Monday, September 15, 2008

Credit Default Swaps

Why are credit default swaps potentially (well, we will soon find out their real life impact) so devastating and pose a huge risk to the financial system?

Here I will think not about the actual amounts floating around the world. They are mind bogling, incomprehensible.
And they do not appear in the balance sheets directly, except as fair value, which might be close to zero at the moment, as long as all goes well (well, now that we have the first real casualty, we will soon learn a bit more). Instead I want to think why CDSs are inherently dangerous, just as a mind experiment.

It is not only, that they allow to distribute the risk to other parties who might have much less knowledge about the risk of depth. It is that CDSs can magnify the impact of a credit default.

Credit default swaps insure bonds. BTW, a bond is nothing else than a loan.
Let's see how the world is different if a CDS gets utilised or not.

Let's say company A issues a bond B. Party C buys some of the bond B.

Company A -> issues -> Bond B

Party C -> buys Bond B

If party C changes its mind about the quality of the bond B or the company C, and thinks there might be an increased chance that company A will default on the bond B, what can it do?

A world without CDSs:

Party C -> sells bond B -> to party D.

Maybe with a loss, if the market also thinks the same. But that is not important at this point, because company A has not defaulted on the bond B at this time, and no one knows the true probability of this event yet.

A world with CDSs:

Now company C can also buy a credit default swap.

Party C -> buys from party D -> a credit default swap E.

Now party C has to pay regular interest to party D. In exchange party D holds the risk if company A defaults on bond B.

Now party D holds the risk of bond B. Just as in the first case, when party C sold the bond B to party D.

So far all is nice and beautiful.

But, what, if party D buys the bond B, there is no other party being able to buy the same bond. Only if party D wants to sell it as well. Party C can only sell the bond once!

With CDSs, now party C could kind of sell it twice, three times, as many times as it could effort to pay the interest payments. In fact, many different parties where able to kind of "sell" the bond B many times over to many different parties (all in the form of "buying" a CDS).

Party C -> buys from Party D -> credit default swap E
Party C -> buys from Party F -> credit default swap G
Party C -> buys from Party H -> credit default swap I
Party C -> buys from Party J -> credit default swap K
Party C -> buys from Party L -> credit default swap M
Party C -> buys from Party N -> credit default swap M

All of them covering for the default of Company A on Bond B.

Now if company A really defaults on bond B, now there is not only one single party that has to pay the difference of what company C can pay back and the original value of the bond, but potentially a big number of other parties will have to do the same payments! This is pure gambling in a big scale without any grounding in any productive activity!

Now the economic impact of company A has a huge impact on many different parties, not just a one to one as with the sale of a bond.

(BTW, ironically, now Party C might actually have an incredible interest of seeing Company A to fail! They are super super short now on company A.)

Getting a loan with the promise to do something productive has the risk that this party than just goes on an extended spending fee for personal gain with the corresponding impact for its creditor.

But CDSs can magnify the impact of any loan gone sour and create a massive chain reaction of insolvencies.

What is wrong with just selling Bond B if anyone doesn't like it and in the end, well, someone will have to pay up for their mistake.

The total amount insured with CDSs goes in the trillions of USD. It seems more in value than the bonds that our outstanding.

This all reminds my of an impressive experience I had years ago in the early days of internet chatting, then the common network was called internet relay chat, short IRC.

There anyone can login, take a free pseudonym, open a chat room with a chat room name that was not yet taken, and invite other people.

The person opening the room had all the power to kick people out and ban them from the room, so they could not enter again.

He was the administrator of this room. Of course, with lot's of people hanging out in a particular room, it became a sign of prestige to hold this admin right, which BTW is transferable. So normally 80 to 100% of the people in a chat room have this admin status after a while (which was visible buy adding a "@" in front of the pseudonym name, or nick name, to be precise).

With normal chat client software, mirc the standard one, there were sophisticated macro languages and other features available. E.g. you could create a list of your friends. If a friend joined your room where you had admin rights, immediately and automatically you would give them admin rights too. And there were standard macros that would help and protect your friends. E.g. someone would kick one of your friends out of the chat room, your client would automatically kick out and ban that person out of the room as well.

Now think for a moment, what this will result in, if almost everyone in this room has admin rights?

And then... one person kicks out, for fun, only one other person?!

Of course, the person kicked out will have friends, kicking out the person who just kicked someone. Now that person has friends as well, kicking out the person helping the first person being kicked out. WHAMMMMMMMMMMMMMMBOOOM!

Almost everyone get's kicked out in a chain reaction.

That is, what you call on a chat server, a Kick Fest. A festival indeed.

It is fun the first two time. Then it get's old real fast!

An example of a negative feedback loop, that happens if all do the same, fully automated, without thinking, and than one person lights a match.

Selling a CDS without having the money to be good for is like selling a naked call when you have neither the underlying stock nor money to cover it. It is not that it makes our system more stable, it makes it much more prone to a huge shake out. IMHO:).

And like a Kick Fest, it might be a good show to tell your grand children about, but it might just as quickly get pretty old restoring your "normal" life once your bank account and job has just evaporated, because a few trillion of funny/fiat money have just vanished in a man made financial mini black hole.

No comments: