Sunday, March 08, 2009

Ten Things Everyone Should Know About CDS(or, "Bad Stuff 'bout CDS)

1. CDS represents a put contract (or, insurance) on a bond, that allows the CDS-purchaser to profit on the difference between par ($100) and the price of the bond on a default date (typically $0-30)

2. Unlike traditional insurance contracts, purchasers are not required to have an "insurable interest" in, or ownership of the underyling bond.

3. Why does this matter? [For example, your home-insurance agent sells you a $200,000 insurance policy on your home for a $500 premium payment. Then, your insurance agent goes to your next-door neighbor and sells 5 different $200,000 insurance policies on YOUR house. Then, the neighbor across the street buys 5 more $200,000 insurance policies on YOUR house. In total, your $200K house is now insured for a total of $2.2Mln... and your neighbors have much to gain from seeing your house burning down.

4. The premium on CDS contracts typically is incurred over time. As such, the insurance-buyer maximizes his gain the sooner a default occurs. For example, a purchaser might pay a "spread of +300 basis points", which equals 3% of the notional-insured value over time. Under our previous example, your neighbors would each pay $30,000/year (3% of $1,000,000 insurance) to insure your property. Since this is a very expensive premium to pay on a property with no insurable interest, your neighbors need one of two things to happen in the near-future: 1. Your house burns down/you default/you go broke 2. Someone else to buy their insurance from them at a higher price

5. The purchase of CDS (insurance) creates a self-fulfilling prophecy, which increases the probability of default. How does the probability of default increase? Using our prior example, it increases the cost of insurance to you, the homeowner, while simultaneously incentivizing your neighbors to see your house destroyed. Okay, but why does the cost of my homeowner's insurance increase(since I have a need and justifiable purpose for having insurance against my property)? Your cost to insure your property rises because there are multiple bidders vying to purchase insurance on your home.

6. The lack of "insurable interest" requirement for CDS(insurance) caters primarily to speculative and destructive elements of human nature. Humans tend to purchase commodities (homes, internet stocks, tulips, etc.) when they are increasing in price. Thus, when your first neighbor buys insurance on your home as a speculation, it causes the price of additional insurance to increase. Your other neighbor (across the street) hears that the price of your home insurance just rose 10% overnight and that your next-door neighbor has already made a "killing" on his insurance policies covering your home. So, your other neighbor decides to buy some insurance (on your home) for his personal-account, which causes your home insurance premiums to increase another 20%. Both neighbors begin bragging about their large gains, which incentivizes neighbor #3 to buy insurance, thus driving up the price even more. This continues and the price keeps rising. Rumors about you walking around your garage with open gas-containers begin to circulate (never mind that you were filling up your lawnmower!) and word leaks back to your insurance agent.

Although you have never had an insurance claim against your property, so much insurance is being purchased against your house that your insurance agent refuses to renew YOUR homeowner insurance policy at year-end, due to the "high risk" associated with your policy that the market is pricing in. The insurer insists that the only way to insure your policy is if you pay 15% of your home's value as a deposit on the insurance, along with a 5% premium per year. Since you are required to carry insurance to hold a mortgage, you have no choice but to pay-up (15%+5%= 20% *$200K =$40K insurance premium, significantly above your previous insurance costs and your total mortgage payments). Given the high costs of insuring your home, YOU the original homeowner are now unable to afford to live in the home anymore and do not qualify for refinancing (since the lender will factor the insurance costs into his analysis).

As your ability to pay bills and maintain your creditworthiness is challenged by the rising financing costs and rumors, your neighbors are incentivized not to help you out. Assuming no one is interested in buying your house, you figure out that the only way out of your mess is to burn down your house and collect the insurance premium. Naturally, your next-door neighbors are all-too-eager to provide you with the gasoline, matches, and alibi (given their vested interest in your home's destruction).

6. CDS purchasers do not have to pass criminal background checks and are not obliged to even indicate their reason for purchasing insurance on an entity (all they need is a signed ISDA agreement!). Using our previous example, how would you feel if your insurance agent knowingly sold $1mln insurance policy on your $200K house to your neighbor* (in spite of full knowledge that your neighbor was a convicted arsonist and had burned down previous houses that he'd bought insurance on?). My guess is, you would be pretty pissed off.

7. CDS (insurance) sellers are not required to notify companies that they are issuing derivatives against that entity, or allowing others to be on their demise. Using our previous example, although you and your insurance agent are aware that an arsonist lives next to you, your insurance agent is not obligated to notify you that he has issued insurance policies against your home. (If this were required, my guess is that you would keep a fire extinguisher in every room and double-check your smoke alarms each night!)

8. CDS (insurance) is perversely designed to allow manipulation by purchasers rather than sellers. How is this done and why does it matter? Buyers of CDS pay a small premium (generally a 1-3 % of notional insurance value) and generally do not have to post margin/collateral on their purchases, since their total premium-payments are not viewed as large risks to their counterparties. In our example, a 5-year CDS contract might only represent total premiums of 5(years)x 1%x $200,000=$10,000 in premiums spread over five years. As such, if your neighbor has $200,000 in a bank account, he could easily purchase 20 insurance contracts on your home, without your insurance agent questioning his ability to live up to his counterparty obligations. Now reverse it for a second. You (the homeowner) see your insurance rates increasing and decide to sell insurance on your home, because you believe the rates are too high and you have no intention of burning down your home.

Assuming you have the same $200,000 in your bank account, that is sufficient capital to sell 1 (ONE) insurance contract against your home. How come $200K in capital is sufficient to buy 20 insurance contracts betting on your home's destruction, but is only sufficient capital for you to sell a single one of them (betting on your home's survival)? The answer is obvious, because to guarantee a $200K insurance payment would require the full $200K in capital. Thus, buyers of protection (aka, short-sellers) have a 20-fold advantage in purchasing power versus sellers. Perversely, if you did sell an insurance policy on your home and your neighbors began driving up your insurance rates, you would have to report "mark-to-market losses", even though you have no intention of burning down your house.

9. Collateral requirements ensures there will be more buyers than sellers of CDS (insurance), which virtually guarantees that rates will increase over time for any insurable entity. As protection buyers chew through each entity (with low insurance costs) and drive the rates up, the buyers will report "mark-to-market" gains on their "trading" books. These reported profits will increase their book-capital, thus enabling their ability to purchase more and more insurance contracts and drive CDS spreads ever higher.

Purchasing CDS insurance is virtually riskless for speculators determined to drive spreads wider, given the near-limitless upside potential. For example, cites the following about a John Paulson bet against Lehman, "Long before the financial crisis hit, Paulson, according to one person briefed on the trade, invested $22 million in a credit default swap that eventually paid $1 billion when the federal government opted not to rescue Lehman Brothers. That amounts to a staggering $45.45 for each dollar invested. "

10. As structured, the CDS (insurance) market appears singularly designed to support massive speculative trading and wreck companies. This dire view is based upon the skewed upside-potential on CDS insurance, lack of an "uptick rule" (preventing a single buyer from pile-driving spreads and wrecking a company from a spread-standpoint), negligible collateral requirements on purchasers of CDS insurance, lack of reporting requirements on purchasers or sellers, and perhaps most importantly............ no requirement of "insurable interest" for purchasers of CDS insurance. Is it any wonder that CDS spreads on Berkshire Hathaway of GE are significantly wider than the cash-spreads on their underlying bonds (what a "mystery")

If you read this, it should be clear that the risk/reward of CDS is skewed against sellers of CDS (those betting on stability) and favors the buyers (those betting on defaults and panic). Unlike equity markets, there are no real reporting requirements and negligible collateral requirements on "short-sellers" of credit. Most disturbingly, CDS spreads directly affect cash-spreads on corporate bonds, which represents the life-blood by which many companies fund their operations and payroll. When massive CDS speculation squeezes out and eliminates a company's ability to fund their operation, it represents more than a zero-sum game between two disinterested counterparties, it represents an unnatural destruction of a company/entity. In presenting my "homeowner example", I tried to analogize how horrible this market would be if applied to individual people. The negative outcomes are obvious. believe in capitalism and free markets, but CDS represents a flawed and contorted anomaly that has warped corporate bond markets for too long (largely within the last five years). CDS markets have been a critical driver of this "credit crisis". So the next time you hear someone cry about "naked short selling" of equities (which is regulated, reported, and restricted by margin constraints), point out how trivial their concerns are next to the +$60 trillion CDS markets and the issues I have laid out.

PS- In case you are curious, it is illegal for your insurance company/agent to sell insurance when there is no "insurable interest"

P.S.S- The next logical question you might ask is, "Wouldn't your hypothetical insurance agent [from my example above] go bankrupt from writing all these CDS (insurance) policies that are designed to self-destruct? The answer: Yes, your insurance agent would become insolvent. The name of your insurance agent is AIG. :)

Best Regards, Troy

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