Tuesday, April 28, 2009

Musings on Credit Default Swaps

Posted on Naked Capitalism:

As readers may know, I view the credit default swaps market with more than a bit of skepticism. I can point to cases where it has caused harm:

1. Bagholders. Dealers claim that CDS are really not bad at all because they haven't been taking risk, oh no, they hedge their position with offsetting swaps.

So let's assume they are right. The dealer community is a closed system with no net exposure. But you have the buyers of contracts (hedgers and punters). Someone somewhere has to be assuming the risk.

We used to know who that someone was: AIG, and on CDOs, Ambac and MBIA (their policies were structured more like traditional insurance but was also sometimes called credit default swaps). But other bagholders have included public investors who bought products with enhanced yields (typically synthetic CDOs) but where they'd actually lose money if defaults on the referenced bonds went above a trigger level. And guess what? Those products typically contained names of real turkeys like AIG, the auto companies, Lehman. They were also peddled heavily overseas to chumps that would only know these were famous American companies.

2. Distortions in cash bond pricing. The theory is that CDS make markets more efficient, but in reality, they can distort the price of new issues. That means they are damaging the real economy by making costs higher than they "ought" to be. From March 2008:
The problem started in the second half of last year when subprime mortgage delinquencies started to rise, causing investors to retreat from complex instruments such as synthetic collateralized debt obligations, or packages of credit-default swaps that became hard to value. The swaps are contracts based on bonds and used to speculate on a company's ability to repay debt.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.

The Financial Times reported that this was continuing in May.

3. Incentives to push companies into bankruptcy. One worry, that seems to be coming to pass, is that CDS are leading investors to be indifferent to a bankruptcy, and in cases to push for it. Since they own a CDS, they'll get their payoff, while negotiating a restructuring takes time and money. Why bother? But negotiations can keep companies out of BK, and are also necessary for Chapter 11 to succeed. And if a restructurings fail, more job losses result. This too is a toll on the real economy.

I have a fourth concern, which is harder to prove, and I'd welcome reader feedback. CDS also create an incentive for lenders and investors to skip or do a cursory job on credit research. Why bother if the market give you a price? The reason that this is particularly bad is that it is the lender that can do the best examination, by virtue of direct interaction with the borrower and being able to obtain non-public information. Having the original lender be able to lay off risk presumably had lead them to cut back on their credit function. Is this correct? If so, what evidence can you point to? When did this start and how pronounced has it become?

Yet another argument when the bank stocks were taking a beating was that speculators pushing up CDS spreads were much bigger culprits than short sellers, but I am not clear as to the mechanism.

I am also wondering if the same thing has happened on the investor side, that credit research isn't what it used to be.

I am similarly skeptical of the purported benefits. More liquidity does not appear to have produced less volatility, which is the theoretical reason why liquidity is a boon. I also don't buy the price discovery argument. In the Volcker era, when bond trading was under stress, I cannot once recall anyone complaining about price "discovery" being a problem in corporate bonds. Please. Even then, there were enough liquid issues to easily grid prices for those that didn't trade much (bonds trade by attribute, duration, rating/credit quality, presence or absence of call features, etc,).

Another bone of contention (although this is a more specific complaint) is that when the industry argues against moving to exchanges, they argue that they need to do OTC trades so they can "customize". Yet I have never read a single example of why they need customization (as in when and how it serves investor needs, with specific examples) and how much the investor would lose by buying off the rack products. The lack of specificity in any of these claims makes me believe the main reason is to create complex products to hive risk off onto bagholders, or to charge extra for an added feature that really does not do the investor a meaningful amount of extra good.

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