Credit default swaps are not insurance.
The most common way to describe these derivatives is to say that they’re a way to insure bonds and other financial instruments against default. I’ve used that explanation myself over and over again.
But as James Rickards explains in a column in today’s Financial Times, while these derivatives may be a way to insure against the danger of default, they very much aren’t insurance in one crucial way.
And it’s that difference that has helped turn the Greek budget “problem” into the Greek budget “crisis.”
It turns out while we’ve all laughed at Greek Prime Minister George Papandreou’s attempt to blame his country’s troubles on speculators, he had a point.
Okay, so how are credit default swaps different from insurance? The most critical difference is that while insurance regulators say you can’t buy fire insurance on your neighbor’s house—and then burn it down to collect—you can in effect do exactly that in the credit default swaps market.
In a credit default swap somebody sells protection against a default and collects a premium in return. The sellers, Rickards notes, are usually big institutional investors such as pension funds that have the collateral to put up to guarantee payment in case of a default.
The buyer on the other end of the swap is frequently another big institution looking to lay off risk or, and this is the crucial point, a hedge fund or some other relatively short-term trader hoping to make a quick profit if the odds of a default start to rise.
Think about what happens in a situation like the ongoing Greek crisis. As the odds of a default increase, the value of protection against a default rises. The buyers of that protection wind up holding the end of the swap that climbs in value every time the situation gets worse.
The seller of that protection winds up on the losing side of the swap. At best as the odds of a default rise, sellers of protection are required to put up more collateral against the possibility of a default. (Makes sense, right? More chance of a default. More collateral against a default). At worst, the actual asset that underlies the derivative, say, Greek government bonds or bonds of Greek banks, goes into default and the seller of protection has to cough up the cash.
Do you see the inherent problem in this set up?
Since the buyer of protection makes money as the odds of a default rise, buyers have an interest in seeing a “problem” turn into a “panic.”
Not all buyers of protection stand to profit as odds of a default rise. Some buyers actually own the underlying asset—Greek government bonds, for example, and they lose money when that asset falls in price as the odds of a default rise. For these buyers, a credit default swap indeed operates pretty much like insurance.
But not all buyers of protection against default by the Greek government actually own the underlying asset. They don’t own bonds that go down in price as the odds of default rise, writes Rickards. Instead the worse the situation seems, the more they profit.
The insurance industry recognizes this problem, which is why buyers of insurance are required to have an insurable interest. You can’t take out fire insurance on your neighbor’s house, for example, because you don’t have an insurable interest in that house. Buying insurance when you don’t have a stake in the underlying asset creates a perverse incentive, the insurance rules recognize. That insurance would actually give you an incentive to burn down your neighbor’s house.
Rickards may not be the most unbiased of observers. He is former general counsel of Long-Term Capital Management. Speculators of the kind he is calling out now had a role in the demise of Long-Term Capital as a result of $4.8 billion in losses during the 1998 Russian financial crisis. And there is no doubt that in the current situation Greece bears the bulk of the fault for the core budget problem: The country has cooked its books and mis-managed its finances for years.
But he still makes a very good point: the current structure of the derivatives market and the current minimal regulation of that market give some big money players huge incentives to turn problems into panics.
Remember that the next time some talking head tells you that what is actually a manageable problem means the end of the world.
Your panic could mean his profit.
Thanks for the insight Jim,
After reading this article and the NYTimes article on Greece a couple of questions started to stir that maybe you or someother reader of your blog may answer. I hear that a country can’t go bankrupt like a Bear Stearns; Why not? and is this info enough to trigger something like what we saw in Sept and Oct of last year? Would you think news like this would keep people from using stocks for their retirement, shifting money to bonds instead?
Thanks for your insight.
South, The Vanity Fair article does a decent job of explaining GS’s (small?) part in AIG, but only from the 40k foot level. It still doesn’t answer my fundamental question of whether the people holding “insurance” actually had a similar amount of money at risk? Based on the GS refusal to be transparent, it makes me think many of their unnamed clients had only tiny premiums at risk. The American people deserve to know who benefitted in this manner. I still see no one working to uncover this or interest in our government to do so. Am I wrong?
Jim,
Thanks for the tip. However, I have an internal resistance of buying stocks on a rise in order to try to sell them even higher. I put it on my watch list and will wait till it dips below P/E=12 or so.
“The country has cooked its books and mis-managed its finances for years.”
The U.S. or Greece? If we were a smaller nation with less power, I believe that all Europe would have united and bombed us to oblivion… or at least bombed Wall Street & D.C. What we have done to the world (and our own country) could accurately be termed an act of war.
I think that much of the blame for our economic mess can be placed directly at the feet of bond ratings agencies. It was their duty and well within their power to bring phony derivative trading to a halt before the problems ever surfaced by properly rating these incendiary devices. The bond ratings agencies failed miserably to provide any semblance of accurate ratings and instead were on the take for ever more consulting fees. WHERE ARE THE PERP WALKS FOR THESE THIEVES? If the people of the US are to ever again have any degree of confidence in our government, SCUM like this must be prosecuted. Is our congress too afraid that they also will be implicated for their own part in this treasonous action?
Boat, there’s been a ton of journalism on this. January vanity fair’s article on gs as but one example.
Jim, I hope you can shed some light on this: if a small group of CDS traders brought AIG down, who in turn was bailed out with John Q. Taxpayer, did these people (speculators) who bought “insurance on their neighbors house” get their full payment from our taxes? I’m not sure why we haven’t seen any kind of journalistic investigation on this. I would think that we could say that if a entity had something at risk for their CDS then AIG(taxpayer) would make it whole, but if there was nothing at risk then we shouldn’t be paying them: instead “here’s your premium back, tough luck, taxpayers won’t be funding your speculation.” Why isn’t this major story more visible? Has AIG (us taxpayers) actually paid speculators via CDS’s that they held? If yes, then can we go get it back? Can we get them named to shame them into paying it back? Where are investigative news journalists?
If I remember, Soros had given a very good explanation of this “mischief” during the peak of the financial crisis – either in NYT or WSJ. Maybe worth looking it up.
However, the next stage is what is crucial. It is easy to understand the “insuring the neighbor’s house” part, but how does one “burn” it – that is the trick…. Well, it is easy (sort of) on wall street – short the underlying security. And that is exactly what these hedge funds do. Buy CDS and then short it to death (er.. burn it). That is exactly what happened in Oct. – Dec. in 2008. And everyone is acting as if there was no malfeasance. Simple solution – must own the underlying security before you buy the CDS – how difficult can this be – even for the enlightened one in congress!?
RE:
DJBarber on 12 February 2010
It seems lately, the only way I can make this market go UP, is to short it….
Please keep shorting then, they are killing me in this market LOL. And to think, when I traded commodities the only time I made money was shorting.
Seriously though, Credit default swaps should be made illegal, as no good has come from them in quite a long time. And as Jim says, they can be used to very nefarious ends.
Thanks Jim, i dont think i’ve heard it explained so simply before, i too wondered how the speculators were profiting from Greece’s problems
Shame the regulators dont put an end to buying insurance on securities that you dont own
XY,
I totally agree, as Jim pointed out, the derivatives were designed to act as insurance. But it seems that how wall street makes there huge sums of money is by, bending the rules, or living in the ‘gray’ area, to skirt the rules. This is why people hate wall street so much, they make huge sums of money, and don’t add any value to the economy. In fact, in cases like this they actually profit from the economy tanking. There needs to be an overhaul of the financial industry, but I don’t see how it can possibly happen, especially since it would require some congressional approval.
Sounds like Mr. Blankfein has been borrowing my tax dollars to do more of God’s work.
Glad to see Congress making so much progress on financial industry reforms.
If we could only figure out a way for GS to make money by ensuring nobody in DC gets re-elected. Now that would be work worthy of $9 million bonus.
It seems lately, the only way I can make this market go UP, is to short it….
Jim,
I appreciate the information that you shared in this post about Greece. I never really look at the the situation in that manner. I feel the same way about China with the fear factor. I feel that there is a lot of negative coverage over the tightening of thier economy. This will continue to drive down China’s stock to benefit the other investors
The whole idea of “insuring” investment is really ridiculous to me. Investment, by its very nature, involve risks. If you can not take it, then don’t do it. Put your money in a bank. It is just a “brilliant” Wall Street invention to generate income for them.
Fuel to the fire
“The German economy stagnated in the fourth quarter after recording 0.7 percent growth in the previous three months, while Italian GDP fell 0.2 percent. France’s economic expansion accelerated to 0.6 percent from 0.2 percent. Greece today revised down its data for GDP for the first three quarters of 2009, indicating its recession was deeper than earlier thought. ”
http://www.bloomberg.com/apps/news?pid=20601087&sid=akPchh4Ed0Vo&pos=4