Sunday, January 25, 2009

CDS Demonization Watch, Gretchen Morgenson Edition

By Felix Salmon at

In the wake of making my proposal below (which I'm entirely serious about, by the way), I'm forced to agree with Gretchen Morgenson about this:

Credit-default swaps clearly played a role in this debacle, and it is crucial that they are part of the solution.

That's about all I agree with her on, however. Consider this:

Sellers of C.D.S.'s spent years raking in premiums while underestimating or simply ignoring the possibility of rising defaults...
The fear that already-hobbled financial companies may have to pay off huge amounts on C.D.S. arrangements hangs like a cloud over the markets.
C.D.S.'s have already figured prominently in taxpayer bailouts. The $150 billion rescue of the American International Group, for example, came about because of swaps the insurer had written on mortgage securities. And the $100 billion taxpayer backstop handed to Bank of America on Jan. 16 had a good bit to do with soured credit-default swaps that the bank inherited when it acquired Merrill Lynch.

To read this, you'd think for all the world that the problem in the CDS market is that the big banks have written lots of credit protection, and that they're liable to make huge payouts if and when companies start defaulting.

But the losses at AIG came overwhelmingly because the insurer was selling default protection to banks on their super-senior CDOs. In other words, AIG was bailed out largely because if it hadn't been, many of the world's largest banks would have found themselves to be insolvent overnight. The banks were the prudent ones, insuring themselves against loss with the world's largest insurer; it was AIG which wrote more insurance than it could realistically handle.

And yes, Merrill Lynch lost money on the CDS basis trade. But that trade, again, involves buying credit protection, not selling it. The problem was that not that the CDSs had soured, so much as that the CDSs hadn't soured enough.

Morgenson writes, from atop her high horse:

Obviously, something must be done to eliminate the possibility that taxpayers will wind up paying off entities that essentially bet against the American economy.

She's talking here about people who bought credit protection. And the entities which bought the most credit protection -- on their loan books, on their CDOs, and for their basis trades -- are America's biggest banks. The net sellers of credit protection, by contrast, apart from AIG and the monolines, were generally hedge funds.

So Morgenson is essentially asking the beleaguered banking sector to bail out the hedge funds it bought protection from. Which makes no sense to me.

Morgenson then pushes a proposal from Chris Whalen that the CDS market on certain financial institutions be shut down entirely:

"It is absurd for the government to allow private speculators to profit by trading against public-guaranteed liabilities of banks," Mr. Whalen said.

Again, this doesn't make a lot of sense. If the liabilities are guaranteed by the government, then speculators aren't going to profit by trading against them, since the entities in question won't default. Sure, there might be some short-term mark-to-market profits if the CDS spreads widen out. But over the medium term, if the guarantee is real, then the government knows that all those speculators who are long protection are going to end up losing all their insurance premiums, with nothing to show for them.

Morgenson also seems to support a proposal from Sylvain Raynes which bears more than a family resemblance to the bright idea which Ben Stein came up with in October. Essentially, all CDS contracts would be unwound -- leaving the banks which hedged their loan portfolios in the nasty position of having much more credit risk on their books than they ever counted on. Raynes's proposal is basically a forced transfer of credit risk from the people who did want it to the people who didn't want it: how that makes any sense at all I have no idea.

It may or may not be true that we would have avoided much of this crisis had credit default swaps never been invented. I suspect it's not true, and that the CDS market, in allowing people to short the credit market, actually helped at the margin to stop the credit bubble from expanding. But even if it is true, that doesn't mean that the solution is to ban or unwind the CDS market which now exists. It was foolish to sell protection too cheaply on risky debt; it was sensible to buy that protection when it was cheap. So let's not punish the sensible people and bail out the foolish ones by abrogating those contracts.

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