I mean that a significant number of trades are 'naked' or synthetic shorts, rather than being insurance in any normal sense of the word. We can all understand insurance; it's the fact that they seem to have the opposite effect that's so startling, I suppose.
Right - I'm with you. It does seem counter-intuitive - but even synthetic shorts are a form of insurance. It's just that the rapid-fire trading of those positions makes it seem un-insurance like. For example, if you sell protection on a credit index like the ABX - a naked, synthetic short position - your counterparty has bought protection against deterioration in the credit quality of securitised subprime mortgages. That still looks like insurance. But if the ABX then widens significantly, forcing you to take mark-to-market losses so you put on a long position on the ABX as a hedge, it stops looking like an insurance business and starts looking like you're just betting on the direction of subprime credit quality - which is exactly what you're doing.
But most banks avoided taking those simple, directional bets. A lot of their credit trading business was about finding arbitrage opportunities. The simplest example I know is the negative basis trade - they'd go looking for companies where there was a sizeable gap between their bond spreads and their CDS spreads, and then hedge a wide bond with a less-expensive CDS: you end up with no credit risk on the bond because you're hedged and you just capture the difference between the two spreads. Do it with money that you've borrowed at practically zero-cost overnight rates and you make a nice return. So banks took huge, unrecognised liquidity risks - but they really didn't have a lot of appetite for outright credit risk.
If you refer to AIG, didn't they get bailed-out by the US government to the tune of something quite substantial? LEH seems to be more encouraging (the sky didn't fall on our heads just yet).
I was referring to Lehman. People have been talking about the CDS market being untested for years. Over that period there have been numerous defaults, big and small, and even crops of defaults like those in 02-03 ... but there's never been a default of a company which was both a popular CDS reference entity and a big CDS dealer. That's what happened with Lehman. The amount of money at stake on each Lehman CDS was significant - protection buyers ended up getting roughly 90 cents on the dollar - and everyone who had Lehman as a counterparty also needed to go and rehedge, but the market coped with both those effects.
DWD -- you're obviously a lot more knowledgeable on this
I don't know about that. Closer to it, maybe - but thats not worth a lot. What everyone
wants to be able to do is separate cause from effect - but who can do that with something this complicated?
Absent massive and unprecedented government intervention, propping up institutions and providing liquidity, how would these instruments have performed?
Absent government intervention, I think most major international banks would now be dead. So, in that scenario, would default swaps have paid out? I don't know. Maybe - after a decade of bankruptcy proceedings. But in that eventuality, the CDS market would have been the last of our concerns. Every financial asset would have melted down - shareholders would be wiped out, bondholders would be queueing up at court, anyone with a swap of any kind would be left hanging, depositors would be rioting.
Do you think that lack of info about CDS exposure increases the reluctance of firms to lend to one another? And ok, so most institutions hedge, but somewhere, someone is a net buyer and someone a net seller of CDS -- someone has to take the hit. Isn't the uncertainty about where and when losses are going to materialise inherently destabilising?
Not especially. I think all the evidence suggests that the banks - the big intermediaries who are crucial to the continued functioning of the financial system - don't tend to have big one-way exposures in their CDS businesses. They might go long Company A and short index B, but those individual bets are fairly small and a lot of their trading was a wash. At the level of the entity itself the exposure is dwarfed by things like MBS and CDOs.
If you want to know where most CDS losses will materialise / are materialising, look to the hedge funds and insurance companies - those are the guys who tended to be net protection sellers.
What about Whalen's complaint that collateral posted against worsening CDS positions is proving a huge drain on liquidity -- any truth to that?
I know some hedge funds have been close to being forced out of business by collateral demands alone - but I'd be surprised if it's a widespread problem for the dealers, for the reasons outlined above.
Similarly, is there any truth to the idea that CDS are a motivating factor behind the possible bail-out of Detroit?
Frankly, I don't know - but I'm happy to speculate! Let's think about this: Ford and GM have been teetering on the brink for years now and there was a big credit market event when they were downgraded to junk in (I think) May or June 2005. Now, despite it being an open secret that they were both effectively walking dead, maybe people took advantage of the wide spreads on those guys to write lots of protection and those people are now sitting on potentially fatal losses if the companies go bankrupt. Could be. But it seems almost suicidal to build up a big net exposure to a company which everyone knows is a real default risk. That's not the kind of business that credit desks do - as mentioned above, they were looking for short-term anomalies between, say, cash and CDS markets, or within certain indices - not betting the bank on the continued health of a sickly company.
The people making aggressive assumptions on CDS and the likelihood of default and banking these assumptions in the form of bonuses (AIG's 40 person strong CDS dept in London split $3bn in bonuses over seven years) -- isn't that problematic too (and not just in a moral sense)?
This is one of the most interesting things about the whole crisis - the fact that the market was systematically underpricing credit risk, which encouraged people to take huge bets with borrowed money. It's easy to say now that they were wrong to do so - but people had been betting against the continuing depression of credit spreads for some time and
losing money. Pimco's Gross started warning in 2003 (I think) that credit would start deteriorating and it just didn't happen. He made the same prediction in 2004, too, and he was wrong again. To be "right" you not only needed to know that credit risk was underpriced - you also needed to know when everyone else would wake up to that fact, otherwise you were standing there alone, building a sandcastle to hold back the tide.
Blimey. I didn't realise this was going to take so long. It's a mammoth reply. Please note that it's only this long because I enjoy talking about this stuff - most of it's probably wrong and I'll likely have changed my mind on it all by tomorrow anyway!
. And doubtless the discussion has moved on from this...