Thursday, March 05, 2009

GE Capital and Credit Default Swaps: The Jump to Hyperspace

Some of the discussion on yesterday's post regarding GE Capital turned to the problem of credit default swaps. Back in October, I outlined some of the major problems as well as the potential solutions to the CDS problem. You can read that piece here if you'd like, but otherwise here is a quick summary of the problems:

  1. CDS aren't really that liquid. In order for any market to be liquid, there needs to be a large numbers of buyers and sellers. In the old days, the big dealers were always willing to write CDS to their customers because the risk was easily passed off in some other manner. Either sell it to AIG (snicker) or put it into a synthetic CDO or some such. Today dealers aren't making a market the way they used to. They have their own credit problems to work out and aren't willing to leverage their balance sheet on this kind of trade.
  2. Thus when an event leads investors to grow concerned about a company, everyone wants to buy CDS protection at once. Yet who is willing to sell? Goldman? Morgan Stanley? There aren't a lot of players left. And let me tell you something. If Goldman is willing to sell you the CDS, it won't be 10bps back. It will be 10 points back.
  3. The problem becomes that much bigger with a name like GE Capital, which is so widely held. Goldman might be willing to quote you CDS on $10 million of some off-the-run name at a stupid price, but when the whole investing world wants protection on GE at once, its another story. No one has the balance sheet to accommodate the demand.
  4. Exacerbating this problem is that bonds aren't easy to short. As a result, firms that write CDS are almost always writing naked.
  5. Putting all this together, CDS are infinitely more manipulable than stocks. If I can't see where something is trading and at what volume, only that the quoted price is 10 points wider, my only conclusion is that the credit is cratering.

Many of these problems could be solved with exchange-traded CDS. This would open up the writing of CDS to a much wider audience. If it were done with regulated margin requirements, with the exchange acting as universal counter-party, there would be far less contagion risk related to a failed counter-party.

10 comments:

ab said...

Amen. The question then becomes why hasn't we made any progress with an exchange-traded CDS market. I realize the dealers don't want it, but why can't the CME get this started? Seems like a great opportunity for them to step in...I'm sure their other businesses are going to be hurting this year as volume drops.

Hawkeye0915 said...

I agree this sounds great, but how long would it take Wall Street (or whatever eventually takes its place once its disappearing act is complete) to create a CDS-like thingy that has almost all the characteristics that would require registration with the exchange, but not quite all? I'd have to think that's where all the big money would eventually end up, private contracts between 2 parties, with minimal disclosure to anyone else. Then we lever them up 99 to 1 again.............you can see where this is going. It may take a while but it will happen. Unless we take the extreme step of requiring ownership of the underlying bonds before buying CDS, another thing that sounds great in theory but just is not workable.

Al said...

I think you're too pessimistic on CDS. I agree that some names are not that liquid at all but Financials CDS are some of the most liquid names out there and I can normally get $100mm done no problem at most 20bps wide. I also normally see about 5+ dealers making reasonable-sized markets on GE. You also don't need much balance sheet as a dealer to trade CDS since it's a derivative ie not a funded product like a bond which would require a risk-weighted asset charge.
http://www.acredittrader.com

In Debt We Trust said...

I find it a strong conflict of interest when CDS buyers buy junk bonds so they can sit on the stakeholders' seats and push for insolvency. Any losses they incur on the bonds (which are already trading at pennies on the dollar) are more than made up for by their exponential CDS payouts.

Advant Guard said...

Isn't it redundant to have both a CDS market and bond rating agencies? If the rating agency give a company a triple-A rating but the CDS trades like a BBB rating, who you going to believe?

We should require the bond rating agencies to post a schedule of rates for each rating grades. If they rate a bond as AAA, they should be required to write CDS for the bond at the posted rate. A real case of putting their money where their mouth is. If they want to rate everything at the highest rating, they can expect to write a lot of CDS and shortly go out of business (like Ambac and MBIA almost did.)

cap vandal said...

GE should just start buying back its debt at 50 cents on the dollar. They have enough liquidity to buy billions.
Equivalent to GE selling CDS's on itself.

Only this isn't some derivative fantasy. Rather it is simply buying the underlying.

http://capitalvandalism.blogspot.com/2009/03/how-ge-can-save-itself.html

Credit Cruncher said...

I think that AI's point, on the who the seller base of CDS is, is crucial. If it wasn't "real" investors (or traditional investors) on the buy side, other than AIG, that is a problem, because that is the group that would short squeeze the market by moving CDS to a more rational price. In cash bonds, they are the other side of the trade. With no limit to the market and only one side of the trade being put on, this pricing is a problem.

Buying back debt sounds good in theory, but so does keeping cash and liquidity. That's a risky set of dice to roll...

In Debt We Trust said...

You probably heard about this by now but the SEC approved ICE for the CDS exchange. It launches Monday.

Thoughts?

DCRogers said...

Citi found a great way to stimulate more CDS sales. Shame the taxpayer will hold the bag if they fail:

http://bloomberg.com/apps/news?pid=20601109&sid=aZjMcuIoat7U&refer=exclusive

Lawrence J. Kramer said...

Exchange traded CDS contracts only exacerbate the real problem - a CDS is an insurance contract available without an insurable interest. Naked CDS contracts should be illegal, not more readily priced.