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By Martin Hutchinson
Contributing Editor
Money Morning
For frustrated investors looking to justify the ban of credit default swaps (CDS), look no further than last week's corporate bankruptcies of Canadian newsprint producer AbitibiBowater Inc. (ABWTQ) and U.S. shopping center developer General Growth Properties Inc. (GGP).
In both of these cases, credit default swaps became an actual bankruptcy catalyst - for the first time ever.
In the lead-up to both bankruptcies, the lenders who had debt outstanding - who would have the right to vote on any reorganization - had hedged their debt through credit default swaps and so stood to benefit from the company's bankruptcy. That made it very difficult for both companies to get the majorities they needed for debt reorganization, making bankruptcy inevitable.
The CDS holders were in the position of seeing a 1929-vintage stockbroker balanced on a window ledge, and yelling "Jump, jump" - while simultaneously taking bets on the result.
In the AbitibiBowater bankruptcy case, holders of credit default swaps played two key roles:
- They were spectators and potential litigants.
- And they were the generator of lawsuits.
Let's consider the first point.
When AbitibiBowater missed a bond payment on March 20, there were a lot of CDS derivatives outstanding that were close to maturity. Holders of these securities wanted to have AbitibiBowater immediately declared in default so that they could collect - a delay would allow their credit default swaps to expire.
However, non-payment of bond obligations generally does not become an actual "default" for several days (because the company is given a few days to come up with the money). Moreover, AbitibiBowater obtained a court order allowing the bond payments to be suspended while the company completed its debt restructuring. Thus, the CDS holders (to a value of about $500 million) were out of luck.
Or were they?
An International Swaps and Derivatives Association (ISDA) ruling on March 28 allowed CDS holders (as of March 20) to claim payment through a cash-auction system, as if a default had actually occurred.
The second role that CDS holders played truly was analogous to sadistic spectators placing bets at a suicide. Bowater (which had merged with Abitibi in an over-leveraged deal just two years ago) wanted to exchange its 9% bonds in order to improve its cash flow and to remove the likelihood of bankruptcy. To do this, it needed 97% acceptance from holders of bonds maturing in 2009 and 2010. The company was only able to get a 54% acceptance - largely because many bondholders also held credit default swaps, and so would actually benefit, rather than lose, from a Bowater bankruptcy.
General Growth, a shopping center developer with $27.3 billion in debt (real money even these days) - making it the largest default in U.S. real estate history - demonstrated the darkening cloud that's hovering over the U.S. commercial real estate market. It also underscored the risks of being involved with credit default swaps.
General Growth's mortgage debt had been securitized into mortgage-backed bonds, many holders of which had also bought credit default swaps, so debt restructuring proved impossible. Credit default swaps on General Growth's vaunted Rouse unit were valued by auction on April 15, and were deemed to be worth 71% of par, so investors in them received $710,000 for each $1 million of CDS they held - a nice reward for voting "no" to a corporate restructuring.
Guess what? If busted insurance giant American International Group Inc. (AIG) was the writer of any of the credit default swaps on either AbitibiBowater or General Growth, we as taxpayers have paid the profits of the guys who forced those companies into bankruptcy.
A comforting thought, isn't it?
The credit-default-swap rap sheet is becoming quite long. In the AIG case, CDS securities allowed an insurance company to write more than $200 billion worth of contracts, booking the premiums as income and reserving nothing against the potential losses, thus bankrupting itself at taxpayer expense.
Credit default swaps then allowed major banks - such as Goldman Sachs Group Inc. (GS) - to collect large sums through their holdings of AIG CDS contracts, while themselves having protection against an AIG bankruptcy, thus double-dipping at the expense of American taxpayers.
These big financial institutions have now facilitated the largest real estate bankruptcy in U.S. history - as well as the bankruptcy of the world's largest supplier of newsprint - by preventing creditors from agreeing to restructuring plans.
These same perpetrators were an accessory before the fact in the Lehman Brothers Holdings Inc. (LEHMQ) bankruptcy, because they provided the best-leveraged and highest-volume method by which hedge funds could benefit from a Lehman default - the CDS markets had much bigger volume than the stock-options markets, and better leverage and less risk than a direct short sale of Lehman's stock. By buying credit default swaps and shorting Lehman stock, hedge funds caused a classic "run" on that unfortunate institution that would probably not have occurred otherwise - or even been possible.
In each of these cases, credit default swaps have imposed costs on taxpayers, on the U.S. and Canadian economies, and on society in general. And these costs are outside the terms of their own contracts.
If credit default swaps were just Wall Street gamblers' playthings - used to "hedge" exposures and provide gaming opportunities for hedge funds - the securities might have some modest net social utility.
However, in the cases we've highlighted, the CDS market has proved to be a means of extracting rents from taxpayers and other outsiders. If AIG had been allowed to go bankrupt properly - causing huge losses to banks, investment banks and hedge funds - credit default swaps might well have died a natural death.
The rescue of AIG provided them with artificial life support - thanks to a U.S. taxpayer subsidy of more than $150 billion - a fact that has perpetuated their existence.
In terms of regulation, a moderate step would be to allow the purchase of CDS securities only by those with an "insurable interest" in a particular debt. Further provisions could be written, providing that voting rights on a debt were transferred as credit default swaps were written on that liability. You could even force CDS securities to be weighted 100% in bank risk capital calculations, as if they were direct loans.
However, even a CDS purchase to offload a direct credit risk can equally well be undertaken by a simple sale of the debt, which would at the same time transfer its voting rights in any bankruptcy.
Since hedging and transfer of a debt position is perfectly possible without the existence of credit default swaps, what valid economic purpose do they serve?
I'm one of the biggest free-marketers on the planet, but these things aren't the free market, they only work because of bank regulation and the "too big to fail" doctrine. When I ran a derivatives desk in the 1980s, we looked at the possibility of credit default swaps - it was an obvious derivatives application - but we decided that they were impossible to hedge and their payout in default was too uncertain for them to be sound financial instruments.
We were right. The market for CDS securities only mushroomed in the late 1990s because - by that stage in the long economic bubble - bankers had stopped worrying about long-term soundness if it meant they could receive larger short-term bonuses.
Let's ban them. Wall Street will scream about the loss of income, but that loss will be trivial compared to the amounts taxpayers have already paid to bail out Wall Street from its mistakes. The modest economic benefits of credit default swaps are dwarfed by the costs and distortions they impose.
Taxpayers have rights, too.
[Editor's Note: When Slate magazine recently set out to identify the stock-market guru who most correctly predicted the stock-market decline that accompanied the current financial crisis, the respected online publication concluded it was Martin Hutchinson, a veteran international investment banker who is one of Money Morning's top forecasters.
It was no surprise to our readers: After all, Hutchinson warned investors about the evils of credit default swaps six months before the complex derivatives did in insurer American International Group Inc. Then last fall, Hutchinson "called" the market bottom.
Now Hutchinson has developed a strategy for investors to invest their way to "Permanent Wealth" using high-yielding dividend stocks. Indeed, he's currently detailing a strategy that will enable investors to make $4,201 in cash in just 12 days. Just click here to find out about this strategy - or Hutchinson's new service, The Permanent Wealth Investor.]
News and Related Story Links:
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Money Morning Special Report:
Credit Default Swaps: A $50 Trillion Problem. -
Wikipedia:
Credit Default Swaps. -
The Canadian Press:
AbitibiBowater granted bankruptcy protection in Canada, U.S. -
International Swaps and Derivatives Association:
Organization Web Site. -
Money Morning Investigation of the U.S. Real Estate Sector (Part I of II):
Will the Dark Cloud of Commercial Real Estate Blot Out the U.S. Recovery? -
Wikipedia:
Too Big To Fail Doctrine -
Investopedia:
Securitization. -
SEC.gov:
Mortgage-Backed Securities. -
Wiktionary.org:
Accessory Before the Fact. -
Wikipedia:
Short Sale. -
Wikipedia:
Bank Run. -
Law.FreeAdvice.com:
Insurable Interest. -
Elsevier.com:
Value at Risk and Bank Capital Management. -
Money Morning News Analysis:
General Growth Files Biggest Real Estate Bankruptcy in U.S. History.
A very insightful and well written article.
[…] central clearing for derivatives contacts, and imposing harsh capital requirements on contracts, such as credit default swaps, which seem to be especially dangerous to the financial […]
If I count the hours spend working to pay of the inherited credit mess to the tax payer and please forget the current cost of the connection between mortgages and tax, I should work between 300 and 1200 years to pay of my mortgage, pending who you can believe how big the crisis is. I found that very positive. The reality is, by law of averaging, i can only work for another 20 years. It looks we will have a massive inflation coming up to reduce the 300 to 1200 or so working shifts back to mens real live span.
Very interesting article Martin. I always enjoy your commentary! Especially when it comes to credit default swaps!!!
This is just more evidence that business ethics cannot be regulated by law. You can teach business practices but you cannot teach business ethics because the ethics must be part of a persons ingrained integrity. Financiers will always find a creative way to ensure an advantage and a profit at the least cost and risk to themselves. Once the risk and consequences to bad decisions and actions are removed or minimized the more self serving the financial decisions will be implemented, with no thought to the consequences visited upon others or investors.
An excellent article. CDSs should either be made illegal or regulated as insurance, with proper reserving, so that payment can be made at time of default. Because of AIG's CDSs, we are using taxpayer money via AIG to secretly bail out European banks like Societe Generale, Deutsche bank and UBS. Time for a Pecora-style investigation!
Instead of banning them, why not make CDSs exchange-traded? In that case, they can't be sold w/o adequate margin, with collateral being posted on a daily basis, like most futured markets. The problem with CDSs is not inherent to them, it's that they're traded in the shadows of the OTC market, not subject to being valued by a liquid market and not properly disclosed on balance sheets.
As for the perverse incentives that they cause in favor of bankruptcy, I'm not sure that there's anything fundamentally wrong with either of the two bankruptcies you cited, or indeed with most situations when companies are forced into bankruptcy. Both companies were on life-support and insolvent for all practical purposes. Despite that, they were being run by the equity owners' representatives (the BoD), whose stake in the company was but a stub of the enterprise's entire value (a quirk of our shareholder system of ownership).
A bankruptcy in this situation is healthy and puts an end to the unhealthy situation we have when a company is run by people whose stake in it has been virtually wiped out by the judgment of the market. From the company's perspective, this is a clean exit for them and an opportunity to start afresh. The only parties affected are the equity holders, and if they hadn't already bailed by now, it probably serves them right (BTW, I owned some equity in Abitibi-Bowater, and while I mourn the money I lost, I knew the risk that this could happen over a year ago. I took the risk and I got hammered. 'Dem's da breaks.).
SRS
Once again, Mr. Hutchinson crafts a fantastic article that makes the convoluted world of CDSs perfectly understandable to the layman. I so look forward to my daily dose of Money Morning. I thank Peter Schiff daily for sending me here.
As you made quite clear, the real issue is the fact that government is preventing the free market from working its often imprecise magic. If there had been no intervention from the start, counterparties wouldn't be getting paid.
Unfortunately, because of a string of unintended consequences caused by well-intentioned but sorely shortsighted politicians going back to at least 1913, we've created a system that has turned short, hard, and fast economic corrections into extended artificial booms that become cataclysmic busts when the market tries to correct.
It seems to me that CDSs would be perfectly viable instruments if the economy that uses them wasn't regulated, and reregulated, and reregulated, and reregulated ad infinitum into something that makes the reason for their use and application irrelevant as well as unsavory when these insurance policies come due.
Eventually, the piper has to be paid. But investors who traded in CDSs never envisioned having to actually make good on the promises CDSs guarantee. At least, they never planned to pay massive amounts in the event of a financial meltdown, so they moved forward without considering the worst case scenario risks. Isn't that like getting paid for signing a contract one never expects to come due, intends to honor, or is even able to payout?
I'm sure the perverse incentives to give companies on which an institution has bought a credit default swap a push into bankruptcy will come to an abrupt halt the first time that the swap counter-party defaults on paying off on the CDS. Then the institution will realize it pushed its debtor into bankruptcy for nothing and became worse off from doing so than by allowing a restructuring where they might get paid. I doubt the till-now-overlooked counter-party risk will be long in making itself manifest. That's when these institutions will discover they signed contracts with counter-parties that never expected to have to pay off on the contracts, never intended to honor them, and never had the ability to pay out.
The economy of Estonia is on the verge of an extremely severe crash due to a high exposure to CDS.
We are the innocent victims of reckless casino capitalism, enabled by US governments who very well knew that the crash was inevitable (several economists have predicted it, for example professors Nouriel Roubini 1-2 years before and Michael Hudson 6 years before) but looked the other way.
It is fundamentally unfair that this destructive financial bomb, created by American finance gamblers and endorsed by the US government, is allowed to cause severe suffering among hundreds of millions of people outside the US. The US government carries the whole responsibility, having eliminated the regulations that were created in the 30-ies to prevent the emergence of another "megabubble" depression. Every economics and business student in the US, and consequently every financial advisor (including the great deregulator, Larry Summers) has been carefully informed during their studies about the mechanisms of the great depression and the importance of preventive regulation, so don't say you did not know. The US government must carry the whole economical responsibility for the consequences of their irresponsible actions.
US is now like someone who, because of severe carelessness, puts your house on fire so it burns down to ashes, and then demands that the owner must pay the whole bill for restoring it.
Can you understand that any remains of sympathy for the US is rapidly withering away in the world? In Europe, even many non-socialists are now detesting capitalism, describing it as a system of organized, egoistic greed for favoring the already rich at the expense of the people. The present bailout of bankers in stead of using the money for financing constructive restorative projects to help the people is a very obvious confirmation of this understanding.
It is extremely naive by the US to believe that such strong and very pervasive sentiments can be calmed by some sweet talk and lofty promises, especially when you have "burnt down our houses", creating untold suffering among millions of Europeans. I talked with the CEO of a real estate company yesterday – she wept out of despair when thinking of the thousands of honest, good people now being thrown out of their houses into misery due to foreclosures.
If the US government does not help defuse the CDS bomb, by taking due responsibility for it, it will generate intense hatred among those billions all over the world, whose "houses it has burnt down". You can forget exporting anything however cheap and useful. Do you believe anyone outside the US will ever want to buy products of a country that has destroyed your country through enabling reckless casino capitalism?
The people of the US has supported this destructive behavior by electing these irresponsible politicians. It is time that you take the responsibility for your mistake and demand that the US repents for its destructive behavior against the whole world taking the full economic responsibility for it and for the defusion of the terrible CDS bomb.
These swaps were 'profit centers', so adored by management too hubris bound to recognize the inherent defects in such 'side bets' on corporate liquidity. This is the 'spider' mentality, so well described by Jonathan Swift, which preened in their genius to spin gold solely from the 'resources' of financial legerdemain.
It seems pretty simple… doing business means taking risks. Wouldn't we all like to start a business and buy a taxpayer backed insurance policy just in case our great idea didn't work out? Wouldn't it be great if banks could get taxpayer backed insurance policies on risky loans so they wouldn't look so risky on their financial statements? NOT. The idea that anything risky can be hedged with a CDS is just crazy. It's like everyone belonging to the same MLM… who's going to be the next down-line to pay the last in? We all learned the economic maxim, "there's no free lunch" and yet, so much effort goes into schemes that seem, on the surface, to imply that there is. Well people, the taxpayers are last in here, and as payers of last resort, I'd say that those with fiduciary responsibilities of oversight and regulation have seriously screwed up this time.
[…] But here’s the rub: After all that, credit default swaps still aren’t regulated. […]
Adam Smith is right that CDS contracts should be banned or regulated as insurance. But regulation as insurance would include banning any CDS not supported by an insurable interest. That means only bondholders can buy them, and even they should have to keep some skin in the game to limit moral hazard.
An insurance contract without an insurable interest is a toxic instrument; it serves no valid purpose and creates incentives to do harm – the polar case of moral hazard. It's surprising to me that such contracts have not generated more lawsuits by destroyed companies. I know CFMA2k tried to preempt state laws on such things, but I don't see tort law in the list of preempted area, and issuing an insurance contract without an insurable interest sure seems like a tort against the owner of the insured property.
But be that as it may, naked CDS contracts are bad and should be banned.