Robert Waldmann of Angry Bear has a fascinating post exploring the possibility that sharp movements in the value of Lehman senior debt could be explained by the possibility that Lehman had sold Credit Default Swaps on itself. Since a CDS is insurance against the possibility of default on debt, this is a no-lose bet for Lehman. If the firm survives, they collect the premiums and pay nothing and, if it doesn’t the losses are borne by the creditors. And, as Waldmann points out, it’s not crazy to buy such a CDS, since it will retain some value in bankruptcy. If you’ve already sold a lot of Lehman CDS yourself, there’s a significant hedging benefit. So both parties benefit, and the losers are the existing bondholders. Waldmann has an interesting optimization exercise to show that optimal (for Lehman) use of the CDS option could explain the collapse in the value of Lehman bonds.
Thinking about this, I’m more and more convinced that Warren Buffett’s description of derivatives as financial weapons of mass destruction applies in spades to CDSs.
For a start, it seems obvious that allowing firms to sell CD swaps on themselves is a terrible idea, but Waldmann says it’s not illegal and has happened in the past. But even if you could stop the most obvious version, there are plenty of ways around it. Suppose for example that Bank A and Bank B sell lots of CD swaps on each other. Then if one gets into trouble so does the other, and both default, so the CDS are reduced to their bankruptcy value. As long as both banks survive, it’s money for jam.
What this means is that it’s not possible to value a CDS (and therefore any kind of debt for the issuer) simply by looking at the risk of default for the insured firm, and then considering the risk of default for the issuer. You need to know the correlation between the two, and this requires not detailed knowledge of the entire asset position of both parties, including their correlations with other parties.
Presumably, at some point, bond markets will start to anticipate this risk. But, in the absence of detailed knowledge of all the counterparty risks involved, the only real option is not to buy corporate bonds of any kind. That’s pretty much what’s happened in recent months.
A centralized CDS clearinghouse might address these risks to some extent. Alternatively, if the risks were ignored, it could create yet more systemic risk by allowing arbitrage between supposedly identical CDS instruments with radically different counterparty risk. I’ve seen a bunch of proposals for such a market to be established and some announcements that its coming Real Soon Now, so perhaps we’ll get more information on this point before long. Then again, perhaps not.
John Quiggin 
This sounds like a very implausible story.
Anyone else starting to entertain the theory that that financial markets have reached a level of complexity where the the two kilos or so of mince inside the human head simply can’t comprehend it – certainly not within the timeframes expected of market traders.
The complexity was certainly beyond the city council finance departments who used and blew ratepayer funds investing in CDO’s.
The Wall Street Journal ran an article in December on Goldman shorting CDOs while hustling customers to buy them.
http://online.wsj.com/article_email/SB119759714037228585-lMyQjAxMDE3OTE3NDUxOTQ3Wj.html
How are so many dodgy practices still legal?
$4bn for ‘competition’ in the housing loan sector. Interesting. For that amount one could build between 10000 and 20000 public housing units, depending on location and facilities, with a positive albeit small rate of return. Is there anything wrong with a smaller rate of return on investment if, in exchange so to speak, one can reduce the pressure on the rental market and, with a bit of luck and goodwill reduce social tension if not outright social problems?
If social-domocracy is distinct from neo-liberalism, then I would be surprised if my question is considered to be silly.
“How are so many dodgy practices still legal?”
Essentially that’s how fractional reserve banking works in creating money out of thin air. The only difference now is that the private sector has cottoned on to the lucrative public sector rort and are joining the party big time too. As John points out it’s becoming increasingly difficult for the public sector to work out how to prevent their loss of monopoly and hence threatens the very existence of irredeemable fiat money. Won’t stop the monopolists from trying of course. I guess the gold bugs would simply say- evolutionary my dear Watson!
Sorry, I put my post in the wrong thread.
“Is there anything wrong with a smaller rate of return on investment…”
Well Ernestine I would suggest that those smaller rates of return via public central bankers was what started all this in the first place. It seems the private sector is having second thoughts about all that now. Not so the public sector by the looks of it and I note the Rudd Govt wants to go into debt for ‘infrastructure’ now. Perhaps all that private sector debt for ‘infrastructure’ has made them somewhat envious, or simply left out.
Yep, you know things are at a crazy height when Warren Buffet and his right hand man go through company books and all the footnotes and then admit; “The only thing we understood was that we did not understand.”
He made that statement several years ago, I’d say about the same time he said “derivatives are financial weapons of mass destruction”.
Looking at the big picture and with the benefit of hindsight we can see some unusual planets aligning-
First up central bankers keep interest rates very low in real terms causing a ‘borrower rather than a lender be’ mentality and so the malinvestments begin.
Central bankers targetting their political masters’ comfort zone (ie taxation by stealth) of 2-3% inflation are fooled by a baby boomer demographic that wants to ‘invest’ the extra money for their retirement. They bid up assets rather than goods and services, prolonging those low interest rates with concomitant observed inflation.
Asian savers, either chastised by their uncomfortable predicament after the Asian meltdown, and/or forced to by their own Govt investment and exchange rate policies (particularly China)jump on board.
Easy money and tax free capital gain quickly attracts the best brains into finance and coupled with nerdy computer types and their new simulations which old guard prudential sentrys shrug off as too hard but it seems to pay, the ponzi scheme and private sector money creation are really off and running.
This produces an asset bubble and an associated tax take that may now be intolerable for a shrinking young cohort since essentially it’s the old that lend to the young for retirement and that overall rate of return organises their respective shares.
All these planets have aligned and as such may have caused a financial threat now that is so great it is beyond any mortal attempts to ameliorate it. Is fiat money now so corrupted beneath the surface as to be seriously threatened existentially? It’s really just Zimbabwe type stuff waiting to happen and the baby boomers have to take the big hit now if it’s to ever recover. Will the market deliver the final blow now with a flight to gold? Would the authorities be powerless to prevent it happening? After all we have already seen a value flight to other real commodities and it does seem the flames of insolvency are jumping many fire breaks rapidly now, by all accounts.
Question: Is the only way out now for the market to decide its new international currency given the incredible strains on the fiat alternative? A new currency, robust, indestructible, infinitely divisible, its quantity determined by nature, rather than the whims of weak men and yet scarcely consumed for our daily needs? Will our salvation lie in the quantum shift to a very old form of currency?
This is a well known risk in CDS, is considered in pricing (by anyone moderately sophisticated), although for most purposes the correlation would be considered to be zero unless some clear link was established. That assumption that counterparties are sufficiently diversified to make this true may be looked at more closely in the future.
Interestingly the point about banks trying to sell CDS on themselves or something very similar in Korea in 97 was first told to me many years ago by a Lehman’s CDS trader who was trying to get my organization interested in some of their CDS offerings.
However while CDS generates obvious examples of this counterparty correlation risk, it is equally possible to generate near identical versions in other markets. In an OTC options market for example. If you are buying puts you better make sure that the correlation and exposure between the seller and the market he is selling against isn’t high. A share fund could for example sell large amounts of out of the money index puts, generating short term income and knowing that it will only have to pay off in the case where it is likely in default. So they are ineffect selling dud gaurentees.
Observa says, “A new currency, robust, indestructible, infinitely divisible, its quantity determined by nature”
This implies gold in finite supply (quantity determined by nature) split into 1 atom lots (infinitely divisible) I presume? Of course, technically it is not infinitely divisible as once an atom of gold is split then it is not gold.
Doesn’t the notion that it is “much divisible” (to be more accurate) imply that this currency can be debased like any other? Wasn’t this the case historically when “gold” coins were debased by being struck with lesser and lesser proportions of gold?
Ah, but obviously I have missed the fact that Observa was being iron-ical… or maybe gold-on-ical!
OK Ikon, more like easily and much divisible unlike say diamonds which can be man-made and hence gold was the traditional choice, although money redeemable for gold has many advantages. Doesn’t matter whether its exchangeable for your dollar at $35/oz or $1000/oz over the long haul. Anyway you hold your shares and RE and I’ll hold my cash and Perth Mint gold warrants for the time being after liquidating my share portfolio a few moths ago. Here’s Chan Akya on my wavelength, telling it like it is with the fiat money creators and manipulators now-
http://www.atimes.com/atimes/Global_Economy/JI30Dj09.html
Notice the underlying demographic problem and those forced Asian savings impacting to create the current catastrophe. The fiat money men are all running about in ever decreasing circles now, like their asset prices, while gold is holding steady and positive value now. Serious deflation could be a distict posibility now.
Well an Austrian would say that wouldn’t he?
http://www.fxstreet.com/news/forex-news/article.aspx?StoryId=1fdb2663-a70d-4dd8-a95e-ed0314c7ccb7
I am not expert in this field but I was wondering, if the suggested “betting on yourself” is true, is it a form of “insider trading”. Obviously, Lehman would have more information on its own risk of defaulting than outsiders, especially as these products were designed to avoid outside scrutiny. In other forms of gaming (eg sports) players are prevented on betting on themselves (and especially the opposition) to avoid risk of “tanking”.