One of the smarter ideas I've heard for trying to prevent this sort of thing net time around is putting derivatives on exchanges. Most derivatives are traded over the counter, in part because US bankruptcy law encourages it: as I understand it, derivative counterparties don't have to get in line with the others, but can seize any collateral they can get their hands on.
Exchange trading enhances transparency, by making it clear what's out there and roughly who owns it. It also moves the clearing risk to the exchange; while exchanges do fail, they do so much less often than financial firms, and if intervention is needed, they provide a centralized locus for any private or public action.
Apparently the Chicago Mercantile Exchange is looking at setting up a major derivatives exchange. For those who are convinced that "more regulation", rather than "different regulation" is the answer, strongly encouraging trading on these exchanges would be a good place for the government to start.
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I understand it, derivative counterparties don't have to get in line with the others, but can seize any collateral they can get their hands on.
It would surprise me a great deal if this were true. OTC derivatives are just contracts; they should be scheduled as assets and liabilities like anything else. Their value is harder to asses than exchange-traded securites, and for something like a CDS where the default event has not occurred, they may not show up as liabilities at all (and thus escape discharge). But there's nothing magical about derivatives that makes them exempt from the usual rules.
On the other hand, I'm certainly no expert.
And once there is an exchange, there will be a lot of spontaneous use (even absent government encouragement) simply to minimize counter-party risk. Especially after the current spate fo problems with counter-parties.
Megan--from a layman's perspective, there's no question that trading on an exchange would be preferable to the current environment, i.e., the Over-The-Counter market. But I suspect that instead of moving onto an exchange, many of these exotic derivatives will just disappear. Remember--who was buying them? Hedge funds, investment banks, sovereign wealth funds, and a host of shadier types with lots of cash from dubious sources. These participants wanted to use CDS and other vehicles precisely because they were in the OTC market. They could make up their own rules, and not have to tell anyone anything.
I agree wholeheartedly. One of the main issues here is the lack of transparency in the huge OTC derivatives market. No one knows ahead of time where the real net risk lies - all we have is an unfathomably large notional value of contracts outstanding.
Placing a central counterparty in between trades would dramatically improve risk netting and transparency. Clearing houses could then set appropriate margin requirements (something that the they are already very good at), reducing the systemic risk of a single counterparty failing a la Bear and Lehman.
OTC derivatives dealers have fought the movement of contracts (particularly credit default swaps) to exchanges tooth and nail for years because their margins on customer trades would inevitably be reduced. Unfortunately, they will need to get on board before any exchange effort can succeed as no derivatives exchage will work without dealer liquidity. Fortunately, dealers' bargaining power is greatly reduced these days. Moreover, exchange listed contracts by definition have to be standardized, so there will still be money to be made on more bespoke contracts.
Megan, I think the bankruptcy law aspect you mentioned is just the "netting" provision, so that if you committed something *as part of* a deal, that something stays in the deal, rather than being retroactively removed for someone else. For example, if write a covered call and put up X shares of stock, then go bankrupt, the stock stays there rather than being used to pay general creditors. Why should it be any other way, unless you believe that bankruptcy law entitles you to renege on *any* agreement you've ever made in your life, regardless of how long ago it was settled? ("Hey, remember those apples I bought from you ten years ago? Yeah, well, my financial situation isn't so good now, and I need that money back. Could you adjust for inflation too?")
If you want to keep crises from happening again in the future some better ideas are:
1) No inflation. It's not that hard: just make sure the Fed's assets go up right in line with the new dollars it prints. That means that people aren't forced to lend out their money just to keep inflation from eating it. That drastically decouples the financial system.
2) Replace opaque intermediaries with public disclosure and muliple, freely competing ratings agencies. Right now the purpose of intermediaries is to ascertain risk of borrowers. If the competition over the quality of that information is public, it can be higher quality. It would also allow better ability to map out how reslient the system would be against various scenarios.
As someone else mentioned above, making a market for these instruments is challenging. I did some consulting for a company called Creditex a while back, and they were trying to setup such an exchange. Having looked at the technical and legal issues, I can say first hand that it will be very challenging to have these trade on a market. To begin with, there isn't a default CDS instrument as there is with a stock or option, and in order to approve a CDS, it must go through legal review (as it is a contract) - this can take a long time. I remember Creditex talking about how there may be trillions of dollars in CDS sitting in legal, and that many of them may have already be traded out of while it sat on the floor an in-house lawyer.
So, it is possible, but not without significant challenges. That said, I agree that having the transparency that an open market can provide would help - if nothing else than to have information about the size of the market and relative position sizes. My guess is that they may be able to put together a market for very generic CDS instruments, but many of them are custom, so I'm not sure it can work there. So maybe there will be new reporting requirements around those instruments. And I expect we will see some form of capital requirements to issue a CDS and that may make them less attractive.
if write a covered call and put up X shares of stock, then go bankrupt, the stock stays there rather than being used to pay general creditors
That sounds analogous to a standard security agreement. Given that I'm not up on "covered calls," does that sound right?
Senior secured creditors always get their collateral regardless of what happens to the junior and unsecured creditors.
For those who are convinced that "more regulation", rather than "different regulation" is the answer, strongly encouraging trading on these exchanges would be a good place for the government to start.
Well, wouldn't that count as "different" just as easily as "more"?
Megan--from a layman's perspective, there's no question that trading on an exchange would be preferable to the current environment, i.e., the Over-The-Counter market. But I suspect that instead of moving onto an exchange, many of these exotic derivatives will just disappear.
That sounds like a useful feature to me.
Well, if we didn't have central banks running short rates up and down like a friggin yoyo, the market for credit insurance wouldn't be so damned large or necessary.
I agree with Sigivald. What's the difference between "different" and "more" regulation? I'd like more *effective* (i.e., different, and if necessary additional) regulation, but I don't think anyone's demanding an increase in the total regulatory word count for its own sake.
humm...
I wish them well, but I doubt it will take off.
For the derivatives contracts that have "worked" on an exchange, they also trade the underlying, correct?
As a goal, we need a way to make sure that CDS contracts can be settled, in the event of a default, in order to protect the system.
As for bankruptcy:
"Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contracts with each other through a credit support annex (CSA), which is effectively a margining arrangement. As a protection buyer’s credit exposure to its counterparty increases beyond a certain threshold, the counterparty has to post collateral to offset the protection buyer’s counterparty credit risk."
At a minimum, the (a) the price of credit risk may go up, based on our recent experience with, er... what appears to have been greatly under-priced credit risk(s) and (b) the amount of capital required to run a derivatives operation ... probably should and will go up.
I understand it, derivative counterparties don't have to get in line with the others, but can seize any collateral they can get their hands on.
Well, you go to settlement with the collateral you have. As noted above, they are standard contracts which include some features of secured lending. If, for example, Lehman had posted collateral to cover net mark-to-market exposure to a specific counterparty, that party (like all other secured lenders) would have the benefit of that collateral in a bankruptcy.
Counterparties who did swaps with Lehman on an unsecured basis (rare, for Lehman; common for the big, highly-rated banks) stand in line with everyone else if the net value of all their swaps would call for Lehman to pay them.
Related point - when AIG was threatened with a downgrade to BBB, their swap contracts required them to commence posting collateral to cover mark-to-maket exposures. That triggered the $13 billion crunch that busted them.
Finally - exchanges are great for standardized contracts (The CFTC and the banks scuffled over the regulation of interest rate swaps, which are customized versions of the CME Eurodollar contract, for years).
Whether credit default swaps are sufficiently standardized that they could make sense for an exchange I don't know. I'd be surprised - my understanding is that CDS are pegged to specific outstanding bond issues, but I don't suppose that is a necessity (given, e.g., the prevalence of cross defaults on indebtedness). I suppose a contract could say that a default by Company Z obliges A to pay B some set amount, such as $1,000,000. Then B could figure out how many contracts he need to hedge a specific bond exposure, or simply buy or sell the contract as a speculation. Ought to work (and may be what is being done right now, although the CDS also include deliverable debt in the settlement auctions.)
This may be a stupid question, but why not just outlaw derivatives after doing whatever to unwind the ones that already exist?
Not being in the business I can't pretend to understand all the derivative variations.
But I think this disaster was caused as much by negligence as by any inherent flaw in finance.
The way I see it the good times were rolling. People well under 30 were making millions and tens of millions. There were parties every night, and your modest apartment in NY might well be making you $10,000/week in appreciation alone.
Much of your work was choosing among recommendations offered by the computers. They supposedly devised by Nobel winners and so hedged as to make any serious loss impossible.
In the R.E. market, all the way from the local house broker and lender up through Fannie and Freddie, no one was rewarded for saying "no" or check forms or appraisals.
"Make the deal, it doesn't have to make sense, and take home your money. We will sell the mortgage within a week anyway."
And similar happy faces prevailed at all the regulators. Why worry? Anyone who expressed caution was working too hard.
To K:
bingo. yes, there are a thousand other contributing factors, but your sentiment, in my view, hits the nail directly on the head.
I wish there was another term besides "regulation" to describe Megan's proposals. When libertarians (or libertarian-ettes) deplore "increased regulation" we're usually referring to policies that relate to social engineering or wealth redistribution, and not to those allowing more transparency. Anything that gives investors/the market more accurate information is fine by me.
We already have an exchange mechanism that documented in real time the valuation declines of Bear Stearns, Washington Mutual, AIG and the rest.
Having a pricing mechanism did nothing whatsoever to spare the financial system or those who depend upon it from the carnage that we have experienced as of late. If anything, we have during this critical moment surrendered the valuation process to frightened laymen, who are inclined to panic and deflate values irrationally to the same baseless extremes that they used previously to overinflate them.
Pricing the counterparty risk only creates another conspicuous forum in which they may implode. The solution to this is much simpler -- place limits on consumer financing so that the loan products are so staid and unexotic that these bogus doomed-to-fail hedges are not required in the first place.
The marketplace functioned quite nicely without derivatives when mortgages were long term, fixed rate products with high down payment requirements and mandatory amortization, and it can do so again. We should not continue to provide buck passing opportunities to lenders and their investors, who will undoubtedly abuse them. If the lenders are forced to directly bear the cost of bad underwriting, the underwriting will necessarily improve. No consumer should have the opportunity to use his house as an ATM machine.
Another, perhaps more important, reason that exchanges work for derivatives is the associated clearing house which guarantees the contracts and has deep pockets and cash to back up the guarantee. To make the clearinghouse work, the exchange uses cash mark-to-market which keeps the cost of failure down to one day's price move.
Some OTC derivatives are already marked to market and there is a further move afoot to create a clearinghouse (called The Clearing House) here in Chicago.
On a related but slightly different topic -
Wouldn't it be nice if the options that are granted to corporate executives were also traded on an open exchange? Doesn't it ever bother you that the options that executives get may have an expiry date that is seven or ten years out (or something like that), while the best that an ordinary investor / speculator can get are LEAP options going out approx. 2-1/2 years?
If corporations had to purchase their executive incentive options on an open exchange, then there would be no question as to their value (for accounting and income tax purposes), no Black-Scholes approximations, no backdating scandals, etc, as well as making them available to ordinary investors.
Just something to consider...
This may be a stupid question, but why not just outlaw derivatives after doing whatever to unwind the ones that already exist?
Because throwing out the baby with the bathwater makes no sense. The insurance policy you take out on your house is a kind of derivative, too. Should that be outlawed?
Outlawing risk management is impossible, and efforts to do so will backfire disastrously in the form of less prosperity. In future we just need better disclosure and one or two reforms (leverage limits, reserve requirements, etc.) to avoid a repeat of the Panic of '08.
Hell, given enough time, we almost certainly will have another one (though most of us may not live to see it). All in all I'd say it's a fair bargain: six or seven decades of smoothly functioning capitalism and the accompanying rise in living standards punctuated by the odd financial panic.
The insurance policy you take out on your house is a kind of derivative, too. Should that be outlawed?
Sorry, but this is an apples and oranges comparison.
Using CDS's to do stupid deals makes as much sense as trying to fix the drunk driving problem by requiring drunks to carry insurance policies.
The proposal to put such ridiculous coverages on an exchange creates no value, but only fixes a price tag on their failure when they fail. When banks act recklessly, they create systemic risk that cannot be mitigated through insurance of any type.
Some behaviors are so inherently dangerous that the best way to prevent the social catastrophe associated with them is to avoid the behaviors in the first place. We have created a situation in which average people with average incomes and average financial knowledge (read: none) have been converted into low-equity, high-leverage speculators who are betting on their ability to forecast interest rates. This was foolish on its face and should have never been allowed in the first place, and the dangers this poses cannot be fixed with insurance.
Banks sell money. Banks have used the securities and derivatives markets to effectively pass on their warranty obligations to other parties, who will not be able to honor during inevitable periods of cyclical economic decline. It's no surprise that the quality control declined, given those circumstances
Using CDS's to do stupid deals makes as much sense as trying to fix the drunk driving problem by requiring drunks to carry insurance policies.
RW: Once you use the modifier "stupid" I agree with you. Nothing makes a stupid deal make sense. But insurance in general is a sensible idea. Surely if you were the CEO of a financial institution who just learned you had loaned $50 million to a now insolvent borrower, you'd rather have purchased protection than not, no? Now, obviously, that protection you paid for is pretty worthless unless the issuer can back up his promise. But all this argues for is disclosure and reserve requirements, not doing away with such products altogether (although I am persuaded that naked CDSs should probably be abolished).
Surely if you were the CEO of a financial institution who just learned you had loaned $50 million to a now insolvent borrower, you'd rather have purchased protection than not, no?
Sure, the theory behind insurance is wonderful. I would love to be able to insure against anything and everything and construct perfect hedges if I possibly could.
But vis-a-vis mortgage markets, we can see from our daily headlines that the actual practice is quite different from the theory. It is not possible to insure against systemic risk, but the CDS market has encouraged the sort of recklessness that raised that systemic risk level several fold.
It becomes much easier to be aggressively stupid if one is promised that someone will pay for the mistakes. By allowing lenders and investors to avoid the full cost of their mistakes, the CDS market has necessarily encouraged bad deal structures, making them normal and typical. They have taken what could have been a mild recession and distorted into a near depression.
If you don't want to see the widespread implosion of faulty loan products that we have seen lately, then don't permit the origination of such loans in the first place. The average person has no business getting a low equity, variable rate mortgage or in using his home as an ATM machine, and no bank should be trying to indulge him, CDS or not.
Sure, the theory behind insurance is wonderful. I would love to be able to insure against anything and everything and construct perfect hedges if I possibly could.
So the fact that hedges aren't perfect means we should disallow them? Again, the key from what I've read is requiring disclosure of the derivatives, and requiring issuing firms to put aside reserves. This will make such products much more expensive, of course, and less widely used. That's all for the good -- and should substantially reduce abuses -- but it's a far cry from abolishing them.
The average person has no business getting a low equity, variable rate mortgage...
I guess it depends on how you define "low" but variable rate mortgages are what all average people use outside the US.
So the fact that hedges aren't perfect means we should disallow them?
We should disallow the low equity, variable rate loan products that necessarily raise default rates. The loose consumer credit that has been promoted by the banking industry should be sharply curtailed so that the degree of leverage that we have used routinely is no longer possible.
I can assure you that if we were to pursue a more rational, lower risk credit policy such as this that the lending and associated CDS markets would be very dull places to inhabit and we wouldn't even be having this discussion. These would be much smaller and more tepid markets, too small or dull to require anything resembling an exchange.
I familiar with the common clearing of derivatives contracts and the industry, and the CME is not going to win the battle to be the clearinghouse for CDS. The winner will be The Clearing Corporation.
They were purchased by the Markit member banks last December and have been working round the clock to implement a solution for CDS over the last 6 months.
What is this insurance protecting against? It isn't protecting just against default, but also interest rate changes (which are also the reason for a majority of the insolvencies and defaults), which have been magnified greatly over the last 40 years by our attempts to manage the economy through monetary policy.
The question is this- can you insure against the fact that I am going to burn your house down sometime during the next 3 years.
I guess it depends on how you define "low" but variable rate mortgages are what all average people use outside the US.
I didn't make the comment, but 100+% LTV mortgages in general shouldn't be allowed with a fixed rate or no. Saving for a down payment is likely one of the best indicators of a borrowers credit worthiness. By saving, I don't mean getting a20% down payment via a second mortgage, a seller "gifting" you the down payment or family members as well. It means living below your means for a long period of time and saving the difference.
I don't think the suggestion of banning CDSes is stupid at all. And the comparison between buying insurance from a specific insurance company - that itself has reason to examine the risks it may be insuring, and that is capable of paying off when it needs to - and the "selling risk downstream" situation that developed in regard to mortgages is mistaken.
Look, exchanges may be more stable, but what we need to worry about is whether the situation would be changed from the unsound configuration we see here. We can say that "the actors acted wrongly", but the incentive problem is the issue: Lenders arranged more and more bad debt, and passed it down the line, because the risk was no longer a threat to them; it was simply in their interest to take the profit and repeat as widely as possible.
Under those circumstances, a number of resolutions are possible. For any situation where this sort of dynamic is active, in any area where risk can be traded away in this way, it seems to me that we can either have a lot of regulation needed, the government standing over things with a stick and using the most interfering kind of specifying regulation for the area, because self-interest does not guide the actors to weigh and worry about risk responsibly, indeed it guides them only to seek any available profit unburdened by the risk aspects ... or we can have a relatively open system where people mind risk levels because the risks are their own, and where creativity will then be safely pursued and allowable.
The CDS was developed because banks didn't want to continue to have to keep big reserves of capital to cover their risks, that couldn't be used for other purposes. Well, if they did have to do that again, the sky wouldn't fall - as opposed to what has happened here. And the negatives in that restriction would only be decisive if stability, and good risk-handling, are given no value.
This thread is talking about what could be a sound arrangement for these instruments. If the discussion implicitly assumes, "we will keep using these instruments," that bounds how far soundness is being investigated, whatever the conclusions - there is danger that "safer" is being treated notionally or relatively rather than definitely. Is there a sound regime of usage here at all?
I'd like to provide a dissenting voice to this whole thread. Everyone is operating under the assumption that the CDS market poses huge systemic risk, etc etc. because it's OTC. Is there any evidence for this?
For example, Lehman was the largest bankruptcy in history with huge amount of CDS written on their debt, but the settlement occurred last week in a fairly orderly manner. No firms failed because everyone had posted collateral. Look, it's not like there is no regulation of the OTC market. The banks had all agreed to use ISDA guidelines when trading OTC swap instruments. Sure, it's voluntary, but all of these contracts are ISDA-formatted because the banks didn't want these headaches either.
I agree that putting some of this stuff on the exchanges would be a lot easier. Price discovery would be easier, etc.
But blanket condemnations of the CDS market, especially by people who know nothing about it, much less how to compute even something as simple as par swap spread, aren't really that helpful.
Just because you don't know how a CDS works doesn't make it scary.
Everyone is operating under the assumption that the CDS market poses huge systemic risk, etc etc. because it's OTC.
I won't speak for everyone else, but that wasn't my point at all. OTC or not, the problem is the same -- CDS's are used to prop up deals that should not be getting done in the first place.
There seems to be a general denial among supporters about the downsides of leverage. When things are going well, leverage is wonderful and profitable. When things go badly, leverage becomes a whipsaw that inflates losses. It cuts both ways, and you can't have one without the other.
The CDS market supports the conditions that result in excessive leverage. The market was created in order to facilitate excessive leverage by creating an alleged hedge for it. Banks should be conservative institutions, but with tools such as this, they behave too aggressively to properly serve their mission, which is to provide stable, steady capital to a broad market.
The only problem is that during times like this, the hedge becomes next to worthless. This forces the socialization of losses upon an unhappy public that didn't get most of the benefit, but the public does get stuck with the bill.
After what we have just been through, the problem should be obvious to anyone who didn't directly profit from it. An exchange solves none of the problems, no more than having Washington Mutual listed on an exchange prevented that company from becoming insolvent with government intervention required.
The buck needs to stop somewhere, and that should stop with the lenders and their investors. Venture capitalists understand the importance of putting principals on the hook -- exposure creates motivation. Using CDS to create a faux shelter from exposure is exactly the opposite of what public policy should be encouraging.
Too much leverage + Insufficient accountability = 2008. As usual, the new math doesn't work as well as the old math.
RW October 14 9pm comment sounds pretty accurate. It's the leverage that in effect causes debt to come into existence as money that is the problem.
Of course, the Fed loans debt into existence as money so what could be wrong with that?(sarcasm off)