Fact and Fiction Behind Too Big to Fail
No product that was financially-engineered during the growth of the Great Bubble is as destructive as credit default swaps (CDSs). They are more insurance than derivatives. Only the largest banks trade them. Only a rather small percentage are cleared on central counterparty clearing platforms, despite Dodd-Frank.
The International Monetary Fund (IMF) and many in the financial services industry claim CDSs are essential as they are the only way to hedge bonds. Due to Dodd-Frank’s officially deeming the largest banks “systemic” and the dominance of five top systemic banks in CDS trading, the taxpayer is providing that hedge benefit. This is a vast change from Congress’s original intent when inserting government support into private-sector banking.
As the bubble collapsed, neither government officials nor the biggest banks themselves could measure the true risks. So the U.S. government paid out claims on credit default swaps at 100 cents on the dollar. A positive trend is that their use has been declining.
Terminology as a Regulatory Smokescreen — It’s Insurance
First, there’s the name. I’ll venture they were named credit default swaps rather than credit default insurance to insert them into the derivatives world and to keep them out of the insurance world with its heavy state-level regulation.
Credit default swaps are essentially insurance contracts, not “swaps” at all. Even the Fed knows that. Credit derivatives — which are nearly entirely CDSs — are reported separately from other derivatives in regulatory reports.
Ordinary folks understand insurance. There’s an underwriter, the insurance company which issues the policy. There’s the insured — the person paying the premiums and receiving the benefit when the insured event occurs. For ordinary individuals the insurance covers common, but catastrophic events like house fires or automobile accidents. You must own the house or car to buy the insurance.
Here’s how a credit default swap works. The underwriter issues a policy that pays out if an event occurs within the time frame of the policy. In this case it’s the default of the underlying obligor. The obligor could be a corporation, a government, or other large borrower. Michael Lewis’s book The Big Short revealed how any party that could pass as a credible institution as contrasted with individuals (even rich ones) could buy credit default swaps on subprime loan portfolios. As many ordinary folks came to understand, it was like being able to buy fire insurance on your neighbor’s house. Maybe more like fire insurance on a house in an area prone to fires.
Traditional insurance companies make a science of measuring the risk of a claim. These specialists are called actuaries. But CDS claim payout risks are much more difficult to assess. The taxpayer shouldn’t be standing behind these risks.
Murky CDS Risk Management
Credit derivative risk is not managed like traditional insurance product risk despite its similarity in structure. Traditional insurance regulation requires the underwriter to retain and invest portions of the premium to have funds available for eventual claims. A bank that underwrites, or “sells” CDS credit protection, turns around and offsets that risk by buying the same or similar protection from another bank. So what passes as risk management results in massive uncertainty when claims need to be paid in a systemic crisis.
Click on the links below to see three of the largest banks’ regulatory filing front page and derivatives page for the last quarter of 2015. Credit derivatives “sold” protection and “purchased” protection are found on lines (1) through (4) in section 7.a. Note that credit default swaps account for nearly all of credit derivatives products and that sales and purchases pretty much offset each other. They obtain the resources to meet eventual claims by purchasing the same protection. One bank linked to another in an endless circle of claims.
In the bursting of the bubble in 2008 with massive defaults on subprime and other mortgage securitization credits, AIG faced massive and growing CDS claims. News articles stated that AIG had been negotiating payouts at discounts as high as 40 cents on the dollar. The New York Fed, led by at-the-time President Tim Geithner, took over AIG’s negotiations and paid Goldman Sachs among others at 100 cents on the dollar. The full payment was said to be necessary to pay, for example, Societe Generale, a French bank. In turn, Soc-Gen owed payouts on credit default swaps it had underwritten. And so it went. In the huge pools of credit default swaps and the shifting valuations during financial turmoil, government officials didn’t want to rely on theory, nifty modeling, or even sorting things out more deliberatively.
One measure promoted by Dodd-Frank to better manage derivatives risk was to have them cleared through central counterparties. Bank regulators required the reporting of this shift beginning in first quarter 2015 filings. The Office of the Comptroller of the Currency’s (OCC’s) quarterly derivatives reports show that other derivatives were being moved to central clearing counterparties much faster than credit derivatives. Only 19.7% of credit derivatives had been shifted in 1Qtr2015 despite Dodd-Frank’s passage in 2010, and only 20.4% had been shifted by 4Qtr2016 — hardly more.
Clearing on central counterparties provides numerous benefits, such as daily margining and the transparency of regular price and trade reporting. CDSs are very profitable products. More profitable when not transparent.
Derivatives traders do use (mostly) cash collateral, i.e. margining, to a degree, but it is not the same as the use of reserves in the insurance industry. Further, moving credit derivatives to central clearing platforms would require not only daily margining, but also daily measurement of these exposures. Opacity suits the biggest banks’ bottom lines better.
The Bias of a Not-So-Free CDS Market
The IMF actually promoted the use of sovereign credit default swaps (SCDS) in Chapter 2 of their April 2013 Global Financial Stability report. “SCDS have become important tools in the management of credit risk[.] … [T]heir importance has been growing rapidly since 2008, especially in advanced economies.”
One justification the IMF offered was that the spreads on CDSs and bonds reflect common economic fundamentals, although not necessarily with the same speed. The IMF went on to say that “the evidence here does not support the need to ban purchases of naked SCDS protection. Such bans may reduce SCDS market liquidity to the point where these instruments are less effective as hedges and less useful as indicators of market-implied credit risk.” Subsequent to that report, the EU did restrict CDSs on their sovereign credits to those who actually hold those bonds.
A private contract here or there is not a policy issue, in my view. The policy issue is the underwriting of this insurance on major asset classes like sovereign bonds or subprime loans by a large financial institution carrying a federal guarantee anywhere within its corporate structure. Especially where “naked” CDSs are sold (without actually having to own the underlying bond), the claims in the event of default could be huge.
The IMF’s report had a very revealing table (next link) showing the transition from the end of 2008 to the end of 2012 in the top ten outstanding credit default swaps outstanding by notional amount. In 2008 three of the largest investment banks plus GMAC (car giant General Motors’s financing subsidiary, active at the time in residential mortgage securitization) were among the top ten. By 2012, CDSs on countries made up the top ten. How does an actuary measure the risk of a default by an Italy or a Spain?
There are thousands of cars, houses, and human lives to insure, but there is only ONE of each of these countries. When a default occurs, the sovereign debt might be settled at a large discount. In August 2014 the ISDA determined Argentina had defaulted on its bonds. The September 2014 auction resulted in CDS claim payouts at 60.5 cents on the dollar.
The IMF with its own vested interest in the European Union’s sovereign debt crisis of 2012 and beyond isn’t the only institution with a bias towards CDS use. The International Swaps and Derivatives Association (ISDA) controls what constitutes a “default” and has driven the documentation underlying this global product. The Determinations Committee that made the March 2012 decision on privately-held debt issued by Greece was comprised of the world’s largest banks and five huge hedge fund/money managers — Bank of America Merrill Lynch, Barclay’s, Credit Suisse, Deutsche Bank AG, Goldman Sachs, JPMorgan Chase Bank, N.A., Morgan Stanley, UBS, BNP Paribas, and Societe Generale. CDSs continued to require default event determinations three years later, concerning Greek sovereign debt held by public entities — like the IMF.
A Shrinking Market
A hugely complex and even political financial product, CDSs have actually declined since the bubble burst. As can be seen in the table linked below, JPMorgan Chase is still the leader in outstandings, but all players’ positions have shrunk over time. The totals in 2007 and 2008 are missing the amounts booked in Goldman Sachs and Morgan Stanley. As these two investment banks didn’t become bank holding companies until after the 2008 collapse, they didn’t report their activities to the Fed. They were, however, big players in this market.