Size of the credit default swap market may not be a problem. A children's game shows why

[HamdenRice]

I haven't been posting much because I've been researching and writing a very long analysis of the credit default swap market, which it seems almost no one understands. I've found really only about five sources that seem to understand what's going on -- three are pretty much nutcases, but also one NY Times Reporter, plus the Attorney General of New York, Andrew Cuomo.

It is a very, very serious, dangerous situation, but not for the reasons most people think. The size of the market, for example, which lots of people are variously mis-estimating, from $45 trillion to $450 trillion to $800 trillion, obviously isn't being accurately portrayed because all those different estimates can't be right; but more to the point, they are probably not relevant.

I'll hopefully post this longish analysis later. Basically, if you can understand "dynamic hedging," you'll be able to understand both why the market seems so large, why the size isn't important, but what the real dangers are.

But in the meantime, here's a child's game that helps explain by analogy what's going on with the size.

Remember the game "hot potato"? You get a bunch of kids in a circle, and the kids pass a potato around. They pass it as fast as possible while music plays, and when the music stops, the kid with the potato loses. It's kind of like musical chairs with a potato.

Imagine a slight variation. Let's say you line up 100 kids. Each kid has about $2.00 in change in his pocket. You start with a baseball card that is worth somewhere between $1 and $2.

You as the zero player "sell" the baseball card to kid number 1 for $1.01 . The kid does not have to pay you right now, but only promises to pay you. That kid 1 now owes you $1.01 .

Each kid in turn sells that card to the next kid adding one penny to the price. Each kid does not pay, but promises to pay. Kid 1 sells the card to kid 2 for $1.02 . Kid 2 sells the card to kid 3 for $1.03 . And so on.

When we get to kid 100, the price is now $2.00 . Each kid owes the kid next to him one dollar and something; but that same kid is owed one dollar and something. In fact, each kid has a net debt of 1 penny.

If you add up the "market" for that baseball card -- the total of all amounts owed on the cards -- it is $150 ! The total debt owed by all the kids in the market is $150! Wow, no kid has that kind of money, right? Oh my God! Holy shit, there are $150 in derivatives but the underlying asset is only worth $2! or maybe only $1 if the market has collapsed! Each kid has only $2, so how can any one kid possibly pay $150?!?!?

But in reality, each kid is only a net debtor of one penny, and a gross debtor of between $1 and $2. The $150 is misleading because it aggregates the value of all the trades (or notional value of all the debts) rather than the value of all the net debts (100 kids owing one penny each or $1) or the value of the underlying asset (between $1 and $2).

Now it is true that if you tried to settle these debts with a bunch of screaming kids, you could create an unsolvable problem which would freeze up the baseball card market -- and the kids are about as disciplined as derivatives traders -- but that's a different problem from the scale of the market.

Now here's some scary data. It seems that Lehman was said to "owe" $400 billion in credit default swaps, and that helped put in in liquidation. But at least one source says that when all the counterparty trades were "netted" against each other Lehman's actual debt was $8 billion. So an $8 billion net debt that Lehman could easily have paid or raised, was magnified 50 times.

On edit: I would ask that you NOT rec this post. I want to work out the rest of the longish piece and get my sources in order before I present it to a larger audience.

[Tansy_Gold]

1. thank you. I've been asking this question for months

Could you maybe post this over in the Stock Market Watch thread?

It seems to me, because I've been wondering exactly about this "notional" value, that we the taxpayers could therefore allow any and maybe even all of the derivatives to unwind and not see a collapse of the economy at all, but that in fact the whole fearmongering issue is just a way to scam us??????



Tansy Gold, curious as always

[Locrian]

2. interesting - thanks

What do you think of these sources? And of the following analogy? Im still trying to understand this as well. Any links would be appreciated.

http://www.ireport.com/docs/DOC-103385
http://nymag.com/daily/intel/2008/10/matt_taibbi_and_byron_york_but.html
http://www.theoildrum.com/node/4629

Banks don't have to own the mortgage to bet on whether it will be paid on time. The banks make bundles of hundreds of loans into "Mortgage Backed Securities". They sell these to other banks, but keep the CDS for each of the mortgages, as well as an insurance policy for the MBS itself. Then each bank that swaps them does the same, and some hedge funds that never even owned the MBS take out a CDS on it, betting that the underlying mortgages will go bad.

It's like if insurance companies allowed everybody in town to take out fire insurance on everybody else's house, and people were actively looking for the one that was most likely to burn.

[TreasonousBastard]

3. This is essentially the multiplier effect that...

banks have been using for centuries.

You deposit $100 in a bank. The bank lends $80 of it. You still have your hundred bucks, but there is now $180 in the money supply-- $80 in "created" money.

The bank has your hundred bucks as an asset, but also has the $80 loan as an asset in another ledger entry. So, it has $180 in assets, but only has $20 in cash, assuming you won't need more than that until loan payments start coming in.

This works out fine until and unless there's a run on deposits and the bank doesn't have the cash on hand because the loans haven't been repaid yet. Or, if enough of the loans default. In normal times, they have ways of dealing with this-- it's abnormal times, or bad management, when they fail.

Pretty much the same thing happens with leverage in investment banking-- put down the required minimum for margin and there's this magic money that's created until prices go down and the margin calls come in.

Insurance doesn't create money that way, but assumes that risks can be calculated and spread and that not everything will burn at the same time. There are capacity limits that try to make sure you don't insure every house a county with forest fires or hurricaes as a regular occurence. There are also some things you just don't do, like insure against war, flood, or some pollution. Insurers are also very interested in just what it is that they are insuring, and that there is an insurable interest without moral hazard.

Insuring against margin calls, getting caught short in a short sale, not getting paid, or anything else was done without the input of actual insurance people-- who understand risk analysis, rating methods, capacity, retention, and the limits of reinsurance. (Shame that AIG let the gonif run that desk when they had some of the best insurance people in the world sitting right across the aisle.)

I don't know the intimate details of all these investment instruments, but it looks like they all fit under the model of either banks or insurance, but the geniuses running the show never bothered to find out how either banks or insurance companies work.

And, yeah, we can make the assumption that not every security in those portfolios is tanking, but just as with banks and insurers, it doesn't take that many to bring down the house.

The multiplier effect can work backwards, too, and be a divider effect.

[HamdenRice]

4. It's a bit different

What I've learned about cds is that rather than using actuarial science and putting away reserves like an insurance company, the issuers of cds used "dynamic hedging" to protect themselves. It's neither bank multiplier nor insurance, but something completely different and relatively new.

Dynamic hedging tended to generate an enormous number of transactions that obfuscate exactly what was happening and led to the system risk we are now all experiencing.

More later.

[TreasonousBastard]

6. OK, you're right about dynamic hedging...

I just took a peek at some of the techniques and the math and this stuff gets scary when you think of the trillions they're playing with.

Tricky enough when there's an underlying stock while they're off balancing long and short positions on options, but doing this with miscellaneous pieces of unvalued debt is like hedging a roulette wheel.

[GliderGuider]

5. CDS isn't the only kind of derivative out there

The valuations I've seen for the CDS market are in the $50 to $60 trillion range. The higher numbers ($500+ trillion) are for the total derivatives market. It's a useful distinction to keep in mind, I think, as different segments of that market will have different levels and types of risk.

[phantom power]

7. Do I understand you that the "real" danger is debt-amplification?

[GliderGuider]

8. Here's a minor critique of your analogy

You say this: "when all the counterparty trades were "netted" against each other"

The problem is that not all the parties will be able to pay all they owe. If each kid starts out with just $0.01, then when the default occurs they will all go broke, each owing 100 times more than they have.

When the chain breaks, there is a system-wide loss of declared worth of $150. If some of the kiddies have used their contracts as collateral for outside purchases, say for $1.00 worth of candy which they ate before the collapse, the default spreads well outside the circle of stupid kids and into the "real" economy. Also, the example ignores the fact that in real life the financial kiddies are all engaged in thousands of these chains at the same time.

It's by now an old argument to say that all trades have a zero-sum outcome. In fact, as you hint regarding dynamic hedging, it may not even be possible to tell what the sum of the outcome is. In this case, the totalized value of $150 (which represents $60 trillion in real life) may not matter so much as the simple fact that it's a Ponzi scheme that will inevitably ruin all the participants and spray economic shrapnel across the landscape. That damage will be similar whether the "real" value being lost is $150 or $2.

[Locrian]

9. great example thanks

Interesting and scary - and NOBODY especially "joe plumber" understands this. I think its starting to come out though how there is no way it was just the "poor people" that caused the melt down.

I would think the zero-sum outcome also makes the same mistake that classical economics makes by not including time dynamics. It may be true that the net is zero, but the chaotic or unstable path to get to that point is a **huge** deal.

[AdHocSolver]

10. The financial firms were allowed to commit a giant fraud made possible by deregulation.

They then ransomed the economy for hundreds of billions of dollars perpetrating another massive fraud.

Why weren't these firms audited to find out the real extent of the "losses" before giving out one cent of a bailout? It didn't really matter what the real amounts involved were since Paulson and Bernanke were complicit in the scam.

The real problems started with deregulation in the 1990's and repeal of the Glass-Steagall Act. Both the sellers and the buyers of these "worthless" financial instruments were guilty because they used other people's money irresponsibly to enrich themselves. The bailout was part of the scam because it was used merely to prop up the profits of the guilty corporations.

Until strict regulation of the financial markets is implemented (again?), this country is exposed to more theft and fraud, and the resulting economic collapse is going to occur.

[HamdenRice]

11. A few answers:

"Why weren't these firms audited to find out the real extent of the "losses""

They were audited. As publicly traded companies, they are constantly audited, and detailed financial statements are filed with the SEC and posted online. For Treasury, or for that matter any person on the globe with a computer, detailed audited financial statements on these companies are a mouse click away. The problem is that even their auditors cannot reliably tell what the value of some of their assets are because those assets presently have no market.

"started with deregulation in the 1990's and repeal of the Glass-Steagall Act."

The G-S Act was not the major deregulatory problem. It was a rider slipped into a bill by Phil Gramm in 1999 that specifically deregulated credit default swaps. Repeal of G-S merely allowed investment banks and commercial banks to merge.

"sellers and the buyers of these "worthless" financial instruments were guilty because they used other people's money irresponsibly to enrich themselves"

Not sure what this means. Depends on which securities you're talking about.

"Until strict regulation of the financial markets is implemented (again?), this country is exposed to more theft and fraud, and the resulting economic collapse is going to occur."

Agreed.

[AdHocSolver]

14. My writing was not clear.

If auditing was ineffective in determining the real values of the assets, then the government showed irresponsibilty in providing a $700 billion bailout based on the estimates of the perpetrators of the fraud.

Repeal of Glass-Steagall was only one type of deregulation that occurred in the 1990's. I should have written, "started with deregulation in the 1990's, in addition to repeal of the Glass-Steagall Act."

When investment banks were allowed to merge with commercial banks, it gave investment bankers access to the commercial banks' depositors' money to gamble with on risky investments. My understanding from what I read about G-S, it was enacted to prevent this kind of activity, which was one of the reasons for the bank failures of the 1930's.

The bankers who bought and sold these "worthless" securities, didn't use their own money, but the money of the depositors and shareholders of the banks that they worked for. The bankers had a fiduciary responsibility to be prudent in their investments. Instead, they leveraged the banks' assets to a level that was reckless, and brought about the mess we are in today.

I worked for a bank, and got to see on a regular basis, how bank executives think and act. It was never clear whether their greed outweighed their incompetence, or vice versa.

[Alpharetta]

12. Nope

The cards are mortgage bundles. The boys wanted insurance the cards wouldn't lose value, so they went into the casino and bought insurance (swaps) their baseball cards wouldn't lose value.

They used the insurance to balance their books and borrow money from the other boys so they could buy more cards.

When AIG started selling their baseball cards, it created a long line at the casino window. Turns out hedge funds bought swaps too. Bets that the boys would bankrupt themselves borrowing money to buy baseball cards. WAY more swaps. Nobody knows how much more swaps.

Now the boys can't balance their books because they don't know how long the line is at the casino. They don't know whether their swaps will be honored. Neither do you.

[lligrd]

13. What If The Card Which Was Worth Between $1 And $2

loses its value suddenly and is now worth nothing?

[Celebration]

15. we might find out n/t

[girl gone mad]

16. Two things.

1. Every qualified analyst I've read values the CDS market at around 60T. I don't know where you are getting the idea that there is disagreement over this statistic.

2. Many people understand the CDS market very well. It's not a lack of analysis or understanding that's troubling people, it's the lack of transparency.

[Celebration]

17. A question/comment

So, this was the beginning of these things--

"The G-S Act was not the major deregulatory problem. It was a rider slipped into a bill by Phil Gramm in 1999 that specifically deregulated credit default swaps."

Couldn't the SEC have regulated these things, or at the very least asked for the regulation of them? It seems to me that sans calling these things insurance, at the very least they should have been subject to securities laws. I am not sure of the language of this rider--but I do remember some discussion about Chris Cox (SEC) specifically using extremely narrow definitions in determining what things should be regulated by the SEC. He has been a complete disaster.

[HamdenRice]

18. It slipped between the cracks of three things

It could have been a security (regulated by the SEC), or it could have been a derivative (regulated by the commodities futures boards) or it could have been insurance (regulated by state insurance commissions).

Gramm managed to get it treated as none of the above, but as contracts --hence without any regulation.

The SEC can only ask to regulate something if it is defined as a "security." Also during the Bush administration, the SEC took a hands off approach to regulation in general, and would not have asked to regulate them.

[Celebration]

19. Thanks, and it is that "hands off" approach by Cox

that I am questioning.

[GuvWurld]

20. Question

If each kid has agreed to sell for $0.01 more than what they agreed to pay, how is that a net debt of $0.01 per kid? If each kid was paid, in turn each could pay their debt and keep a $0.01 profit.

Am I missing something obvious? :shrug:

Regardless, thank you for offering a laymen's understanding to a very complicated subject.