; the profitability of the business to the major
dealers that would be lost through greater transparency is so high that the
obviously necessary central settlement and clearing house proposed by the
Depository Trust & Clearing Corporation has been imminent for over a year
and never finally emerges.
The CDS market has long since ceased to be a means of hedging credit exposure,
if indeed it ever really was. At its peak, its outstandings totaled $62
trillion, more than twice the world's total outstanding loans. What's more,
there can be no doubt that if the credit crunch had not arrived, the market's
outstanding volume would have gone on expanding ad infinitum, becoming an ever
larger multiple of the loans it theoretically hedged.
If the paradigm of the Efficient Market Hypothesis really held, and markets
were governed by infinitely rational investors, operating on rational estimates
of risk and price, the CDS market would still have its problems of pricing and
escalating credit exposure, but if those were solved, it could be contained,
without representing a threat to the entire financial system.
However, as the unfortunate Wall Street practitioners who hedged their
exposures using the value-at-risk methodology now know, the Efficient Market
Hypothesis is a poor match against the realities of the market. Markets can
become irrational in both directions, and by exploiting irrational fear, it is
possible to drive a company into bankruptcy, particularly if it is a highly
leveraged financial institution.
That's what appears to have happened on a number of occasions last year. Bear
Stearns, Lehman Brothers, AIG, Citigroup, Fannie Mae and Freddie Mac all
suffered crises of confidence that resulted either in bankruptcy or in
government takeover. The theoretically rational market proved in practice to be
highly irrational. At the time, market participants and the media blamed short
sellers. Yet it is likely that CDS holders were very much more to blame.
For one thing, look at the economics involved. An equity short seller wishing
to drive a company into bankruptcy has to take the risk that the stock will
rebound, forcing him to cover his position at a loss that is theoretically
unlimited. He has little leverage available, so he must put up an amount of
money that is comparable to his potential winnings. A buyer of put options does
not have infinite potential loss, but on the other hand his premium is
substantial and the time decay of option premiums is rapid, so that he has only
a few months to carry out any nefarious schemes he may have.
Conversely, a CDS holder, like an option buyer, need pay only a modest annual
premium, so his potential gain can be many times his investment. Moreover, CDS
are typically outstanding for several years, so he can wait until market
conditions are propitious before striking.
However, the greatest attraction of CDS as a vehicle for bear raids is their
outstanding volume. There were recently $1.4 billion nominal of Citigroup and
$2.1 billion of JP Morgan Chase outstanding in the traded equity options
market, while the short interest on both banks was of the order of $1 billion.
Conversely, in the CDS market, the outstanding CDS volume was over $60 billion
for each bank - much of the discrepancy in volume is natural enough since
financial institution balance sheets contain far more debt than equity. For a
hedge fund wishing to make an extraordinary return through promoting
bankruptcy, the CDS market thus offers far greater buying power, lower prices
and lower risk. The choice is a no-brainer.
In the early years of the London insurance market, it was possible to buy a
life insurance policy on a complete stranger. Then insurance companies noticed
the high incidence of unexpected homicides among their lives assured, and the
concept of insurable interest was devised, codified by the Life Assurance Act
of 1774. Today, you can't buy a life insurance policy unless you can
demonstrate some loss by the assured party's death. The business is safer that
way!
The same consideration must surely apply to the CDS market. The legitimate
hedging purpose of CDS today represents only a tiny proportion of contracts
outstanding. The US taxpayer is already on the hook for $150 billion, with more
to come, through the inept CDS operations of the insurance behemoth AIG. With
multiple bankruptcies and huge market instability owing at least part of their
provenance to CDS, the public policy consideration for closing or at least
sharply restricting the CDS market is even clearer than that promoting the
restriction of the insurance market in 18th century London (at least taxpayers
weren't expected to pick up the tab for insurance policies on murder victims!)
As a minimum, therefore, CDS writing should be restricted to those holding
bond, loan or swap obligations against which CDS might reasonably hedge. CDS
should be distinguished from stock short positions and stock options (which
have similar theoretical possibilities) because their greater leverage and
higher outstanding volume make them uniquely dangerous. Such a market would be
highly illiquid, but it would fulfill the essential function of CDS of enabling
credit risk transfer. Other advantages of CDS, of demonstrating credit spreads
over a public marketplace, allowing the hedging of baskets of similar credits,
providing an instrument for hedge fund "investment" and making huge returns for
the major dealers, would be lost.
However, the destabilizing effect of CDS on global financial markets would also
be lost, and the cost to taxpayers of rescues for those major institutions
which had either got the CDS market wrong or were victims of CDS "bear raids"
would be eliminated.
The free market is a wonderful thing. However, allowing unrestricted free
markets in everything, without regard to the real-world economic effect of
those markets, is a Whig shibboleth similar to the "Repeal the Corn Laws"
unilateral free trade policies that destroyed Britain's economic strength in
the 19th century. The great and economically highly sophisticated Tory Prime
Minister Robert Lord Liverpool, a generation prior to the mid-century free
traders, also believed in free markets, but was a realist in their application
to the world in which he lived.
The real world is messy and does not conform to simplistic equations either
mathematical or moral. The wise policymaker will legislate accordingly,
providing the maximum market freedom but inserting restrictions where the
temptations to malfeasance are too great. The CDS market forms an open and shut
case for restrictive regulation.
Martin Hutchinson is the author of Great Conservatives (Academica
Press, 2005) - details can be found at www.greatconservatives.com.
(Republished with permission from PrudentBear.com.
Copyright 2005-09 David W Tice & Associates.)
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