The Market Price of Financial Ruin

As I have now cornered the local market in economics-themed posts of questionable relevance and little focus, I was hoping to talk a little bit about everyone favorite financial derivative, the Credit Default Swap.
In case you've been living under a rock and this is the first time you've heard the term, I'd ask that you kindly invite me to stay with you under that rock, because according to just about every article in the world ever, CDSs are the sulfurous products of Satan's sweatshop that have ruined all Christmases henceforth and, incidentally, are the sole reason that global capitalism is neither quite so grand nor so likely to inspire the Charleston as it was in the glory days of 2006.


Above: These women will never touch any of you again.

Maybe this seems an awful big fuss to be making over some insurance contracts. Because as much as anyone talks about how incomprehensibly complex so many of these destructive financial instruments are, the seemingly most destructive among them, the "credit default swap," is simply insurance that you can take out on a bond. And, were the world a little bit shorter on its stock of dickheads, the reasonable and legitimate practice of insuring against potential losses would be about as sinister as anything gets.

Lets imagine that world:

Imagine that the diabolical and nebulous conglomerate Groves Pharmaceutical, Weapons and Sorrow Incorporated wishes to raise a little bit of extra cash. To do this, it might sell a few bonds---I.O.U.s which anyone can "buy," that is lend money to GPWSI, for an expected rate of return. Sol Klein, a well known investment banker and Jew wishes to buy a $10,000 GPWSI bond which matures (that is pays back in full) by the end of next year. However, while the rate of return is quite high and up to Klein's Talmudic standards of usury against Christians and their children, he is worried that GPWSI may in fact go bankrupt between now and next year and therefore default on Sol's bond.

In order to hedge--that is, counterbalance--this risk, Sol goes to Prudent Pinnington Financials to buy a credit default swap. Though Prudent Pinnington Financials is currently under investigation by the SEC, it still wishes to increase its profitability. Therefore, realizing that there is money to be made in the short-term, PPF sells what is essentially insurance on the GPWSI bond to Sol. Sol will pay PPF a certain fixed amount every quarter for the duration of the bond (say, $250 a quarter for a total of $1000 by the end of the year). In exchange, if GPWSI goes bankrupt between now and next year and cannot pay Sol back, PPF steps in and makes Sol whole again. If, on the other hand, GPWSI does not go bankrupt, Sol still makes a handsome profit from the bond, despite the $1000 CDS cost, PPF has made $1000 for taking on the risk, and GPWSI has in the process been enabled to more easily sell its bonds to an insurable market. Everyone wins!

So why do we call bond insurance "credit default swaps"? Most likely because if we started calling credit default swaps insurance we might have to start treating them like insurance. And if we started treating CDSs like insurance, that might mean we would start imposing all kinds of restrictive and unreasonable regulation on them like, just to throw out a wild example, that a person can't buy insurance on a bond unless he or she owns it. And its just that kind of slippery-slope that gave the world Stalinism. If that kind of regulation were imposed, the following blessing of uninhibited financial capitalism would not be able to take place:

Sol Klien purchases a $10,000 bond from GPWSI. Lion Summerbell, who has absolutely nothing at all to do with either Sol Klien or GPSWI and who is in all likelihood both a tax-cheat and a pedophile, decides that GPSWI isn't looking so hot right now and is probably going to go bankrupt. Summerbell thus decides to buy a CDS on a particular GPSWI bond from PPF, paying the $1000 cost over the year and hoping that GPSWI will go bankrupt which would trigger PPF to cover the default, and thus reward Lion a handsome $10,000 - $1000 in CDS price assuming the default occurs around maturity. $9000 profit for a maximum $1000 investment.

On the other hand, while Lion Summerbell is hustlin' and scammin', Elias Gardiner discovers that, though he also doesn't have anything do with either GPWSI or Sol Klein, he could make quite a bit of money selling these insurance contracts. After all, Elias figures, GPSWI will probably not go bankrupt, will probably not default on its bonds, and so he could make a quick $1000, just like PPF by assuming the risk of a default. $1000 profit. For absolutely nothing.

The wonders of the market do boggle the mind. Especially when you consider that instead of just one Lion Summerbell and Elias Gardiner buying and selling insurance on a GPSWI, there may be two, or three, or seven essentially betting for or against a default. Just think: for a single bond, there might be seven different insurance contracts (fourteen daring entrepreneurs!), the total payoff value of which exceeds the value of the bond seven-fold!

Of course a cynical mind might imagine what could occur if GPWSI really does go bankrupt and really does default on its bonds. Instead of Sol Klein's initial $10,000 loss, with the CDS market left unregulated, the total loss might be amplified to $70,000 or $80,000 or $100,000. Of course in the event of such a default, for every loser (Elias loses his bet as a CDS seller) there is winner (Lion, the buyer).

Unless there isn't.

Remember Bear Stearns? That was that bank held up to $2.5 trillion dollars in CDS contracts. Bear Stearns was a big seller of CDSs--assuming house prices, bank stock, and financial profitability could only go up, it sold insurance on bonds and collateralized debt obligations (essentially a big cocktail of various kinds of securities) assuming that the risk of default was negligible. And when the impossible ended up happening, Bear Stearns, the loser in the above example, couldn't pay off all of the winners because it had insured so many bonds (perhaps the same ones repeatedly) that is liabilities exceeding the total value of company. Maybe regulation could have prevented such fantastic overstretching on their part. And maybe I want a pony.

So where do things stand now? How many CDS contracts remain outstanding and how many of them should we worry about? According to the New York Times:

While the amount of credit insurance outstanding is around $30 trillion, Robert Arvanitis, chief executive of Risk Finance Advisors in Westport, Conn., says he believes fully half that amount isn’t problematic because it consists of winning and losing stakes that offset each other.

But that still leaves $15 trillion worth of contracts that may be in need of triage. (Source: Gretchen Morgenson)

At the moment, the entire CDS market stands at about $64 trillion (or some other incomprehensibly enormous figure), but to assume losses of this proportion assumes that every house, bank and factory in America will spontaneous burst into flames. On the other hand, $15 trillion contracts that might potentially be left unfulfilled is nothing to sneeze at. Unless you're practicing for the typhus you will invariably get when we all end up living in modern-day Hoovervilles.

So what to do to stop the hemorrhaging? One proposal I remember hearing last September, and one which I thought had long since been killed and buried with a shovel, was to suspend so-called "mark-to-market" regulation. Mark-to-Market is the radical principle occasionally and loosely upheld by the S.E.C. that financial assets and products ought to be valued by the market price. That is, that their price reflects the approximate and legitimate value of that asset. If Sol purchases a $10,000 bond for $9,000, mark-to-market regulations would put that bond at...surprise, $9000.

Of course, it does get a little bit more complicated than that. If Sol purchases the bond for $9,000 in January and then a few months later, the hypothetical corporation GPWSI announces it has lost an enormous amount of money, there is a certain risk that Sol's bond will in the very near future be worth a sum total of $0, since GPWSI might very well go out of business. The selling price for Sol's bond might therefore plummet to $4000. The market, the regulation framework assumes, judges risk relatively well so if the bond is priced at $4000, that must be because there is a substantial risk of default which acts a heavy discount against the value of the bond.

Of course, if Sol had purchased a CDS on the bond, depending on how the swap contract had been written (there is no standard CDS model since up until recently it was a completely unregulated market), a drop in price of over 50% might constitute a "credit event," leading his "insurer," the hypothetical PPF, to pay Sol $10,000 in exchange for the junk-ish bond.

Noting that the PPFs of the world have been having a great deal of difficulty paying of their respective Sol's, many great minds out there have proposed that we simply stop paying attention to prices altogether. If the drop in price of Sol's bond from $9000 to $4000 is dismissed as a product of market myopia, panic, and irrationality, perhaps we ought to value the bond somewhat higher. This in turn would might not trigger so many of these CDS payments, leading to quite so many bank losses, failures, and the need for bailouts.

Abandoning mark-to-market principals extends beyond the CDS market. If a bank has to consistently devalue its assets as housing prices fall and confidence within financial markets continues to plummet, this only forces them to lend less in order to meet a certain degree of capital requirements. In this light, maybe the proposal isn't quite so dumb. In its oh-so-subtly titled article, "Does Fair Value Accounting + Credit Default Swaps = Global Deflation?," one blog makes the case:

The fact is, normal people are simply not able to react to and understand the torrent of short-term swings in assets prices, thus the net effect of FVA is not greater understanding, but instead fear, panic and systemic instability...The subjective, speculative perspective that is the essence of FVA, when applied to illiquid assets has, we believe, the net effect of increasing the instability in the global economy. (Source: IRA)

To be fair, this is probably one of the more coherent arguments against mark-to-market regulation that I've read. In most cases, and maybe counter-intuitively, its been screaming Wall Street Journal conservatives bemoaning the existence of any kind of regulation. The IRA blog, on the other hand, writes that financial markets are anything but efficient and rational. Prices reflect mania and "irrational exuberance" in boom years, and panicked hysteria during busts. This kind of volatility is bad for investment confidence but, in the case of CDS, actively exacerbates the crisis by triggering "credit events" when the actual bond might still be considered "performing"--that is, not expected to default just yet.

What all criticisms of mark-to-market seem to lack in my mind, however, is a viable alternative. The hysterical Republicans in September had simply proposed that asset valued be determined "internally." That is, by the company which owns the asset. Which is kind of like allowing a serial killer write the law defining murder.

From what I could grasp of it, it seemed that IRA was proposing a somewhat more "objective" standard of valuation; a regulatory formula of some sort that would take into account volatility and derive some sort of mean value.

We might even construct some type of averaging rule for FVA [fair value accounting=marking asset prices to market prices] swings in assets, affecting income and even reserves once the swing in value if confirmed over time, but the notion of instantaneous and immediate price discovery, disclosure and financial adjustment is a childishly idealized notion that must be gently restrained.

I find this somewhat convincing, but I think I would need to see something concrete before really hopping on board. Until then, there seems something a bit perverse to me about blaming prices for the low value of an asset. I completely agree that massive financial volatility is in no way conducive to healthy investment activity, even if the price swings are supported by so-called fundamentals (which I think they often are not). But until a new mechanism is proposed that would somehow distinguish "real" changes in value from those resulting from irrational fear or mania, I think the following analogy is pretty appropriate:

"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick." (Source: Calculated Risk)
analyst Dane Mott, JPMorgan Chase & Co., Bloomberg

What do you all think?