Without going into details (my employer would not be happy), let me say that I work at a firm deeply involved in the CDS wing of the credit crisis. And while I partly agree that CDS are a sign rather than a source of the current market ills, I think you would also agree that that's perhaps downplaying their role. They've had an immense exacerbating effect, by prompting a lot of government action (like the AIG acquisition), and, most importantly, by hypercharging confusion, chiefly because CDS are so poorly understood. As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority, and I've often seen trading by major banks that takes place in ignorance of recent, public and relevant corporate news. Which is precisely what you'd expect from shops that use CDS for speculative and not hedging purposes, but still dismaying.
The big point, though, is that if CDS insiders have occasional gaps in their understanding, then it's frightening to think of bank management and government regulators acting with even less understanding. Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don't understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean. THAT is why Buffett called them "financial weapons of mass destruction" - not because they START a war, but because they have immense capacity to radically ESCALATE it. They didn't start the credit crisis - all of us, collectively and naively overextending ourselves, did - but they have absolutely played a subsequent role in accelerating this from a crisis to a major crisis.
And they did it quickly too: CDS turned this from crisis to major crisis in only 17 hours - from roughly noon on Sep 14 (when it became clear that Lehman would fail and I got a call to report for duty on a Sunday) to Sep 15 when it was widely reported that S&P had downgraded AIG due to its CDS obligations. At that point everyone started worrying about collateral, and then discovered that they were not able to properly worry about collateral, since they did not fully understand derivative collateral requirements. All they knew is that they were facing something big and scary, and so - once again collectively and naively - we all stopped lending just to be safe....which is sort of like movie victims who close their eyes when the monster is right in front of them: it's both the most intuitive and the least productive thing to do.
It's absolutely clear to me that we bailed out AIG because of its counterparty CDS risk, and that they're escalating other problems more generally. But it's less clear to me that they're the main source of contagion in the financial markets. And at this point, many, many, many things are escalating other problems.
I don't mean to downplay the role of CDSs. I'm just not sure how they came to be the main villain of the piece, that's all.
Megan,
"I'm just not sure how they came to be the main villain of the piece, that's all."
That would be NPR and "This American Life", looking for -anything- to blame it on other than the F.M.s and the Community Reinvestment Act.
A pundit correctly predicted that the auto industry would be bailed out because of CDS exposure. As a guess it would be AIG again.
I officially resign from reading this blog (but rarely commenting). Chalk it up to Megan's regular pronouncements about "If you're not a finance genius, then you have no business commenting about this crisis", only to then admit she doesn't fully understand the same problems, or has been proven stunningly incorrect on so many occasions in the past month. I'll also chalk it up to the progressive dumbing down of comments here. That's what Townhall.com is for people.
I still don't understand why we can't void all CDS contracts by regulation or law, and be done with that aspect of the crisis. What bad thing would happen, at least compared to the bad things we're experiencing already?
"And at this point, many, many, many things are escalating other problems."
I've read this sentence over and over, and it has made me so much dumber that, at this point, I'm not sure I can even read anymore.
So when the morons on Wall Street said they had gotten better at pricing risk, they really had just found some fun new instruments to play with, and to the extent that they might have ameliorated risk, they just took that as an opportunity to take on more.
I don't understand why they don't read their contracts and figure out what they mean. Hire extra lawyers and accountants if necessary.
Why are CDSs the villans of the piece? Because the other villans (potential and real) are things that we all like to think we understand -- which means that if there was a problem, it was us screwing up.
With CDSs, nobody seems to understand them -- so if they are the problem, then WE are not. And everybody prefers not to be at fault, especially due to their own stupidity in not understanding the contract that they were signing.
What I want to know is when this fricking market is going to start climbing the wall of worry?
Thanks for posting this Megan. It's very useful. 2-cents below.
do not understand crucial details of contract terms and bond seniority
====
It may depend on the specifics, here. Do you mean to imply that traders need to know every aspect of the ISDA master agreement? Probably not, right.
On the other hand, if you are talking about details that are obviously germane to the pricing of risk, then this is just a terrible, terrible indictment. For comparison, corporate bond traders can get walked off the floor the same day, if it is ever shown that they made a bid on something they didn't know fully what it was.
they did not fully understand derivative collateral requirements. All they knew is that they were facing something big and scary, and so - once again collectively and naively - we all stopped lending just to be safe
=========
This is a kind of contagion, right?
It suggests one of the worst kind of risk management worries was realized: the front-office got ahead of the back-office, where "back" is broadly interpreted to be the "collateral monitoring" schema.
Why are they the main source of contagion?Or at least a major source?See Michael Lewis's article "The End" at Conde Nast Portfolio.com.It is long,so if you can't read it all,go to page 7 and read paragraph starting"That's when Eisman finally got it."
As I've commented on this blog many many times, CDSes may not be the root source of the crisis, but they most definitely have a multiplier effect. Add to the fact that they were completely unregulated, and that leads to a conclusion that is unfortunately not very "centrist": that we need to regulate CDSes.
"because CDS are so poorly understood. As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority, and I've often seen trading by major banks that takes place in ignorance of recent, public and relevant corporate news. "Which is precisely what you'd expect from shops that use CDS for speculative and not hedging purposes, but still dismaying.
The big point, though, is that if CDS insiders have occasional gaps in their understanding, then it's frightening to think of bank management and government regulators acting with even less understanding. Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don't understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean."
I'm having a hard time understanding how selling and trading investments that you don't understand isn't either fraud, negligence, or fiduciary mismanagement.
Personally, I find CDS's very clear,and CDO's as well. What's a little strange is how they were used in various hedging strategies, which a careful investor never would have been talked into.
Also, AIG and CDS's, Lehman, etc., all have slightly different problems, so you have to look at each case individually.
To the extent that CDS's are a problem for AIG, you'd have to figure that the main problem is the defaults. Otherwise, AIG would be collecting the premiums and rolling merrily along. Surely the default has to precede the claim. The downgrade which led to the increase in capital requirements must have been based on something.Namely, actual defaults, or fear that AIG wouldn't be able to cover forthcoming defaults.
CDOs, CDSs, GSEs, Greenspan, Bernanke, Paulson, Bush, Democrats, Republicans - Who's next?
When the Santa Ana winds blow in and tragically ignite hundreds or more homes, it's counter-productive to fret over exactly how the fire managed to ignite each house. Did some stray cinders ignite the roof? Did the flames lap against the wooden deck? How exactly did the fire start?
Like most financial crisis, the firewood for this panic was excessive leverage. The ignition source is mostly irrelevant. Efforts to narrow the cause are likely miss the mark, especially in the short term. The last thing we need are attempts to diagnose and repair the gaps in the regulatory system before the fire is out.
The flames of this crisis are burning at their peak now and the winds are as strong as ever as the painful but required deleveraging progresses. It's not fun to watch, but it will run out of fuel eventually.
Amicus, let me give a vague but potent example. I obviously can't offer any concrete examples. One problem that I've seen with some frequency is a corporate event - a spinoff or merger - that changes debt...these can of course get messy, with some bonds passed on to a surviving entity, some repurchased and exchanged, etc. there's often a window of time when CDS are traded on, say, called or converted bonds, simply because people are in the habit of quoting familiar debt. Likewise, when the surviving entity is unclear, there is often confusion on which subsidiary or parent, issuer or guarantor should be referenced. Resources are certainly directed towards sorting out corporate events, but not quickly, with some questionable trades filling the void in the interim.
Hey Megan, I just saw that Citigroup is below the $5/share threshold and that this could mean a massive sell off by institutional investors and pension plans. I also recall you were thoroughly disgusted at the initial failure of the bailout. But no I have to ask, WTF? I thought the bailout, which you supported, was supposed to prevent this kind of thing. Several other fincancial institutions seem to be right behind Citigroup--i.e. Bank of America and Morgan Stanley.
One way in which CDS are villains is that they permitted people to move balances off the books, and thus increase their leverage. Just for that they deserve their current infamy and more. But in a broader sense, they are the financial zeppelins of our time - dangerous, poorly engineered products which should never have been allowed to go into regular use.
Imagine if someone took a nuclear power unit from a sub and figured out how to fit it into a car, and then regulators sat on their thumbs while automakers built them into all manner of vehicles (perhaps with warnings everyone ignored). After a number of explosion, contamination and irradiation events, nuclear power units would end up being the villains of that story, even though much stupid-feasance led up to their widespread use. From the engineering perspective, CDS look a lot like other badly designed products which have never faced a serious risk evaluation. If a few accidents earned infamy for the Pinto, CDS more than deserve what they're getting.
"we all stopped lending just to be safe"
This is how the falling housing prices and many bad subprime loans turned into a crisis - it has been like a classic bank run. Everyone wanted to be the first one out, so they stopped lending, started redeeming their mutual fund/hedge fund holdings and just generally panicked and ran for the door.
CDS complicated things because they're complicated, confusing and non-transparent, but they didn't start the run.
Jay nailed it in the very first comment. The reason that CDS have drawn so much attention is:
"NPR and "This American Life", looking for -anything- to blame it on other than the F.M.s and the Community Reinvestment Act."
Under Clinton, the government began forcing banks to make riskier loans. Fannie and Freddie encouraged lower lending standards to please Barney Frank and Chris Dodd, especially after 2003, and everyone got carried away with making high-risk loans to fuel the housing bubble. Then when the problems began, they all panicked.
Given that such radical leftist figures as the Ben Bernanke actually called for expansion of CRA loans via securitization, we must surely be on our guard for more plots from the known communists at the Federal Reserve.
First of all, the Community Reinvestment Act was passed in 1974, and Clinton's changes to it were incremental at best. It was intended to, and largely succeeded at eliminating redlining.
Second, most of the banks that are failing aren't obliged to make any CRA loans at all. Do some basic reading on, say Wikipedia, and you'll find:
By most measures, thrifts, which issue the most loans regulated by the CRA are presently showing some of the best performance in the banking sector, so perhaps they've figured out some secret to making some money from the ACORN-addled hordes.You true believers sure don't like to read much, do you? I know whatever Rush carps on about is doubtless the truth itself, but please try to read a little bit before reciting it verbatim.
I am not an expert on CDS's, but I think they helped produce the present in crises in part because they produce moral hazzard. The risk of a bond is supposed to be accounted for as part of the interest it pays. With a CDS you as a bond purchaser believe you have an insurance policy against a bond defaulting, and so you get sloppy in assessing if the risk is actually as low as the bond issuer (or bond rating agency) says it is. Beyond that, you take on higher risks to achieve higher returns than you would if you lose you whole investment if the defaulting of the bond would mean a total loss.
In other words, you are trying to achieve both high investment return rates and no risk, which of course is not possible, and so you are deluding yourself. And so of course at some point it catches up to you when the whole market collapses.
"First of all, the Community Reinvestment Act was passed in 1974, and Clinton's changes to it were incremental at best."
Clinton substantially changed the CRA, from a process based (consistent lending standards) to a performance based (quota) system. Beginning in 1993, the Clinton administration used the CRA (and ECOA, HMDA and FHA) to force low-income-lending quotas. Basically, every institution in what was considered a relevant market had to lend roughly the same portion to lower-income borrowers as all other institutions in that relevant market. If they didn’t hit their quota, they were refused permission to merge or open new branches.
Clinton was in part responding to pressure that began before he took office, with community groups such as ACORN using the CRA to extort changes by delaying mergers. ACORN knew that delay was very costly in mergers, and thus most banks couldn’t afford to focus on the merits of their cases but would simply be forced to give in to demands, however unreasonable. And ACORN or other community groups usually negotiated fees for themselves, to ‘organize’ the loan efforts, so they profited directly from the extortion.
Around 1998, Fannie and Freddie aggressively moved into the subprime market. Here’s a very interesting NYT article from Sept., 1999:
http://query.nytimes.com/gst/fullpage.html?res=9c0de7db153ef933a0575ac0a96f958260&sec=&spon=&pagewanted=1
A few select quotes from the NYT article:
“Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people.”
“''Fannie Mae has expanded home ownership for millions of families in the 1990's by reducing down payment requirements,'' said Franklin D. Raines, Fannie Mae's chairman and chief executive officer. ”
“By expanding the type of loans that it will buy, Fannie Mae is hoping to spur banks to make more loans to people with less-than-stellar credit ratings. Fannie Mae officials stress that the new mortgages will be extended to all potential borrowers who can qualify for a mortgage. But they add that the move is intended in part to increase the number of minority and low income home owners who tend to have worse credit ratings than non-Hispanic whites.”
The source of the lower lending standards wasn’t the CRA – that was simply one of the main tools used to force lower standards. The government, along with community groups, enticed (through Fannie and Freddie) and often forced (through the CRA and other tools) banks to lower their lending standards.
Yes, once the new, lower standards were established, banks got carried away and became used to those lower standards. If banks had been careful to apply the lower standards only to minorities, and only when forced, the number of bad loans wouldn’t have been nearly as large. But I’m not sure how long such a double standard would have been sustainable (either legally or practically), particularly with Fannie and Freddie using their automated underwriting systems to encourage lower standards for all.
There's always a balance between greed and fear. The government taught financial institutions to stop fearing low-quality loans, and the greed took over. I'm not excusing the lenders (or borrowers, or rating agencies), but it's still important to be clear about how it all began.
I suggest that CDS's are the problem only because nobody knows for certain what they are and how they are supported.
Business loves the Holiday Inn. Pig-in-a-poke is not "business."
Ann, your nonsense, in general, has been quite thoroughly refuted on Paul Krugman's blog, even this week. Your idea that Fannie "moved aggressively" is trash [they "moved" exceptionally deliberately and with care].
Seth, thanks for the background. I never really thought about the corporate actions aspect of single name CDS. What a nightmare. On the other hand, I would say, if anyone knows CA, then you have job security on Wall Street!
Amicus -
If it's such nonsense, then you should easily be able to be more specific about my errors. If you don't like the one word "aggressively", then fine, ignore it. Fannie and Freddie clearly moved into the subprime market during the Clinton administration (and I agree that they did it deliberately).
So, what else did I get 'wrong'? Are you saying that Clinton didn't move the CRA to more of a quota system? That the NYT article is wrong in saying that Fannie and Freddie were under pressure from the Clinton administration to expand loans to low-income people? That the NYT's quote of Franklin Raines crediting Fannie with lowering down payment requirements is wrong?
Seth's comment brings up an issue that bears some exploration:
How exactly are CDS dealers modeling and pricing/trading recovery rates?
My hunch is that they may not be, that this aspect is being left to people with egg-heads who want to study Basel-II and the like.
Ann, you bring the charges, you bring the proof.
What evidence do you have that
(a) there was a boom in sub-prime lending during the Clinton years, whether it was related to policy or not?
(b) that loans to low-income people represent uncompensated risks that are somehow unacceptable or that Fannie/Freddie did not systematically study?
(c) that the CRA or any Fannie/Freddie platform is materially related (as in a dollar figure) to the current financial panic (which is related to hundreds, if not thousands, of billions).
Color me confused about Fannie and Freddie being the root cause of this.
If Fannie and Freddie aggressively moved in and bought the sub-prime mortgages from Citi and all the other lenders, shouldn't this have stopped when we rescued Fannie and Freddie. Aren't they the ones left holding the bag?
Sam Jackson -
There's no question that, once lenders got used to the lower standards, they fully embraced them and made far, far too many high risk loans. They're to blame, and the borrowers and rating agencies are to blame. Many people are to blame, since everyone got carried away, not just Fannie and Freddie.
But for policy purposes, it's important to understand how it started and what went wrong initially. Some liberals are arguing that the problem was 'deregulation', and that the solution is to have politicians like Bill Clinton and Barney Frank doing even more meddling/micro-managing of financial markets.
But it was actually meddling by Clinton and Frank that forced banks to lower their standards initially for certain loans, encouraging them to get used to the lower standards.
The debate isn't between regulation and non-regulation. The people that try to equate free markets with anarchy are disingenuous.
The debate is over regulation that sets standards (say, the traditional downpayment and loan-to-value ratios) and encourages competition, vs. regulation that allows politicians like Clinton and Frank to choose winners and losers - setting quotas to demand that some borrowers should get loans regardless of whether they qualify for them, shielding semi-monopolies like Fannie and Freddie that get special government privileges, etc.
Liberals don't want that debate, so they pretend that the crisis was caused by 'complicated, unregulated' financial contracts such as CDS.
That would be [insert diehard freemarket defender here], looking for anything to blame it on other than the delusional recklessness of Wall Street and its cluelessness about the risks of complexity in an environment that is always potentially subject to the irrational trend-following of millions of market participants.
The apologists for derivatives and heavy reliance on securitized leverage should be forced to read Frederick Brooks' "No Silver Bullet" one hundred times.
A psychological diagnosis of the disease, from someone who evidently has it [The Poker Face of Wall Street, by Aaron C. Brown]:
So, modern finance has been (until recently) the perfect playground for malignant narcissists...