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Source link: http://archive.mises.org/13113/the-social-function-of-credit-default-swaps/

The Social Function of Credit-Default Swaps

June 29, 2010 by

In the current sovereign-debt crisis, governments want to shift attention and blame to speculators. But who is responsible for government debts if not governments themselves? FULL ARTICLE by Philipp Bagus

{ 24 comments }

Carlos Novais June 29, 2010 at 7:10 am

CDS is the interest rates spread to the market interest rate without default risk. So we can derived the free default interest rates using the CDS prices for US debt which would represent a kind of nominal pure time preference market interest rates.

Brent June 29, 2010 at 8:24 am

Not for US debt. Also inside that interest rate is chance that the US monetizes.

Christopher June 29, 2010 at 8:40 am

The biggest problem with the naked CDS is #1 the purchaser of insurance doesn’t hold any of the debt in question, #2 the cost of insurance is pennies compared to the potential windfall. Consequently there is a large inducement to make the sure the debtor defaults as quickly as possible. A slow unwinding cannot be allowed so what happens is that gov’ts swoop in with taxpayer money while the hedge funds makes millions if not billions of dollars at everyone elses expense.

Regrettably (sp?) the gov’t rewards the elites on both the upswing and the downswing without remorse.

Matthew June 29, 2010 at 9:14 am

I suggest you also evaluate the “unseen” not mentioned in this article of who it is selling the CDS. In essence, a CDS is a put option on a bond. For options on equities, the companies that sell them hedge themselves by shorting the underlying equities. With a CDS, the real danger is that the bank that sold the insurance policy is totally exposed in the event of default. Indeed, it was the banks such as AIG who were naked short the CDS’s that were bailed out.

Of course, through back room deals, the money that was handed to AIG was passed directly to Goldman, et al. to honor those CDSs, but in my view it was more AIG’s fault for being naked short than Goldman being naked long…though the argument that Goldman failed to properly evaluate counterparty risk is certainly a good one.

Lumping “hedge funds” in with the banks that received bailouts is as naive and ignorant as blaming speculators in general.

Christopher June 29, 2010 at 11:35 am

I simply used “hedge funds” because they were mentioned in the article were they not? In any case maybe using the term ‘buyer’ would have made you happier? If I remember correctly it was a hedge fund back in early-mid 2000′s which was showcased as earning a couple hundred million dollars via CDS.

Of course AIG’s has some blame, however it was also the fault of the federal gov’t which allowed AIG to exclude CDS from the same capital requirements of normal insurance policies. I believe the depression era law was overturned by Congress in the summer of 2000.

David C June 29, 2010 at 12:10 pm

It’s hard for me to fault AIG. AIG did what any insurance company would to, they evaluated the risk of default in the market, and insured based off of that calculated risk. So why did they mis-calculate so badly, well because there was a sudden panic in 87, and the federal reserve rushed to the rescue to cover all the counter-party risk … making it seem like counter-party risk was a lot less dangerous than it really was.

Christopher June 29, 2010 at 1:43 pm

Yep and LTCM in the late 1990′s.

Shay June 29, 2010 at 9:16 am

The only argument I need is that CDSs are two parties making a voluntary exchange and contract. As mentioned, it’s merely a bet, like any other. The buyer believes that he will receive many times his bet. The seller believes that he won’t have to pay out often enough to suffer a loss, based on the return rate. If these bets reveal the (accurate) beliefs of the solvency of the one paying the loan being betted on, so much the better. End of story.

Also, two possible typos: “the price of the insurance increased in CDS markets and spreads on [as?] the banks rose”, and “costumers [customers?]“.

Bill Miller June 29, 2010 at 11:48 am

If there was a sound entity whose credit was actually being undermined by speculators, then all that that would mean is that lenders were missing out on a good deal (since if the debtor was actually solvent, but had to pay higher interest rates, a creditor who recognized the opportunity would make a profit at the expense of the other potential lenders who passed up the opportunity). I would actually argue that this applies even when maturities do not match up (such as in carry trades). This would also make it extremely difficult to manipulate a CDS market (since if the firm was actually sound, a smart lender would provide liquidity, and the CDS price would go down) which would in turn mean that our hypothetical manipulative speculator would impose a loss on himself (by bidding up CDSs, and then seeing their price decline). The “self-fufilling prophecy” can only take place if the firms that speculators bet against are actually insolvent.

Indeed, it is primarily because of speculators who short bad assets that bubbles (generally formed by inflation) do not get even worse. Going after short sellers and CDS traders only hurts society by making sure that malinvestment continues for longer

David C June 29, 2010 at 12:03 pm

Before this crises happened, I complained that we had trillions of “unregulated” derivatives, on this very blog. And one of the Mises scholars came back at me about why I would want to regulate derivatives. And I came back at him that, “yes, in a normal free market derivatives would be good and regulations bad, but we don’t live in a normal free market, we live in one where the federal reserve pumps in trillions of dollars of credit out of thin air and implicitly covers counter-party risk …. that plus derivatives is almost certain to cause a disaster of epic proportions if they are not regulated. ” He conceded my point.

Well the disaster happened, but I must admit that I was still wrong. The disaster was a consequence of money-credit printing, not “unregulated” derivatives. As I watch the derivatives take down corrupt governments and corrupt central banks around the world, it’s becoming more and more obvious that these are not the evil beast that I first saw. Derivatives caused the crash, but this was a well deserved and well needed crash. In fact, Krugman wants to do my very suggestion, regulate the markets to keep the consequences of the bubble in check, while still having the ability to print up money for themselves and their cronies.

Thankfully, with derivatives he is going to have a very hard time. The nice thing about derivatives is that I can make an voluntary agreement with someone in any one of 100′s of national jurisdictions. They can also split risks so that you can currency raid countries without having zillions of dollars on hand to call out their fraud like what was required in the past. IMHO, it really is the end-game for national currencies, fradulent central banks, and those who rely on them.

One more thing about the naked shorts. If I sell you a soda-pop at a cheap rate, even though I don’t posses one. I have every right to do that, as long as I get the soda-pop to you at the agreed upon price before the delivery deadline. However, being able to sell things you don’t (yet) have does leave the door open to rampant fraud and con-artists in today’s environment.

Craig June 29, 2010 at 6:10 pm

Thank you. This is the best explanation of and best justification for CDS’s I’ve read.

Allen Weingarten June 30, 2010 at 6:23 am

Ditto.

Joe Peric June 29, 2010 at 10:58 pm

I have to echo Craig’s comment. This is an easy and excellent read. It really goes to show that these financial instruments can help to regulate the economy instead of allowing screw-ups to continue.

Nick June 30, 2010 at 3:43 am

What’s missing is that a CDS is a zero sum game. Why no comment on naked selling of CDS contracts? You can’t have it both ways. (To Merkel)

However, there are issues with naked CDS but they aren’t the issues of the canary down the mine indicating the mess.

It’s to do with settlement. If they CDS is physically settled, naked CDS leads to major disortions and pass the parcel of the final losses. It’s not a proper hedge against lossses

Roxy April 12, 2011 at 8:51 pm

Walking in the presence of giants here. Cool thinking all aorndu!

martyn strong June 30, 2010 at 7:38 pm

Capital markets are unstable. In the past there was no way to make them stable. But today we have computer power that can be used to make them stable.

By using the greater computer power of today we can have a much higher turn over of capital in the capital market. This higher turnover will make the market harder to game or control and the market will no longer have the unstable run ups or declines. Who can change or control the market when say 20% of the capital is trading each day?

So now that we have the compute power to provide for all these transactions that will smooth out the market how do we force people to turn over at a rate of 20% a day? Easy, put a cap gains tax of 0% (zero) on all gains of 7 days or less and put a cap gains tax of 90% of all gains of more than 7 days.

The likes of Yahoo, Micosoft and/or Sun Micro Systems will give us the systems that will provide automated software agents to support turning over one’s investments every 7 days (based on the specs you give the agent).

A system like this will make the financial markets work as smoothly as the local fruit market.

Stephen Grossman July 3, 2010 at 1:59 pm

>Capital markets are unstable. In the past there was no way to make them stable.

I ate steak yesterday. Today I may eat fish. My eating habit is unstable. Yesterday I caused steak firms to have more profit. Today I’ll cause fish firms to have more profit. My eating instability will indirectly cause the capital markets which invest in steak and fish firms to be unstable. I will henceforth eat only one food so that markets will be stable. Of course, other people, the weather, agricultural science and a zillion other things may cause market instability. Market stability is impossible and not good in reality. Its merely a method for understanding market process, a process which is the product of many choices of buying and selling. Plato’s Forms are not a valid context for the science of economics.

Bill Miller July 1, 2010 at 9:53 am

“CDS is a zero-sum game”
So is insurance, in theory. In practice, it helps to hedge against risk and transmit information to society about the relative riskiness of particular activities. Similarly, CDSs serve as a barometer for the riskiness of an entity’s credit. I find it interesting that the statists blame the European debt breakdown on CDSs, when all that they can affect, in theory, is liquidity (and in practice would probably not have an effect on solvent entities). Notably, the crisis has hit only countries that were either A.invested heavily in inflated, unstable markets through central bank and government guarantees (Ireland and Iceland) or B.engaged in fast and loose fiscal policy (Portugal, Spain, and Greece). Nations that had taken a fairly stable and cautious course (France, Germany, most of Scandinavia) haven’t been hit, for the most part, except in the form of having to bail out less responsible governments. My point is: the only governments whose debts were downgraded by CDSs were those that were likely to be basically insolvent, so liquidity isn’t the issue here. The CDS market, thus, did serve as the canary in the coal mine.

Robert T July 1, 2010 at 10:43 pm

And once again, Mises.org hits it out of the park… amazing job.

Gerry Flaychy July 2, 2010 at 7:56 pm

“By just paying $2,500, a hedge fund could make a gross profit of $1,000,000 when Citigroup defaults on its obligations.”… And the ‘insurer’ make a gross loss of $1 million. If there is 1 000 bets at $2 500, it’s $1 billion gross loss for the ‘insurer’, and for 10 000 bets it’s $10 billions loss for the ‘insurer’: enough to go bankrupt !

What were the amounts in the AIG case ?

Lisa - Social Networker July 24, 2010 at 4:34 pm

The buyer of a credit default swap pays a premium for effectively insuring against a debt default. He receives a lump sum payment if the debt instrument is defaulted.
The seller of a credit default swap receives monthly payments from the buyer. If the debt instrument defaults they have to pay the agreed amount to the buyer of the credit default swap.
Some have suggested credit default swaps have exacerbated the financial crisis of 2008.
I have a different opinion and do not believe that swaps caused as big a problem as indicated or feared.

Gerry Flaychy July 24, 2010 at 6:29 pm

“CDS contracts … As of the end of 2007, they had grown to roughly $60 trillion in global business.”
http://www.reuters.com/article/idUSMAR85972720080918

Sylvester McMonkey McBean August 11, 2010 at 1:02 pm

Upon reading this article I immediately thought to myself, THIS MAN KNOWS ECONOMICS, BUT NOT PUT IN TO PRACTICE. I read his bio, and found this to be true. He has never worked in the industry, and has made an error that strictly academic economists make all the time.

HE LOOKS AT WHO IS BUYING THE CREDIT DEFAULT SWAP RATHER THAN WHO IS SELLING. A GOOD ANALYSIS LOOKS AT BOTH SIDES.

THERE ARE TWO PROBLEMS WITH NAKED CREDIT DEFAULT SWAPS:

1) THE SYSTEMIC RISK AND CONSEQUENCE OF ONE STUPID COMPANY
2) WITHOUT A CLEARING HOUSE OR EXCHANGE, ONE BIG COMPANY OR HEDGE FUND CAN BET AGAINST A LEGITMATE COMPANY THROUGH 100 DIFFERENT ENTITIES, SENDING FALSE SIGNALS OF INSOLVENCY. IF THIS HAPPENS ENOUGH, A GOOD SOLVENT BANK CAN GO BANKRUPT. This has happened.

VISIT MY BLOG http://economic-profanity.blogspot.com TO READ MORE.

I believe in free markets and limited government, but some basic regulations are necessary.

Sylvester McMonkey McBean August 18, 2010 at 2:55 pm

Parochial adj; very limited or narrow in scope or outlook
example: Philipp Bagus

Correctly, Bagus points out the self-validating nature of naked credit default swaps. In other words, they can increase distrust in banks by betting against them, forcing the banks to offer a wider spread. Where Bagus goes wrong is his conclusion that this makes CDS’s powerful corrective instruments that discipline banks.

The problem with the analysis is that it only looks at who is buying the CDS, never at who is selling. The seller is taking on the risk of default by insuring against default. Yet the companies that are doing this are not insurance companies- anyone can issue this insurance. This is not the case with most insurance. Insurance companies are regulated and are forced to hold reserves against the risk they are taking on and the quality of those reserves is monitored. In this way, people who take out insurance know what the odds are that they will collect from the insurance companies. Or, what the odds are of default.

The first problem with unregulated (and therefore unreserved) insurance such as CDS is the systemic risk that can be caused by bankruptcy of the CDS seller. AIG was a huge seller of CDS – and when they went bad the whole company went under- this means that anyone else that had investments and legitimate insurance with AIG would have lost everything – causing more bankruptcies, and so on.

The problem with naked CDS is this: If you write normal insurance on a house or a person’s life, you can only be required to pay it off once – that is a person can only die once. With naked CDS’s, a $100 million bond can be insured by anyone that bets against it. This could mean that a stupid company (which deserves to go out of business), that insures the $100 million ten times over could end up with $1 billion of debt if the bond defaults. This one stupid company can take down many many others, putting the overall economy at risk, and some would say forcing the government (taxpayer) to intervene.

The second problem, which Bagus touched on but not to its full extent, is that a naked CDS can be a problem even if they are written by an intelligent insurance company with normal reserves. A smart hedge fund can start buying CDS’s on a quality credit. They could buy $1 billion dollars even though there is only a $100 million dollar bond, and they could do this with 100 different providers. Since there is no exchange or clearing house, all of this is done with private contracts and so no one knows what is going on except the big buyer. The price will be pushed up, indicating higher risk for the seller, but there really isn’t higher risk, it’s just one buyer trying to successfully rig the market. This leads to the legitimate insurance company owning a less valuable asset (their CDS contract), and thus having to put up more reserves. If this happens enough, the insurance companies have financial difficulty, and you can have a financial crisis.

To make a proper analysis one must look at both the buyer and the seller. This is where Bagus went wrong, and this is why he comes to the wrong conclusion.

Forever pissing off PHDs,

Sylvester McMonkey McBean

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