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Regulate Cds As Insurance: Rolfe Winkler

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http://www.guardian.co.uk/business/feedarticle/8594315

By Rolfe Winkler

NEW YORK, July 6 (Reuters) - Credit default swaps nearly brought down the world financial system last fall when it was discovered that AIG Financial Products had written hundreds of billions of dollars worth of credit protection without setting aside sufficient reserves. Yet since then, pathetically little has been done to get this corner of the derivatives market under control.

There's a simple way to fix the problem. Regulate CDS as insurance. That could happen if some state insurance legislators get their way.

Treating these financial weapons of mass destruction as insurance instead of as merely swaps would subject them to sensible regulation. But Wall Street is fighting the idea because it would hammer profits and, more importantly, force them to reduce leverage.

Are credit default swaps insurance? As with insurance contracts, the seller of credit protection promises to reimburse the buyer's losses in case his creditor defaults. If that sounds like an insurance policy, that's because it is.

I recently attended a conference on derivatives regulation where a trader argued that CDS aren't insurance. Asked to describe their precise function, he struggled mightily for the correct infinitive, finally settling on "to insure."

Why the obfuscation? For one thing, to pump up the real estate bubble Wall Street needed a cheap way to hide risk, for securities they marketed to investors and for their own balance sheet. Toxic CDOs "wrapped" by an AIG insurance policy were suddenly marketable as AAA-rated investments. Risky assets retained on Wall Street's collective balance sheet could be "hedged" with CDS in lieu of holding actual capital.

In properly regulated insurance markets, when insurers ramp up risk, their regulators force them to increase reserves. As risks rise, so does the cost of insurance. Had credit protection been properly regulated, it would have been too expensive to enable the fiction that subprime risk, wherever held, was somehow free. Consequently, it's likely that risk wouldn't have been manufactured in the first place.

Another reason to confuse the issue is that Wall Street makes markets trading CDS, a far more profitable business than selling insurance policies.

Selling insurance is pretty boring thanks to regulations that date back to 18th-century England. In a recently published paper in the Connecticut Insurance Law Journal (http://link.reuters.com/fyv38c ), Arthur Kimball-Stanley argues that, in its earliest days, insurance policies were often used to gamble. Policies could be purchased for items that weren't yours, and for amounts greater than the insured property was worth. The moral hazard is obvious: Unregulated insurance gave speculators incentives to destroy property.

Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds. If CDS were subject to insurance laws, investors would be required to show an interest in the insured bonds. This would drastically reduce trading volumes, hammering Wall Street's profits. It would also reduce systemic risk.

The bank lobby counters that regulating CDS as insurance would restrict liquidity. It would, but that's a red herring. Wall Street is more concerned with the profitability of their trading desks and their ability to continue hiding risk. And in any case, markets functioned fine before CDS.

With no solutions coming out of Washington, state authorities are taking the first steps to restore order. This week the National Conference of Insurance Legislators, or NCOIL, will discuss model legislation for credit default insurance.

New York State Assemblyman Joseph Morelle, the chairman of the state's Committee on Insurance, is leading NCOIL's task force that drafted the legislation.

"Credit default insurance can provide a very valuable function in the market by protecting legitimate credit investors," he argues. "But sacrificing fundamental business practices at the altar of liquidity is dangerous."

And very expensive. The $183 billion needed so far to rescue AIG is but a fraction of the bill. To it must be added much of the cost of recapitalizing the entire financial sector, which grew ridiculously overleveraged thanks to unregulated CDS.

Does this smell like mass fraud to anyone?

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Fraud that someone was allowed to write such anoos? I agree

What's your argument for why CDS's aren't insurance / shouldn't be reserved for?

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It's been done to death on here and the internet.

http://blogs.reuters.com/felix-salmon/2009...t-regulate-cds/

No, sorry, CDS are insurance, there's really no counter argument. The difference between derivatives (not just credit derivatives) and insurance exists only in the rather feeble minds of lawyers. Gambling too - sports betting, political betting - its all exactly the same.

That isn't to say the $1B cross-currency swaps should be treated in the same way as a scratchcard or the insurance on a range rover, but that's not because of any fundamental difference in those products.

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No, sorry, CDS are insurance, there's really no counter argument.

Dear God, fountain of knowledge and expert on all things. Can you correct the wikipedia page that you no doubt authorized (perhaps you were too busy to give it a proper read?)

http://en.wikipedia.org/wiki/Credit_default_swap

"A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded."

"CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:....."

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So there is no way any fraud could exist in these CDS contracts then?

If you can find anything new in the article that we haven't discussed on here 1493 times, I will drop and do 10 press ups.

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Dear God, fountain of knowledge and expert on all things. Can you correct the wikipedia page that you no doubt authorized (perhaps you were too busy to give it a proper read?)

http://en.wikipedia.org/wiki/Credit_default_swap

"A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded."

"CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:....."

CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:

- The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event.[1][2][3][4] In contrast, to purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt obligation;

- the seller need not be a regulated entity;

- the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;

- insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;

- in the United States CDS contracts are generally subject to mark to market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;

- Hedge Accounting may not be available under US GAAP unless the requirements of FAS 133 are met. In practice this rarely happens.

Legal distinctions, not physical differences. A CDS is a gamble on the default of a company, flood insurance is a bet on floods.

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If you can find anything new in the article that we haven't discussed on here 1493 times, I will drop and do 10 press ups.

Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds. If CDS were subject to insurance laws, investors would be required to show an interest in the insured bonds. This would drastically reduce trading volumes, hammering Wall Street's profits.

Is this accurate reporting? Was there $20bn of CDS referencing $2bn worth of bonds, or is this just everyone hedging there own bets meaning the writer fails to understand the workings of CDS?

If you are going to do the press ups can you film it and post on Youtube so that we know that you've done them, obviously you'll need to reference this site to prove it's you and not you just find some bloke doing 10 press ups. :P

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Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds. If CDS were subject to insurance laws, investors would be required to show an interest in the insured bonds. This would drastically reduce trading volumes, hammering Wall Street's profits.

Is this accurate reporting? Was there $20bn of CDS referencing $2bn worth of bonds, or is this just everyone hedging there own bets meaning the writer fails to understand the workings of CDS?

If you are going to do the press ups can you film it and post on Youtube so that we know that you've done them, obviously you'll need to reference this site to prove it's you and not you just find some bloke doing 10 press ups. :P

Apparently Noel knows everything there is to know about finance and financial products, and we should just take his word for it. Because if we don't, we must be stupid.

And any of us who think that the financial system was less stupid when CDSes didn't exist must just shut up, right?

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Apparently Noel knows everything there is to know about finance and financial products, and we should just take his word for it. Because if we don't, we must be stupid.

And any of us who think that the financial system was less stupid when CDSes didn't exist must just shut up, right?

That is not what I am saying at all you cretin. Did you partake in the thread many aeons back where we all discussed this? What is the point in going over the same old ground again.

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Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds. If CDS were subject to insurance laws, investors would be required to show an interest in the insured bonds. This would drastically reduce trading volumes, hammering Wall Street's profits.

So what? CDS is a derivative instrument. Options and futures may also be sold in bigger volumes than the underlying market, have you ever had a go at those, too? In fact, that is the very purpose of these instruments: to have more resilient and deeper markets when trading the risk of the underlying - many may use the as speculative instruments, but the true reason these derivatives exist is easier hedging of the credit (CDS) or other risks respectively. As a person lacking trading experience you may be understandably unaware how funny and absurd the underlying market can get in credits at times - it can be easily squeezed, especially in such shallow markets as these days. No offence meant, simply some points to take into account.

And don't forget that a CDS contract has two parties involved: what one is paying, the other is receiving. In case there is a credit event, CDS contracts get cancelled out without involving the delivery of the underlying, i.e. simply cash settlements take place. CDS contracts get revalued daily and marked to market. What one counteparty makes (cap gain + carry) is exactly the mirror of what other one loses and there is no net exposure in the system. 20bln u referred to in that specific case is probably the total gross volume outstanding where market participants are 10bln long and 10bln short. Net position is 0.

As Noel said, these things have been discussed in length a number of times.

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And don't forget that a CDS contract has two parties involved: what one is paying, the other is receiving. In case there is a credit event, CDS contracts get cancelled out without involving the delivery of the underlying, i.e. simply cash settlements take place. CDS contracts get revalued daily and marked to market. What one counteparty makes (cap gain + carry) is exactly the mirror of what other one loses and there is no net exposure in the system. 20bln u referred to in that specific case is probably the total gross volume outstanding where market participants are 10bln long and 10bln short. Net position is 0.

Back to the net position is zero again, yes I know this has been argued about ad infinitum in the past.

If the net position is 0 is that an inflationary cost in the system?

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That is not what I am saying at all you cretin. Did you partake in the thread many aeons back where we all discussed this? What is the point in going over the same old ground again.

And again

No, I did not partake in this thread - a pointer would be handy. All I see is you making a series of unsubstantiated assertions that people are wrong, and my scientific training dislikes this.

For instance, you claim that a CDS is not insurance whilst pointing to a page that shows that CDS is exactly like insurance, except unregulated. That's not exactly a convincing argument. It's a bit like taking all the bodywork and lights off of a car and declaring that it's no longer a car. It is, just not road legal..

My more general complaint about both CDSes and other 'innovative' financial products is not about the huge notionals, but that I have seen no explanation of their real-world value. For example, if (as I would expect) my example pension fund holds many bonds, then the total payments for CDS insurance must (if correctly priced) exceed any losses that would be incurred through default. The only case in which this would not be true is when lots of defaults happen unexpectedly - which is o course where the pricing models break down anyway and counterparty default is likely to happen.

So as far as I can tell these products don't add any value; they merely take an income stream from investors. After all, the profits generated must come from somewhere - this is very much a zero sum game.

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No, I did not partake in this thread - a pointer would be handy. All I see is you making a series of unsubstantiated assertions that people are wrong, and my scientific training dislikes this.

For instance, you claim that a CDS is not insurance whilst pointing to a page that shows that CDS is exactly like insurance, except unregulated. That's not exactly a convincing argument. It's a bit like taking all the bodywork and lights off of a car and declaring that it's no longer a car. It is, just not road legal..

My more general complaint about both CDSes and other 'innovative' financial products is not about the huge notionals, but that I have seen no explanation of their real-world value. For example, if (as I would expect) my example pension fund holds many bonds, then the total payments for CDS insurance must (if correctly priced) exceed any losses that would be incurred through default. The only case in which this would not be true is when lots of defaults happen unexpectedly - which is o course where the pricing models break down anyway and counterparty default is likely to happen.

So as far as I can tell these products don't add any value; they merely take an income stream from investors. After all, the profits generated must come from somewhere - this is very much a zero sum game.

"No, I did not partake in this thread - a pointer would be handy"

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Back to the net position is zero again, yes I know this has been argued about ad infinitum in the past.

If the net position is 0 is that an inflationary cost in the system?

A CDS contract does not itself create any money. What one counterparty is making, the other is losing.

Now, if anything, money could be destroyed if a credit event happens and the party short the CDS needs to pay up the "insurance" to the party long the contract. In theory, it may cause serious cash flow problems if a sound credit goes bust one day, like a lighting from blue skye, and the counterparty short this CDS needs to pay up unexpectedly. In practice though this is highly unlikely:

1) credit does not deteriorate overnight meaning that outright short CDS positions affect P/L gradually - it's leaking and loss is coming daily;

2) As long as the underlying does not default, one counterparty pays to another the agreed coupon ("insurance premium") every 3 or 6 months.

3) there are risk limits of how much one can have outright position and it's measured by something called VaR (value at risk) - first, this puts a limit on how much of a naked position in a name an organisation can have, to start with; second, if credit deteriorates, the VaR of the open position goes up, breaches the limit and at least a part of it must be closed ASAP and loss capitalised in real cash flow terms;

4) in credits that are distressed (say, CDS is 1000bps and above) - on the sovereing front, examples include Ukraine and Argentina, just to name a couple - the CDS trades "up-front" meaning that the potential carry of the CDS contract through its theoretical lifetime is expressed in NPV terms and settled up-front. This is done in names that are very certain to default during the life-time of the CDS involving decent cash settlements in the future. When the panick was hitting the highs half a year ago, Argentina or Ukraine CDS were settled at 6-7mln upfront to "insure" 10mln nominal position.

5) CDS cannot be traded by amateurs or retailers (minimum lot is $5mm usually). There have to be risk limits established, lines open with counterparties, agreements signed, i.e. counterparties must be creditworthy. CDS are not traded anonymously with unknown buyers/sellers, you are not walking a high street and entering a shop of your choice doing anonymous transactions. This is in stark contrast to some mortgage backed securities where the holder cannot be sure which mortgages is he exposed to - the very reason the hell broke loose 2y ago.

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Dear God, fountain of knowledge and expert on all things. Can you correct the wikipedia page that you no doubt authorized (perhaps you were too busy to give it a proper read?)

http://en.wikipedia.org/wiki/Credit_default_swap

"A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy or even just having its credit rating downgraded."

"CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:....."

Your point is? The only differences listed are those that suggest it is just an unregulated insurance market. CDS's are insurance policies that, because of lack of regulation, have turned into gambling tools. Derivatives as insurance are positive lubrication for the financial system...as tools for raw speculation they are a serious danger. We don't allow people to take out insurance policies without an interest in the underlying for very good reasons, why should financial institutions be allowed to behave differently?

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Your point is? The only differences listed are those that suggest it is just an unregulated insurance market. CDS's are insurance policies that, because of lack of regulation, have turned into gambling tools. Derivatives as insurance are positive lubrication for the financial system...as tools for raw speculation they are a serious danger. We don't allow people to take out insurance policies without an interest in the underlying for very good reasons, why should financial institutions be allowed to behave differently?

Where is the problem? Lehman was a serious enough case - did you hear of anything after it? Ecuador did default on the sovereign front, did you hear any lamenting on the CDS front? GM has been trading as bankrupt, i.e. CDS positions have been revalued to the recovery values of the underlying, have you got any evidence of any distress caused? At times it feels media has managed to spin this so hard around that they have managed to get attention away from the true problems. A CDS is not to be blamed for the sub-prime fall out. CDS is the most efficient credit market out there that assesses creditworthiness of an entity better and more timely than the cash market often dragged around by retail sheeple not knowing where to park their money.

Edited by Meerkat

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Where is the problem? Lehman was a serious enough case - did you hear of anything after it? Ecuador did default on the sovereign front, did you hear any lamenting on the CDS front? ...

The CDSs created to provide insurance for the CDOs? We all know that securitisation is perfectly harmless. Over $100 billion of US taxpayers money didn't flow out to the banks through the bailout of AIG's CDSs

Yep, I agree, there was no problem. :blink:

That was sarcasm in case it wasn't obvious. You can argue that it was the CDOs (or whatever else you like) but CDSs "allowed" banks to take even bigger risks 'cause they had bought "insurance". Of course AIG had insurance too...provided by the taxpayer. This is the problem. CDSs are zero sum only until one counterparty becomes insolvent. This seems to be a blind spot for everyone who comes on here defending the (over)use of derivatives during the past decade...the counterparties involved were huge companies, their positions were clearly highly correlated, and their failure has had real effect...which kind of makes a laughing stock of your point number 5 in post 17 above. Clearly AIG were amateuers (or crooked). Similarly, credit may not deteriorate overnight, but it certainly deteriorated fast enough to destroy a few banks and insurers (your point 1). Point number 2 was dealt with above, and as for point number 3, clearly AIGs VaR calcs were out too.

Edited by D'oh

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You can argue that it was the CDOs (or whatever else you like) but CDSs "allowed" banks to take even bigger risks 'cause they had bought "insurance".

Is there any regulatory issue with CDS and soverign debt, or how will someone cover for the UK defaulting on a payment. At that point it's probably

a world wide collapse.

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The CDSs created to provide insurance for the CDOs? We all know that securitisation is perfectly harmless. Over $100 billion of US taxpayers money didn't flow out to the banks through the bailout of AIG's CDSs

Yep, I agree, there was no problem. :blink:

That was sarcasm in case it wasn't obvious. You can argue that it was the CDOs (or whatever else you like) but CDSs "allowed" banks to take even bigger risks 'cause they had bought "insurance". Of course AIG had insurance too...provided by the taxpayer. This is the problem. CDSs are zero sum only until one counterparty becomes insolvent. This seems to be a blind spot for everyone who comes on here defending the use of derivatives over the past decade...the counterparties are huge companies and their failure has real effect.

"The CDSs created to provide insurance for the CDOs?"

Noone is disputing that AIG was a problem. But that was a very small (no of trades) part of the market. Why focus on that?

" CDSs are zero sum only until one counterparty becomes insolvent."

Don't understand this - why doesn't collateral posting work - have you discovered a flaw?

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For anyone wondering what they are talking about here is a little lesson about CDS's..

Linky

Decide for yourself whether it is used as insurance or not.

Maybe if there is another aspect to CDS's not covered here Noel could enlighten us (in laymans terms ;) )

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" CDSs are zero sum only until one counterparty becomes insolvent."

Don't understand this - why doesn't collateral posting work - have you discovered a flaw?

If collateral posting was enough, why did AIG need an external $100 billion to pay off their obligations?

$100 billion is $330 for every man woman and child in the US. Iirc AIG has had nearly $200 billion straight from the taxpayer. Isn't that proof of a flaw? If AIG was a "small" problem, I would hate to see a big one.

Moreover, my point is that CDSs allowed institutions holding large CDO positions to claim/believe they were protected/hedged...hence allowing further increases...but all this did in the case of AIG was remove the risk from one institution (allowing it to expand its holdings and hence the securitisation mess) to another (AIG) and hence to the taxpayer.

The double whammy to the average Joe is that house prices were also bloated by securitisation, and whilst there were some winners, on average, I suspect the average member of society has lost (in the end due to financial friction, i.e. increased mortgage interest, excess consumption with little utility etc.) So, you pay more for your house and you pay more taxes to bail out the system that created the conditions in which you had to over pay for your house (or more correctly, the piece of earth lying under it.)

I just cannot see how it can be argued that CDSs have been innocent in this whole mess? Meerkat listed a number of points in post 17 which I presume were meant to imply CDSs are/were a harmless sideshow. I don't believe it, and in the case of AIG it appears that 4 of the checks, which make a single CDS contract harmless didn't stop a herd of them causing massive problems.

Edited by D'oh

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