Bloomberg Article on CDS...Plus I think Buffett Is Wrong

I ran across a very good article on CDS, with some neat insight (such as how it is in the interest of CDS dealers to keep the market opaque; or how primitive the pricing system is (I'm actually shocked to see how lame it is.)) If you have time to kill (it's kind of long) and are interested in what was happening in the credit markets while Bear Stearns was imploding, I recomend reading the article. Here is a taste of it:

(source: Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults By David Evans, May 20, 2008. Bloomberg.com)

The banks played the role of dealers in the CDO market as well, and the breakdown in that market holds lessons for what could go wrong with CDSs. The CDO market zoomed to $500 billion in sales in 2006, up fivefold from 2001...

By the middle of 2007, mortgage defaults in the U.S. began reaching record highs each month. Banks and other companies realized they were holding hundreds of billions in toxic debt. By August 2007, no one would buy CDOs. That newly devised debt market dried up in a matter of months.

In the past year, banks have written off $323 billion from debt, mostly from investments they created.

Now, if corporate defaults increase, as Moody's predicts, another market recently invented by banks -- credit-default swaps -- could come unstuck. Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.

``There's a high probability that many people who bought swap protection will wind up in court trying to get their payouts,'' he says. ``If things are collapsing left and right, people will use any trick they can.''

The article talks about the potential for a collapse in the CDS market due to the looming increase in corporate defaults. Corporate defaults have been extremely low in the last few years and that's one reason a lot of private equity takeovers were easily done (often via the use of junk bonds). In addition, several companies issued bonds and used the proceeds to buy back stock (this actually isn't a bad idea if you have low leverage and interest rates are low but it's still probably best for companies to buy back stock using their internal cash flow).

I still think that there is no way anyone is going to regulate OTC markets--especially if some of the players are unregulated parties such as hedge funds. I think the best thing would be for the government to ban regulated banks (commercial banks, investment banks, etc) from dealing with unregulated entities (such as hedge funds, foreign funds run from anonymous tax havens, etc). It will be very painful for JP Morgan, Citigroup, et al, to give up their lucrative involvment in the shadow world (shadow world refers to the unregulated world) but it would avoid any detrimental impact on the rest of the economy. You'll end up with parallel banks that are isolated from each other. If something blows up in the shadow world, well, that's capitalism ;) I think it's dangerous for a "normal" bank that has access to the Federal Reserve to load up on these unregulated derivatives. To make matters worse, these players are taking bank deposits and using them in unregulated business with very little knowledge of the true risk.

Having said all that, some people in the investing world don't think there will be much of a problem with the CDS market. You can add Buffett and Munger to that list. The most surprising thing I heard from Buffett and Munger in this year's annual meeting is their sanguine views on the CDS market:

(source: 2008 Berkshire Hathaway Shareholder's Meeting Notes. Transcribed by Peter Boodell; courtesy Reflections on Value Investing)

(WB = Warren Buffett; CB = Charlie Munger (yes, some newbies might not know who Warren and Charlie are ;) )

WB: I think there is no question that corporate default rate will rise. That has been included in price in writing this insurance. Will CDS market lead to chaos? Probably not, but if bear had failed you would have had chaotic conditions. A CDS is a payment by one party to another. When someone loses money on a loan, they’ve lost real money, but there is not a swap of dollars immediately when loan goes bad. In CDS, there is an exchange of cash. Whether counterparties fail -- I don’t think it will happen. We’ve had enormous collateral payments from one firm to another in this recent crisis. Fairfax Financial made $1bil in CDS. This means another guy lost $1bil. They have been most volatile of instruments – and it really hasn’t created a problem in system. If Fed must step in, I don’t think it will be due to CDS. It may cause big losses, but will be matched by big gains by others. There is a problem of an overnight disruption in the system (bear, nuke bomb) – where discontinuity and collateral postings inadequate. At that time, large CDS exposure could exacerbate chaos to considerable degree.

CM: Could we have mess in CDS? Yes, but stupidity not as bad as sweeping bums off skid row to give them houses. There is an issue of insuring against outcome of losing money on $100mil bond issue, when you have $3bil of contracts on $100m bond issue – there are incentives to manipulate the smaller loss to make big collection on the larger position. It used to be illegal to buy life insurance on people you didn’t know, with big payoffs in event of their death. Why did we want enormous bets to be made in unregulated markets? We have a major nutcase bunch of regulators and proprietors in this field.

Similar to what Buffett and Munger mentioned, I also think the final losses won't be too bad because derivatives are a zero-sum game. But if there are counterparty losses then it won't be zero-sum and can result in wealth destruction. My problem isn't so much that I fear losses. Some people are scared of derivatives because of the losses but I am not, given that they are a zero-sum game. My concern is that they can bring down a "normal" bank such as JP Morgan (#1 bank with derivatives exposure) or Citigroup or Merrill Lynch. Losing those banks--if it happens--will cause massive damage to the financial system. Overall, I actually think derivatives are a financial innovation and are good for the economy in the long run.

As a side note, I wonder if Buffett is starting to turn positive on derivatives now that he is embracing them a lot more. Buffett seemed to be almost vehemently against them a few years ago but now is using them quite a bit (including writing sizeable put options on some stock indices).