Wednesday, March 25, 2009

One Way to Stop Bear Raids: Stricter Regulation for CDS

In the Wall Street Journal by George Soros:

In all the uproar over AIG, the most important lesson has been ignored. AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bonds ought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG's outstanding positions without abrogating any contracts.

CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes them toxic is that such speculation can be self-validating.

Up until the crash of 2008, the prevailing view -- called the efficient market hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. the underlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matter of anticipation, not knowledge. Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. (I call this feedback mechanism "reflexivity.")

With the help of this new paradigm, the poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.

The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.

AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk.

The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.

Taking these three considerations together, it's clear that AIG, Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDS mutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of the uptick rule, which would have hindered bear raids by allowing short selling only when prices were rising. The unlimited shorting of bonds was facilitated by the CDS market. The two made a lethal combination. And AIG failed to understand this.

Many argue now that CDS ought to be traded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. Under this rule -- which would require international agreement and federal legislation -- the buying pressure on CDS would greatly diminish, and all outstanding CDS would drop in price. As a collateral benefit, the U.S. Treasury would save a great deal of money on its exposure to AIG.

Commentary by A Credit Trader in italics below:

• AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions. Perhaps I’m reading in too much into this sentence but to expect AIG to somehow have hedged or offset its CDS trades is akin to an insurance company kidnapping sick people who have bought life insurance and sticking them in incubators to prolong their life. AIG sold protection because it viewed selling CDS as an insurance business. The oft-uttered phrase that AIG was a hedge fund are missing the point that these trades were buy-and-hold; AIG was not in the business, unlike a hedge fund, of dynamically trading in the market.
• What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated. I like when the conclusion is stated upfront without any salient points.
• It [heavily regulating CDS] would also save the U.S. Treasury a lot of money by reducing the loss on AIG’s outstanding positions without abrogating any contracts. In fact, the US Treasury had three options in dealing with AIG’s trades: 1) take over AIG and have AIG’s counterparties face the government, 2) post enough cash to cover AIG’s collateral calls, 3) unwind AIG’s trades. It chose 3 which I think is the worst option as a) it locks in massive losses, b) it does so at the absolute wides of the market (spreads naturally blew out as soon as the market realized AIG was in big trouble), c) it commits the most amount of cash upfront.
• Since they [CDS] are tradable instruments, they became bear-market warrants for speculating on deteriorating conditions in a company or country. CDS can be used as easily to go long risk as short risk. In fact, for each nefarious speculator betting on the demise of the poor company by buying protection, there is an avenging angel who is sitting on the other side of the trade and is a seller of protection. While, it is true that there can be heavy one-way flow in CDS on the back of strong protection buying or selling which will drive the market in one direction, the dealers obviously adjust the CDS levels up or down based on this flow at which they are happy to take the other side of the trade.
• Thus, we must understand financial markets through a new paradigm which recognizes that they always provide a biased view of the future, and that the distortion of prices in financial markets may affect the underlying reality that those prices are supposed to reflect. “Reflexivity” strikes again. I don’t think it has ever been news that the prices of assets affect investor psychology which will, in turn, have an effect on the prices of financial assets. This is certainly true of all other assets including CDS.
• Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. If the CDS product payoff profile is so skewed in favor of buyers of protection, why did credit spreads rally for many years until 2008. Also, if the average price of a high yield bond is in the 50s vs. an average historic recovery (yes recoveries in this cycle will be lower) of 40 – that suggests that the payoff profile is in favor of protection sellers, not buyers. Finally, gamma is on the side of protection sellers as well as duration increases as spreads rally – in other words, a protection buyer makes less marginal dollars for each basis point of widening in spreads since risky duration goes down. This can be seen via the Merton debt/equity model as well. Also, for distressed names, protection tends to be priced upfront which means that buying protection in expectation of a quick default is actually quite expensive.
• People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. I don’t understand what is wrong with this. If the risk of default increases, protection should be more expensive. That’s called a fair market.
• AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk. AIG was insuring mark-to-market risk rather than default risk which is where they went wrong.
• A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating. Lehman went bust largely because it could not raise short-term funding, not because of any CDS pressure. A rating downgrade caused the stock price to fall, making it difficult for Lehman to raise enough cash by issuing equity which caused rating agencies to downgrade it further, leading…. Also, Morgan Stanley CDS traded wider than Bear or Lehman and yet it miraculously survived. I guess reflexivity is only invoked when it works, kind of like those technical indicators.
• I believe that they [CDS] are toxic and should only be allowed to be used by those who own the bonds, not by others who want to speculate against countries or companies. What is wrong with speculation as such? Should we ban short-selling in stocks forever and ever? Metalgesellschaft lost a lot of money on commodities and Orange county on moves in interest rates. Let’s ban those as well. Also, reading this sentence suggests that CDS can only be by those who hold bonds. So, will sellers of protection be required to hold bonds as well. I’m sure this is not what Soros meant, just thought I’d be cheeky.

1 comment:

Cormick Grimshaw said...

Mr. Soros misinterprets what happened to AIG, Bear Stearns and Lehman Brothers. AIG's problems stem from a fundamental mismanagement of risk in its CDS business. Bear and Lehman were devastated by their exposure to too many subprime real estate assets (financed by overnight loans) that led to a classic run on the bank once investors lost faith in their creditworthiness. These problems were not caused by CDS market participants.

Mr. Soros is right to point out the need for additional regulation of the CDS market, but his underlying argument relies on a misreading of the facts.

Timothy Ryan
President & CEO
The Securities Industry and Financial Markets Association
Washington