Why CDS are Not Your Friends

Charles Davi and I agree for the most part.  For example, I share his dim view of Hernando de Soto's recent op-ed.  However, he linked to an older piece where he criticizes my view of credit default swaps, and I wish to defend that view.

Davi writes,

Kling begins his analysis with the conclusory statement that credit default swaps have no "natural seller." That sounds brilliant. But what does it mean?

It means that there is no institution which, in the ordinary course of its business, takes a position for which selling credit default swaps is a natural hedge.  Many financial transactions have natural buyers and natural sellers.  For example, an oil producer is a natural seller of oil futures, and an airline is a natural buyer.  A corporation funding a long-term capital expansion is a natural seller of bonds, and a pension fund or life insurance company with long-term obligations is a natural buyer of bonds. 

Credit default swaps allow companies to trade the default risk on, say, a mortgage-backed security.  The holders of that security have a natural interest in buying protection.  But nobody has a natural interest in selling protection.

Davi writes,

Kling boldly states that banks and other unspecified entities "could hold AAA-rated or AA-rated bonds but ... are precluded from holding B-rated bonds." Unfortunately for Mr. Kling, this statement is completely false.

Indeed, banks are not prohibited from holding B-rated bonds.  However, the cost of holding such bonds is prohibitive, because risk-based capital regulations on such bonds are so onerous that the return on equity for banks is too low to justify holding them. 

Later, he writes,

While it is possible that there is some wiggle room to profit from protecting a B rated bond to the point that it's treated as an A rated bond, there shouldn't be much, since it's a rather obvious scheme and arbitrageurs will eventually pick up on it and cause prices to stabilize to arbitrage-free levels. Despite this, Kling places the weight of the entire credit default swap empire on the tiny spread between the price of protection and risk premiums on bonds, which as we discussed, should not be a long term phenomenon.

It is a rather obvious scheme, and that is why the CDS market grew to more than $50 trillion in a decade.  The profit opportunity did not disappear quickly, because the supply of securities that could benefit from protection was relatively unlimited.  Wall Street kept coming up with ways to manufacture AAA ratings out of weaker and weaker underlying instruments--the subprime mortgages that we have come to know and love. 

Davi goes on,

why would such an elaborate ruse be necessary when banks could simply invest in an A rated tranche of a CDO comprised of a diversified portfolio of B rated bonds?

Because AIG came up with a more efficient way to turn B paper into AAA paper.  AIG "rented" its own AAA rating to banks by providing guarantees on securities, which it did by selling credit default swaps.  Other ways of manufacturing AAA ratings impose costs.  AIG bore no costs, as long as regulators did not touch its AAA rating. 

Davi concludes that the reason for credit default swaps is their efficiency in trading.

the short answer is liquidity. That is, corporate bond markets are not very liquid markets. And the market for loans is even less liquid. The CDS market by contrast is a very liquid market with highly standardized agreements that allow credit risk to be sliced up and allocated in ways that are prohibitively expensive if not impossible with ordinary debt instruments.

That is true.  It is true for any derivative.  If you could take a position quickly and easily using the underlying instruments, derivatives would not exist in the first place.

Derivatives, including credit default swaps, enable investors to take and trade positions more efficiently than is possible with the underlying instruments.  Other things equal, that is a good thing.  However, other things are not always equal.  Sometimes, positions are created and traded in order to take advantages of regulatory anomalies.  I believe that is the case with credit default swaps.  If you could go back ten years and remove all of the regulatory anomalies that made it advantageous to artificially manufacture AAA ratings for assets, then I think that the credit default swap market (a) would have been harmless and (b) would have developed more slowly or perhaps not at all.

I return to my original point, which is that no institution was in a position to sell credit default swaps as a natural hedge against its other business.  As exhibit A, I offer AIG, the hole down which taxpayers are pouring so much money.  If the costs of bailing out AIG are measured against the benefits that CDS provided in the form of lower transaction costs, I do not think many of should be thankful that CDS were invented.

Having said all that, I am not sure that the lesson to draw is, "Ban credit default swaps" or "Beware of financial innovation."  Instead, the lesson I would draw is that when regulatory regimes are set up, markets evolve to exploit anomalies.  The main lesson that I would draw is that we should not place much confidence that regulatory regimes will succeed over the long term. 








Presented by

Arnold Kling

Arnold Kling earned his Ph.D in economics at MIT. He was an economist on the staff of the Federal Reserve Board. From 1986-1994 he worked at Freddie Mac. He started Homefair.com in 1994 and sold it in 1999. His fourth book, From Poverty to Prosperity, co-authored with Nick Schulz, is due out in April of 2009. He blogs regularly at Econlog.

The Best 71-Second Animation You'll Watch Today

A rock monster tries to save a village from destruction.

Join the Discussion

After you comment, click Post. If you’re not already logged in you will be asked to log in or register.

blog comments powered by Disqus

Video

The Best 71-Second Animation You'll Watch Today

A rock monster tries to save a village from destruction.

Video

The Case for Napping at Work

Most Americans don't get enough sleep. More and more employers are trying to help address that.

Video

A Four-Dimensional Tour of Boston

In this groundbreaking video, time moves at multiple speeds within a single frame.

Video

Who Made Pop Music So Repetitive? You Did.

If pop music is too homogenous, that's because listeners want it that way.

Video

Stunning GoPro Footage of a Wildfire

In the field with America’s elite Native American firefighting crew

More in Business

Just In