Ian Welsh

The horizon is not so far as we can see, but as far as we can imagine

Category: Credit Default Swaps

Insuring Shadow Banks Without Proper Regulation Is Asking For Disaster

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On April 20, 2010

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A correspondent suggested to me that what needs to happen is to create a system like the FDIC for the shadow banking system (largely unregulated financial institutions which act like banks without being regulated like them.) The argument is that this mitigates against hysterical herd behavior and that the shadow banking system is necessary because it’s where a lot of institutions put their money.  And no one is willing to insure this system but the government.

Shadow banking didn’t always exist at these levels, institutions found places to put their money.

As I understand this, it means insurance without equivalent regulation to ordinary banks—because if you used equivalent regulation you’d just make them into banks who have to follow the same rules as retail banks.  This means investors being insured who engage in extraordinarily risky behaviour in order to get returns which normal banks can’t and don’t provide.

I should note that, in fact, other people were willing to provide the insurance.  AIG did.  They just couldn’t pay up, because only the government could afford to pay up.

So therefore shadow banks, who can’t find anyone who could possibly afford to insure their risky business model, need governments to do it?

The question is if they are willing to charge the full price for the insurance?  I’ve worked in insurance, real insurance where we worry about having enough money to pay off when the loss event occurs, and here’s the way it works: it costs more than the value of the insurance.  If there’s going to be a crisis every X years because of these fools, then we need to charge enough money to not only cover the cost of their insurance every X years, but to cover the cost of things like the stimulus to clean up their messes, the unemployment insurance costs, and so on.  Or we could move to 90% taxation on all income over a million, which would only be fair, if we’re going to have to bail the rich out again and gain.

Either way, the high cost of real insurance would mean a lot lower profits.  It isn’t going to happen that way, the real cost is not something the shadow banking system is willing to pay.

And if they know they’re insured, without proper regulation, what they’ll do is drive over the cliff again.  Why not, if they know they’ll be bailed out, and in the good times they get to pay themselves massive bonuses and wages?  Moral hazard 101: heads they win, tails the taxpayer bails them out.

Maybe there are better solutions.  Like reinstituting Glass-Steagall, forcing everyone to 10:1 leverage ratios with nothing off the books, and shutting down the majority of shadow banking, which has shown that it costs the real economy more than it can possibly be worth.  What we don’t need is investors putting money into shadow banks in attempts to pursue 15%+ returns, thus ignoring putting money into the real economy.

As for hysterical herd behaviour, the real problem was the herd behaviour involved in CDOs, CDSs and the housing bubble.

Behaviour which should simply never have been allowed to occur.

If you don’t want bad behavior, don’t insure it, just outlaw it.

The 400 Billion Fannie Mae and Freddie Mac Robbery

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On December 24, 2009

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Jane Hamsher connects the dots over at FDL. The NYTimes has reported:

Fannie Mae and Freddie Mac, which buy and resell mortgages, have used $112 billion — including $15 billion for Fannie in November — of a total $400 billion pledge from the Treasury. Now, according to people close to the talks, officials are discussing the possibility of increasing that commitment, possibly to $400 billion for each company, by year-end, after which the Treasury would need Congressional approval to extend it.

Now, on the face of it, this makes no sense whatsoever.   They’ve only spent $112 billion of 400 billion and they need another 400 billion?  There two most likely possibilities, which aren’t mutually exclusive are that Freddie and Fannie have a ton of bad crap on the books that they haven’t acknowledged yet.  I have always believed that their losses would be much higher than originally acknowledged.  The second is what Jane suggests, and which I think must be part of the picture:

The White House knows it can’t get approval for more TARP money through Congress, so the administration is going to double the commitment to Fannie and Freddie from $400 billion to $800 billion, and then they can use the money to buy up more toxic assets from the banks

Jane also points out that due to a bill Rahm authored, there is no inspector for Freddie and Fannie.

Because there is a good chance the Fed will be audited, and because banks are still very impaired with bad debt (ie. they still need to be bailed out) Freddie and Fannie may be the only place left to store all the toxic financial wage—to take it off the banks hands.  In the meantime, this is a back door extension of TARP, done this way because the administration knows that Congress would never approve it.

The Next Bailout: Guaranteeing Municipal Bonds

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On May 29, 2009

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Barney Frank, chairman of the House Financial Services Committee is apparently putting together a bill to guarantee municipal bonds. In particular, variable rate demand obligations (VRDOs), which make up a little under one-seventh of the muni-bond market, have been imploding, with their interest rates jumping to higher rates, costing municipalities a great deal of money when they can least afford it.

Debt guarantees are one of the main ways the Feds have dealt with the crisis.  The Feds have promised that if a raft of banks default on their loans, the Feds will make it up.  With such promises, the banks (among others) have been able to borrow money at lower rates than they otherwise could have, and in some cases borrow money when they normally couldn’t have at all.

The problem with debt guarantees is that the Fed is on the hook.  That is to say, you, the taxpayer, is on the hook for what are essentially no different than credit default swaps (CDS), in which a private entity promises to pay up if a loan or bond defaults.  CDSs are the business which destroyed AIG.

Moreover, as with CDSs, rather than decreasing risk, debt guarantees increase them.  If you know that you’re going to get paid whether the borrower defaults or not, you’ll be willing to lend money even to folks who probably will default.  Heads you get the money, tails the taxpayer will give you the money.  This sort of systemic risk transfer is one of the major causes of the current financial crisis.

So if the government goes ahead and guarantees muni-bonds, expect defaults to increase, not decrease, as municipalities borrow even more money they can’t afford to pay back and investors lend it to them knowing they’re covered no matter what.  Then you, personally, as a taxpayer, will eventually pay for it.

Now that’s not to say that guarantees are necessarily always a bad idea.  The advantages of not having municipalities go bankrupt right now may outweigh the disadvantages.  But at the least some protections need to be added in.

First: New issues of VRDOs need to not be guaranteed.  Perhaps guarantee the old ones, on the condition that once guaranteed interest rates drop, since default chances have dropped, but not new ones.  Such bonds are inherently risky, and municipalities shouldn’t be playing in that market.

Second: new bonds guaranteed must be vanilla bonds.  Fixed rate, fixed curation, no fancy features.

Third: the municipality must have a reasonable shot at repaying its debt load.  The worst of the housing crash is not over, there is a wave of defaults yet to move through the system.  Housing prices, and thus housing taxes, will not recover to pre-crash levels for many years, probably not for over a decade, at best.  Municipal revenue projections and budgets which assume otherwise are unrealistic, and guarantees made to such municipalities will default.  That’s not insurance, that’s giving municipalities money.  So just give them the money if you want to, instead of making guarantees you know will fail.

In general, just giving municipalities the money they need is the smarter way to go.  There is going to have to be a new round of stimulus, since the last one wasn’t large enough.  One of the focuses will have to be local government.  Debt guarantees are much more problematic, due to the way they actually increase systematic risk, because of how they encourage municipalites to borrow money they may not have the capacity to pay back, and because they increase rather than decrease certainty about the final cost of the intervention.

Did AIG Never Intend to Pay Off Most Collateralized Debt Swaps?

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On April 3, 2009

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There’s an interesting article going around which notes the widespread use of side-letters in the insurance industry. Side letters were used to say “even though you’ve said that you’ll take on X amount of risk on this insurance policy, we won’t hold you to that.”  The letters were generally buried off to one side, only to come to light if things did go wrong.  Insurance companies did this because if they bought say 1 million of reinsurance for $100,000, they freed up $900,000 of regulatory capital which they could continue to use for further insuring or lending and so on.

Think of this as essentially the same as fractional lending.  Insurers have to have enough assets on book to cover their liabilities—policies they may have to pay off on.  If somene else is going to pay off on that risk because you bought reinsurance from them, you don’t need that capital.  So buying reinsurance frees up capital.  As for the seller of reinsurance, they get money in exchange for no risk, if there’s a side letter.  Win, win.

The article goes on to suggest that many Credit Default Swaps (CDSs) AIG sold may have had similiar side letters, which since AIG was never seized, may have been destroyed.  I don’t know if such side letters existed, but my take is that neither side, in many cases, expected to every have to collect on CDSs, or pay on them.

But when everything went to hell, they certainly tried to.  The key fishy problem with AIG wasn’t the bonuses, it was that counterparties were getting paid 100% of the value of CDSs with government money, something they had no right to expect from what amounts to a bankrupt company.  In such a case, either as AIG or the counterparty, why would you bring up the side letters, if they exist?  The counterparties are getting money and AIG is paying out with money that isn’t theirs anyway.

As for the government, the reason all that money was given to AIG was specifically so they could pay off counterparties—it was a way of getting money to various damaged financial firms, including overseas ones, who needed the money, without it being obvious that the government was giving that money away, especially to foreign firms, which would have caused a firestorm

So, I don’t know if these side letters existed, and it’s worth finding out because if they did, that makes all the transactions fraudulent and we can insist on all the money back and prosecute.  But the bottom line is that the government, AIG and the counterparties all wanted the money to be paid out, whether there was a legal obligation or not.  So don’t expect anyone to look too hard, unless Congress really gets the bit between its teeth.

How To Reform Credit Default Swaps

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On March 26, 2009

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Geithner was asked today if he believed in naked credit default swaps.  Apparently he does, but it was both the wrong question and answer.  Reform of credit default swaps needs to be thorough, and though through from basic principles.  Here’s how to fix credit default swaps.

The first step is a name change.  Call them insurance, because that’s what they are.  The insure against the possibility that you won’t get paid money someone owes you.  Once they’re called insurance, regulate them like insurance.

  1. Require an insurable interest.  That is, if Joe owes Fred money, Emma can’t buy insurance on Joe not paying Fred.  This is a fundamental rule in most insurance, you can’t insure someone else’s house against fire, because then you have a reason to want that house to wind up on fire, and no reason not to want it to burn down.
  2. Don’t allow over-insurance.  No debt can be insured for more than it’s worth.  If Joe owes Fred $100, then Fred can’t buy more than $100 worth of insurance.  In fact, better, he can’t buy more than $90 worth of insurance.  Again, we don’t want anyone better off if the debtor defaults than if they make the payments.  In life insurance there are many studies which show that people who are worth more dead than alive tend to die a lot more than people who aren’t over insured.  Imagine that.
  3. The mathematical models and actuarial tables used to figure out how much must be paid for insurance, the premiums, are set by government actuaries, just like they are in most other insurance businesses.  Current credit default models tended to assume things like “this housing bubble will last forever” and “there will never be another recession” and “defaults don’t cluster”.  Those assumptions were so wrong that building them into models amounted to fraud.
  4. No product which insures against credit default can be put on the market without actuaries from government regulatory bodies reviewing it.
  5. Proper reserves.  The party issuing the credit default swaps must have enough money to back them up, based on the governments actuarial charts and reserve requirements.  Life insurers and property insurers have to, so should credit insurers.  These reserves cannot be the debts the insurer is insuring.

There are other methods one could use to regulate and fix the default market, like having open exchange traded contracts, which could be made to work as well, but this is the simplest model and one that has worked well in the rest of the insurance industry.

The larger rule is simpler: no unregulated financial markets or entities without sufficient capital to cover their bets, so the taxpayer winds up stuck with the bill.  If you want to gamble, go to Las Vegas.  If you want to sell insurance, be a nice old fashioned stody insurance company who pays your executives low six figure salaries.

Does the Geithner Plan Reduce Credit Default Swap Risk Too?

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On March 24, 2009

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Credit default swaps (CDSs) are still a big issue. Estimates of how much of the market is at risk vary, but the lowest I’ve seen is about $15 trillion.  If that goes bad, we’re probably talking another $3 or $4 trillion of damage.

While I agree that CDSs are an issue, I also think that taking bad assets off firm’s hands makes defaults on CDSs more unlikely, and thus reduces exposure to them.

Of course, this really depends on whether the fundamental problem lies with the economy or the financial market—or both.  If the economy keeps going south, then bailout after bailout will be needed, defaults will happen anyway, and CDSs will be called.  If the combination of fixing the financial sector plus the stimulus bill and military spending is enough to stop the economy’s downward spiral, on the other hand, then Geithner’s plan may well do the trick (once a couple more trillion are spent). We’ll see.

(Aside: Interest rate and currency swaps are about a 7 times larger market than CDSs.  The real risk is a currency meltdown by a major economy.)

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