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Trying to make sense of arcane financial issues

Readers, I’d love your help on this one.

There was an article I read in Sunday’s New York Times that I found mildly terrifying. It focused on “credit default swaps“, a financial instrument invented about a decade ago to protect investors from losses when companies default on their bonds. This seems to me (as someone whose knowledge of financial markets is basically limited to handing money to mutual fund managers and reading the statements they send me) like a reasonable idea – some bonds are risky, and insurance might well be a reasonable hedge against that risk.

What’s scary is the size of the market, which according to Gretchen Morgenson in the Times, has grown from $900 billion to $45.5 trillion in the past eight years – the market now is twice the size of the US stock market. This isn’t just because people have wanted to insure their bond investments – credit default swaps have become a favorite way to bet against the health of a company. Instead holding a short position on bonds on GM, you can simply insure yourself against the collapse of bonds you don’t hold. The seller of the insurance – usually a bank or a hedge – is betting that the bonds will be honored, and will be paid insurance premiums in exchange for agreeing to compensate you for losses should the bond issuer default.

So far so good. But both sides of this contract are transferrable. That means that your insurer can sell your contract to another entity, who might be less able to honor the bargain. And you might find yourself trying to collect insurance from “Madame Merriweather’s Mudhut Phillipines” instead of from Citibank, as economics blogger Mike Shedlock suggests. Morgenson offers this analogy: “It would be as if homeowners, facing losses after a hurricane, could not identify the insurance companies to pay on their claims. Or, if they could, they discovered that their insurer had transferred the policy to another company that could not cover the claim.”

The fear, as I understand it, is that a major crisis of confidence in financial systems could occur if a big bond issuer – let’s say GM again – defaulted on its bonds. Those who hold CDSs on GM debt would try to collect from their insurers. If their insurers default, or if they can’t find their insurers, they’d find themselves taking significant, unanticipated losses. And other CDS holders, who bought the derivatives to hedge against bond risk, might realize that they had less protection than they thought and would have misvalued their holdings. ANZ Bank in New Zealand was forced to set aside $200 million because it holds a number of credit default swaps with ACA Capital, a New York bond insurer. ACA has had its credit downgraded from A to CCC due to losses in the subprime mortgage market. Because it is now below investment grade (way, way below), banks have to reassess the risk of their CDS hedges, as it’s possible ACA won’t be able to honor these contracts. So ANZ’s risk exposure is higher than they’d calculated, and they now need to set aside cash to cover those possible liabilities.

It’s not hard to find smart investors telling you that derivatives are a dangerous thing – Warren Buffet has said, “Derivatives are financial weapons of mass destruction.” But it seems too easy to just dismiss derivatives as making money from thin air, as some commenters have been quick to offer. It makes sense that investors would look for instruments to help them manage risk. It makes sense that one might want to purchase insurance on high-risk bond investments.

What I haven’t been able to understand is why this market is so freaking big. Shedlock observes that the market capitalization of GM is about $15 billion. There’s roughly a trillion dollars in credit default swaps linked to GM. This amount of money can’t just be a hedge against the possible failure of GM – investors could only lose $15 billion in bond holdings if GM collapsed. It’s not hard to imagine a huge fiscal catastrophe taking place if GM collapses and CDS holders discovering that they cannot collect on their insurance… or even find who’s holding those contracts.

So here’s what I’d love some help with – I’d very much like someone to explain to me why it makes sense for the derivative market in CDS to be so much larger than the market for the underlying securities. I’d also love someone to challenge Shedlock’s claims that it’s going to be extremely difficult to figure out who actually is responsible for these CDS’s and to collect against them in the case of corporate bankruptcy.

It strikes me that issues like this one represent a really serious challenge for reporters and bloggers. Clearly, the subprime mortgage crisis has had a huge impact on many people’s lives, both in America and around the world. Much of the media coverage of the situation focuses on concrete examples – here’s someone who lost a house in Detroit – rather than on large financial issues – was it really such a good idea to allow thousands of mortgages to be sold as a bundle as a single security? It strikes me that it’s very hard to concretize an issue like CDSs, and therefore, it’s pretty hard for an interested, but uninformed, reader to make much sense out of the issue. I find Shedlock much more readable than Morgenson, but I also get the sense that he’s got a serious axe to grind on the issue.

My friend Dan Caplinger, who is a regular contributor to the Motley Fool, has some very useful insights in the first comment below. Thanks for weighing in and making this a bit clearer, Dan.

2 thoughts on “Trying to make sense of arcane financial issues”

  1. Some thoughts:

    — Don’t confuse market cap with debt outstanding. Common shares are worth roughly $15 billion, but until a few years ago, GM had $300 billion in debt on its books.


    That debt got taken off the balance sheet when GM sold a 51% interest in its financing units to a private equity consortium including Cerberus.

    (see note 2)

    According to Wiki, the size of the world bond market was $45 trillion in 2006.


    So when you consider that both stock and bond investors might use credit default swaps to hedge positions, the market isn’t so large — especially when you allow a role for speculators.

    As for Mish’s positions, he posted on the Fool for years before setting up his own site and blog. Some refer to him as a “permabear” who only sees the negative sides of the economy, and his views don’t reflect the mainstream, but he has interesting insights from time to time.

    On identifying counterparties in the event of default: you’ve already seen some of that in the mortgage market. Owners of mortgage-backed securities are finding that courts won’t allow them to foreclose because they can’t prove they actually own the mortgage itself.


    In fact, in many cases, they probably don’t own the whole mortgage — it’s been parceled up into tiny bits. Getting everyone together to file a foreclosure suit will be practically impossible.

    While exchange-traded derivatives have clearinghouses that stand as counterparty, privately negotiated derivatives don’t. Yet private derivatives are indeed transferable. Presumably, private parties should be incorporating the possibility of counterparty default into their pricing decisions (and, perhaps, trying to hedge that counterparty default risk by buying credit default swaps on their counterparty, creating an interesting little avalanche of derivative transactions).

    The problem is that if the swap ends up basically getting packaged into some other complicated security, suddenly you have thousands of little swap bits floating around, where no one necessarily knows how to collect and from whom. Theoretically, there should be a clearing agent or someone in the middle to complain to — consider, for instance, the recent suit by the city of Springfield to collect on defaulted short-term paper from Merrill Lynch.


    But it isn’t always clear who that person is in the middle, especially with these more complicated securities.

    And as for the challenge to journalists, you have to understand that even the financial companies that wrote these things are claiming that they don’t really understand them. Whether that’s really true or not is another question, but to expect to condense these instruments into language that people can understand is too big a challenge for most journalists.


  2. I think there’s a misconception. Nobody is on the hook for the value of the full bond amount in case of default. The actual amount of the market is a few hundred billion dollars. The $45 trillion is just the “notional value” that they are betting on.

    The misconception is the same as if you said the market for betting on basketball is higher than for baseball because more points are scored in basketball. When in reality the amount of points in the games you’re betting on has no relation to the money at risk that you’re betting.

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