Monday, September 19, 2011

European markets and Credit Default Swaps (CDSs)

Do they say anything?

A recent email discussion worth posting follows. It’s presented in reverse chronological order.

The Hedged Economist wrote:
Bringing CDSs onto exchanges makes sense if the margin requirements are set reasonably. It shifts all the counterparty risk onto one counterparty (i.e., the exchange). If margin requirements are set reasonably, that's considered a positive. If not, it's a disaster.

The transparency issue is not “cut and dry.” If one buys a CDS privately (i.e., off the market), one knows who is offering the CDS. On an exchange, the counterparty is the exchange. One doesn't know who offered the CDS. It could be any seller or even the market maker.

The reference to Basil III is indirectly very relevant. The issue is capital: how much capital should each type of transaction require. Put differently, the issue isn't CDSs or where they are traded; the issue is leverage. You may have confidence regulators will get it right, but history suggests capital requirements tend to be pro cyclical. This is a topic discussed on The Hedged Economist back in March of 2010 “Regulatory capital and who’s got the money?” It’s hard to figure anything to add to this excerpt: “Increased capital is ultimately the solution. But, timing changes is probably more important than the level. What we know about reserves is that people lower them in good times and raise them in bad times. We also know this aggravates the cycle. Well, surprise, surprise, governments are people; they do the same thing. Unfortunately, the government has a long history of changing capital requirements in the wrong direction over the business cycle. It’s the fallacy of composition writ large. Individual banks are safer with higher reserves, but if every bank raises more capital, oops, no credit even for productive endeavors.”

Banning CDSs wouldn’t accomplish much since it’s possible to construct a synthetic CDS. It’s less efficient than a CDS at gaining a like exposure. Further, saying they are not an efficient hedge and that their information content is questionable is very different from saying that they create systemic risk. CDSs don’t create systemic risk: at most, they concentrate it. The systemic risk originates from the total leverage.

Your argument that CDSs create systemic risk is correct if they function the way advocates say they do. The argument used to justify CDSs is that they reduce the risk of making loans by providing a vehicle that lets the lender transfer the risk to someone who wants to take the risk. Thus, the lender is free to lend more. The argument is that by shifting the risk to people who want it, the cost of getting someone to bare the risk is reduced. That, the argument goes, allows lower lending costs and more credit creation. Since credit creation is leverage and leverage (over-leverage specifically) is the source of systemic risk, your argument is then correct.

However, the presence of leverage isn’t supply constrained. If people will borrow, someone will find a way to lend to them. It may be CDSs, securitizations (squared or cubed), syndications, a loan shark, doesn’t matter. Generally, one party is a principal (usually the borrower) and one is an agent (generally the lender). By trying to regulate the agent (or the vehicle they use), regulators fail, usually for the very reason regulators focus on lenders. The regulators won’t directly tell people who buy credit that it’s a mistake. In the European case, numerous efforts were made to constrain public sector borrowing starting from the basic efforts to form the European Union. The problem is: Who can tell sovereign entities what to do?

That leaves a very perplexing problem. CDSs create asymmetric risk. The only justification for banning them might be that humans don’t do asymmetric risk well. But, the answer to the question: “Who would ban them?” certainly isn’t governments. They’re worse at asymmetric risk than markets as illustrated by “accidental” wars, revolutions, etc. Current economic distress pales by comparison to civil wars, WWI (often referred to as the accidental war), and more than a few revolutions.

There is a very effective way to eliminate the risks created by the asymmetry inherent in CDSs: don’t play; neither long nor short, directly or indirectly. Following that maxim, this may be the most The Hedged Economist will ever write about CDSs. Certainly, you won’t find them discussed as if they were investments.

Right now, most central banks are flirting with systemic risk by betting they can manage the asymmetric risks they are creating. Here’s hoping they’re right. But, unlike CDSs, central banks’ bets aren’t ones an individual can avoid.

Response to the entrepreneur from a person who focuses on the analysis of stocks of firms in the financial industry:
I believe the Dodd Frank Bill regulates them and requires exchange or clearing house transparency.

International financial regulations abound. The Basel III requirements alone are a massive set of new international requirements.

The entrepreneur’s response:
Who would ban them? Last I checked it is a global world. Like all good things CDS are good in moderation, it’s just in large volume they don’t perform as expected.

Response to The Hedged Economist from a person who focuses on the analysis of stocks of firms in the financial industry:
So...if Credit Default Swaps are poor hedge instruments, and introduce systemic risk, they are not useful economically? We can ban them and have no economic repercussions?

The Hedged Economist wrote:

CDSs are an extremely clumsy way to hedge against default on a specific position. The prices can't incorporate the correlation between the probability of default (PD) on the position being hedged and the PD on the CDS. Consequently, they are mispriced. At a cruder level, what is clear is that most CDSs are very effective at shifting default risk from a specific issuer to systemic risk.

There is a more basic problem with CDSs that contributes to the mispricing. People don’t seem to process asymmetric return calculations very well. Either (1) they view large sums of money as worth more than equal to the total of small sums that add up to the same amount or (2) above some number they can’t calculate beyond a general view that all numbers are big.

CDSs do seem to be effective at hedging downgrade risk if and only if priced right. Generally, however, my impression is that getting the right exposure to the CDSs to hedge a position is a crap shoot.

Thus, levels of CDSs on European banks’ stocks contain less information than the change. Change relative to the sovereign CDSs are usually the most informative. In the case of European banks, because the monetary authority and sovereign are separate, the only way to interpret the change is through exchange rates. In fact, cost of a currency swap that would eliminate the currency risk would seem to be the relevant thing to monitor.

Since monetary authorities have taken it upon themselves to intervene based on CDS pricing, there doesn’t seem to be much that this economist can say other than to quote from the August 25 posting: “In economics, Goodhart’s Law states that for policy purposes one can target an economic phenomenon as measured by a particular indicator. However, when one does that, the indicator will lose the information content that would qualify it to play such a role. By targeting the indicator, the policy kills its information content. It no longer conveys the same information about the economic phenomena that one wishes to target.”

My take is that the CDSs represented a highly leveraged bet on two things: the probability of a downgrade, and the probability of central bank intervention. It proved to be a profitable trade on both accounts. Since CDSs are consistently mispriced and there is a feedback loop, a reasonable conclusion is that those willing to risk the leverage are good at manipulating the monetary authority and rating agencies. That may be a good bet, but it’s not one where an economist can add insight.

Response to the entrepreneur from a person who focuses on the analysis of stocks of firms in the financial industry

That's my point, who's writing CDS swaps on sovereign credits and international money center banks and Insurance companies? Seems like a feedback loop.

The entrepreneur’s response

The market knows best. The problem with CDS on banks is counter party risk. Will your CDS pay if it is cotemporaneous with a total financial meltdown?

From: A person who focuses on the analysis of stocks of firms in the financial industry

• September 12, 2011, 1:02 PM ET (Quoting)
CDS Spreads at European and U.S. Banks Getting Scary-Wide
• By Avi Salzman
Investors are pricing a ton of risk into debt protection for European banks and sovereign debt today, as Greece teeters near default and the health of numerous banks hangs in the balance. CDS spreads reached new highs for many of the banks this morning, with investors keying in on French banks in particular. CDS spreads on Societe Generale (SCGLY) hit 450 basis points shortly before noon, up from 387 on Friday, according to data from Markit. At BNP Paribas (BNPQY), spreads jumped to 320 from 275.
Spreads on Greek sovereign debt jumped to 3,787 early this morning from 3,188 on Friday and the mid-2000′s during the crisis weeks in July.
U.S. banks were also hurting, with spreads on Bank of America (BAC) hitting 375, up from 353 on Friday and under 200 at the beginning of August (pre-Standard & Poor’s downgrade of U.S. credit rating). Citigroup (C) spreads swung to 263 from 245 on Friday. Goldman Sachs’ (GS) spread hit 272, up from 252.

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