How Credit Default Swaps Create Bankruptcies
The Institutional Risk Analyst folks say Citigroup is is insolvent and needs to be either restructured or liquidated. They believe restructuring is possible by three steps:
- Forced management change
- Agreement from bondholders to convert Citgroup's debt into common equity
- A 'prepacked' Chapter 11 filing under the FDIC's open bank assistance
I agree with the diagnosis. Citigroup is insolvent. But I believe that the restructuring is impossible as many Citigroup bondholders have no incentive to take a loss by agreeing to a debt for equity swap but instead have a huge incentive to let Citigroup fail.
The reason are Credit Default Swaps.
One can distinguish two types of Credit Default Swaps buyers:
- A. The CDS buyer that buys insurance against the default of an asset s/he really owns.
- B. The CDS buyer that buys insurance against the default of an asset s/he does not own.
On a first view type A looks like a homeowner who pays for fire insurance on her home while insurance buyers of type B are firebugs who establish insurance on some other person's house to cash-in after they burn it down.
It is obvious that the second kind of insurance buyer is a serious danger to the public and to the solvency of the insurance seller. Indeed no sane insurer, that is others than AIG Financial Services, will sell fire insurance on a home to someone else than the home owner.
As I call for ALL credit default swaps to be declared null and void I should explain why the first type of CDS buyer is also a systemic danger.
A person gives $1 million credit to Citigroup and receives a bond from it, a written declaration by Citigroup to pay back the $1 million plus a certain interest in a fixed number of payments distributed over time. The person also buys insurance for the full value of the bond. If Citigroup goes bankrupt the insurance will pay out for the full loss to the bondholder.
But Citigroup is a big company and before such companies go bankrupt and out of business they try to restructure. They will call in all the bondholders and ask those to forgive some of the debt or exchange their bonds for shares. They will also ask their workers to work for less. Such restructuring is usually good for the economy as a whole. Not all company workers get fired and the general economic disruption that occurs with any large bankruptcy will be less painful.
But here is the rub. The bondholder that has insured the Citigroup bond has no incentive to agree to any reduction in what Citigroup owns her. If Citigroup goes bankrupt the bondholder will not bear any loss. Then why should the bondholder agree to take a loss in a restructuring procedure?
Indeed the analogy of this type of CDS buyer to a homeowner that insured his home is not completely correct. A home fire insurance will not pay out 100% of the rebuilding costs of a home that had already decayed. It might pay the time-value of that house or the repair costs, but the payout for a burned down 50 year old house will usually not be enough for to pay for a brand new one of the same size and quality. This makes sure that the homeowner has no financial interest to burn the house down and gives an incentive to stop a small fire before it burns down the whole house.
But the CDS buyer of the first type will be made whole to 100%. The incentive here is not to stop the small fire but to make sure that the fire actually burns down as much of the house as is possible.
As the Financial Times reports (alt link) that is exactly what happened twice last week:
Credit default swaps, the derivatives instruments that have figured prominently in the global financial crisis, are now being blamed for playing a role in two bankruptcy filings this week.
Bankers and lawyers involved in restructuring efforts say they are concerned some lenders to troubled companies, such as newsprint producer AbitibiBowater and mall owner General Growth Properties, stand to benefit from a default because they also hold default swaps, which entitle them to payments in such events.
The same will occur with General Motors which is now trying to restructure:
The Obama administration has directed General Motors Corp (GM.N) to prepare a new restructuring plan that would pay off bondholders and the automaker's major union in stock in exchange for $48 billion in debt, people briefed on the plan said on Friday.
The GM bondholders who have in total $38 billion credit insurance will certainly not agree to a voluntary shares for debt-reduction swap. Outside of bankruptcy procedures there is little anyone can do to make them accept such. Inside a bankruptcy the insurance makes the whole. GM and Citigroup will thereby have to go into bankruptcies with all the nasty things that will be involved. Likely more jobs will be lost than necessary and more damage done to the economy as a whole while the bondholders who bought insurance will be perfectly well.
It is weird that the Obama administration and even the smart IRA folks have not grasped the problem that CDS' have created. These insurances by their very existence give an incentive to 'liquidationists'. They are institutionalized Andrew Mellon's that prefer total destruction over restructuring.
There is a way out of this: Declare all Credit Default Swaps null and void.
There is no real economic justification for these instruments. They only skew risk. If A gives a loan to B the payed interest is the gratification for taking the risk that B might default. A will demand higher interest from C if C is a higher default risk. That is the way it should be and it has worked well for thousands of years. If CDS' are allowed A will insure itself and no longer carry a risk at all. Any decay in B's financial state will give A an immediate interest to see B's total fall. This is a systemic danger that the public has a clear interest to avoid.
So lets get rid of these papers once and for all.
Posted by b on April 18, 2009 at 15:13 UTC | Permalink
Let's hope so. Citibank needs to be blown to smithereens. CDS may turn out to be the only way to effect politically inconvenient resolutions like that. With luck they'll work their magic on J.P. Morgan too. What's a little decade of depression if you manage to flush out the stables?
Posted by: ...---... | Apr 18 2009 16:40 utc | 2
@jony_b_cool - But if we presume/accept as you do that the govt has the authority (or methodical means) to declare all CDS's null & void, then it probably also has same to compel bondholders (not the firebugs) holding CDS's to accept equity in return for their bonds.
These are different cases. The first would not require a new law, the second would require several changes in law.
1. The administration could simply declare CDS contracts to be "contrary to public policy" (i.e. immoral) which would make them not enforceable in court. The CDS would immediately lose their value as no-one makes such businesses when they are not enforceable. (Keep in mind - every contract you make involves three entities: you, the other side and the government that makes you and the other side stick to the commitment. If the government finds the contract to be void on public policy doctrine grounds, it is useless for you and the other side.)
2. There is a legal and well defined process for forcing bondholders to take equity instead of getting their loan back. That process is bankruptcy and all the laws and legal procedures around it. On could add to that as there are already grades of bankruptcy (chapter-11, chapter-7) some mandatory exchange but that would be quite unsystematic to the existing body of commercial law and I doubt that Congress could agree on such addition anytime soon.
b -
Good one. In the spirit of your post, I recommend the following link:
http://online.wsj.com/article/SB123785310594719693.html?mod=article-outset-box
Though I struggle enough with just basic finance, the following excerpt wreaks of disturbance:
The poisonous nature of CDS can be demonstrated in a three-step argument. The first step is to acknowledge that being long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reduces one's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. This asymmetry discourages short-selling.
The second step is to recognize that the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments.
AIG thought it was selling insurance on bonds, and as such, they considered CDS outrageously overpriced. In fact, it was selling bear-market warrants and it severely underestimated the risk...
Are we scared yet?
It is estimated, that there is a worldwide capacity for car production of 90M/a, but a demand of 60M/a.
The rescue of GM wrecks havoc elsewhere, and give it an advantage over non-defaulting companies, despite it makes the worse product. There big advantage is simply easy default then compared with other companies.
If contract modification when it suits (I think the PPP contracts are much more immoral, and are uphold) becomes normal, it will be difficult to attract capital for the private sector of the US. And given that Americans want to invest abroad, there is need for foreign capital in the US private sector, even when the trade balance becomes zero. Perhaps an AIG default could have saved Citi and GM. But AIG is simply closer to Goldman Sachs aka the US gov't.
Posted by: Jemand | Apr 18 2009 20:30 utc | 5
very interesting Jemand.
what are the complete consequences to GM defaulting? I would think that GM tows a lot of smaller industries behind it. are they of greater or lesser consequence than Hyundai or Subaru or some other smaller auto company.
no snark or disrespect intended. I am really curious
Posted by: dan of steele | Apr 18 2009 21:40 utc | 6
@5
If contract modification when it suits (I think the PPP contracts are much more immoral, and are uphold) becomes normal, it will be difficult to attract capital for the private sector of the US. And given that Americans want to invest abroad, there is need for foreign capital in the US private sector, even when the trade balance becomes zero
this factor has been overlooked, but hopefully not by the US Govt. Also, I think it was Parvis who commented that aggressive USA actions in the financial sector that hurt overseas investors could spark off a wave of international law-suits.
Posted by: jony_b_cool | Apr 18 2009 22:47 utc | 7
Thank you, b, for this valuable explanation of the two types of CDS holders and their two separate dangers.
There is an excellent article on the whole scam at Village Voice here- Village Voice
and I have written a commentary on it here-
Winterpatriot.Com
I will post a link to this entry
Posted by: james | Apr 19 2009 1:06 utc | 8
Indeed the analogy of this type of CDS buyer to a homeowner that insured his home is not completely correct. A home fire insurance will not pay out 100% of the rebuilding costs of a home that had already decayed. It might pay the time-value of that house or the repair costs, but the payout for a burned down 50 year old house will usually not be enough for to pay for a brand new one of the same size and quality. This makes sure that the homeowner has no financial interest to burn the house down and gives an incentive to stop a small fire before it burns down the whole house.
I live in Canada. I do not know what is the case in other countries.
Our home insurance is currently for about 100% replacement cost. It includes the cost of removing the old structure in case of fire - minus the deductible. It's a pretty small amount of decay that is required.
I have worked as a (wicked) landlord for a number of years. The building we owned was required, as a condition of the mortgage to be covered at 100% replacement cost. In fact, it was covered for probably 120% due to arguments with the bank about what replacement cost was. From a profit point of view, I suspect 80% replacement cost on an older building would represent a break-even situation in case of a fire. Keep in mind that the replacement of an old building will 1) allow higher rents, and 2) require less repairs and 3) be worth more money. (Of course 20% is a substantial amount of money that would have to be mortgaged or otherwise come up with.)
We ran with a very high deductible. Even so - the cash value (at 50% of the insured value for rebuilding) was quite close to the actual value of the building without the land.
Posted by: edwin | Apr 19 2009 13:15 utc | 9
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b,
excellent post. But if we presume/accept as you do that the govt has the authority (or methodical means) to declare all CDS's null & void, then it probably also has same to compel bondholders (not the firebugs) holding CDS's to accept equity in return for their bonds.
Posted by: jony_b_cool | Apr 18 2009 16:36 utc | 1