I speculated here that credit default swaps would make it difficult for GM to reorganize outside of bankruptcy. Other people agree that CDSs are a problem for out-of-court restructuring, including the Financial Times, George Soros, the Economist, and Professors Henry Hu and Bernard Black. The International Swaps and Derivatives Association (ISDA), the trade group for issuers of this stuff, has labored mightily, and brought forth a paper explaining that all those people, especially Hu and Black, are wrong.
This paper is in the same category as the notorious AHIP/PriceWaterhouseCoopers paper on the public option. The industry is trying to kill regulation, because banksters are making tons of money off their unsophisticated clients. Intellectual dishonesty is a tool in this struggle.
The claim of Professors Hu and Black is that bondholders protected by a CDS have different interests than unprotected bondholders. An unprotected bondholder only cares about whether the debt is worth more in or out of bankruptcy. For the protected bondholder, the issue is whether to hold out for a credit event, like bankruptcy, which will force the CDS counterparty to pay off the face amount of the debt. Other factors include whether there is a market for the CDS at that point, one with buyers, so that it might be better to sell the CDS and/or the debt instrument or both. These factors are beyond the economic question of the value of the debt. There is every reason to think it may be more profitable to force a bankruptcy than to participate in a workout, even if the workout is more profitable for the non-protected bondholder.
The ISDA paper doesn’t address the possibility of differing interests. Instead, it argues that there is no evidence that the existence of CDSs affects the number of out-of-court restructurings as compared to bankruptcy restructurings. One of its arguments is that in an 18-month period between 2008 and mid-2009, 11 companies were able to complete restructurings even though there were CDSs protecting their debt.
The paper doesn’t explain how this fact supports the argument. The restructurings were done by tender offer for a portion of the debt at distressed prices. The restructuring company offers to buy the debt at much less than a dollar for a dollar in debt, sometimes as little as $.20 on the dollar. They don’t insist on buying the entire issue, just a part of it. Tender offers like these might well have succeeded whether or not the tendering debt holders had CDSs. They provide no useful information about whether the factors deemed important by CDS holders would be different from those of unprotected debt holders. In fact, it isn’t clear how anyone would know whether CDSs affected any investment decision, because no one knows for certain who actually has them.
The ISDA paper is an example of one of the fallacies Nassim Nicholas Taleb describes in The Black Swan, which he calls the Ludic Fallacy. Casinos put most of their risk management efforts into catching cheaters, who aren’t likely to be able to make huge dents in their profits. It turns out that the real risks to casinos are outside the gambling tables. Taleb explains that four of the largest casino losses came from a) the injury to star performer Roy of Siegfried and Roy, b) an unhinged contractor who tried to blow up a casino, c) a clerk who failed to file important tax papers, and d) the kidnapping of the daughter of the owner, which caused him to dip into the till in an illegal way to raise ransom money.
The ISDA paper ignores the Ludic Fallacy. It assumes that all of the risks can be identified by looking at a single market. Wrong. No one can predict the interactions of multiple markets, multiple trading strategies, the different motivations of the players, and the impact of real world events. Nor can anyone predict what new interactions players can use to try to make money. The problem can’t be solved with smart people or big computers. It’s too complicated, and there are too many unknowns.
The ISDA paper doesn’t discuss the failed General Motors efforts to get an out-of-court settlement. Did I mention intellectual dishonesty?




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I assume you did not expect any honesty ISDA in the first place so you aren’t disappointed with them. However, disgusted is allowed.
I kind of feel like I did when I saw the AHIP paper: do they really think we are stupid? No one reads this stuff who can’t see through it, so who is the target audience? The PR stiffs for the association?
Data mining. My Wall St. economist competitors were experts at that. Look very carefully for something that supports your preexisting notion and ignore all the evidence that refutes it.
Isn’t that what Faux News does every minute of every day?
They know the MSM is lazy and won’t bother to check.
Nope. Not at all. Faux just makes it up as they go along. They don’t even bother looking for a scintilla of data that supports what they assert.
All this crap is just another way to transfer wealth to the Rich & Powerful…And they never risk their own money… we be fucked…
Let me count the ways.
Great, great read Massaccio . . thanks.
You sure know your stuff, and I appreciate it . . there are also 5 comments above me now, that are spot on. Ok now there are more comments above me that are spot on. Hi Nahant!
Smart folks with experience in the matters at hand . . . you all make the rest of us better informed.
For Those With A Need For Four Days Of Reading About Corruption On Wall Street, On Main Street, And On All Streets.
The pull-it-out-of-their-asses routine?
That’s more like it.
Hi eC & Larue (:>))
And yes there are many ways the Rich are sucking the wealth out of the middle class… Like I said “We be Fucked”
Hi nahant.
It’s pretty amazing how rapacious the combo of corps, govt, media & analyst whores can be. Or not amazing.
I looked at your link. It looks like it’s very much into the weeds. Though some articles seem to be of more general interest like role of naked short selling wrt Bear Stearns & Lehman. How do you use the site?
ISTM that the ISDA paper assumes that the thought processes of bond or debt holders can be thoroughly documented in some way. Why else would they insist there was no evidence of CDS causing a debt holder to opt for a bankruptcy?
These instruments wreak distortion, period. Value is no longer important – an indicator that this entire industry creates none.
What’s important is eliciting an “event of default” and whether the bookie can pay off on his end of the bet – before too many other bettors come calling for their money, too.
Racketeering used to be a felony. Now it gets you a corner office in Manhattan and a house in the Hamptons. Time, I think, for this house of cards to shake a little.
Thanks. You have to read these papers as a lawyer reads a brief. What do they put in? What isn’t there that should be. Only then do you understand what they think their weakness is.
I don’t pay much attention to the ISDA for this reason. Besides as we saw with AIG, Goldman used AIG to short the subprime market and then left AIG and ultimately taxpayers to foot the bill for their bet. So shorting with derivatives could be accomplished in other ways. Shorting specific companies via derivative plays is just a subset of derivative related shorting.
I’m going to guess it’s the pundits and popular press, who will pass on the conclusions without bothering to either understand or elaborate on the thinking behind it. Now, there’s a “she said” for the “he said” of Hu, et. al.
It strikes me as being in the same vein as employers betting on their employee’s health, instead of buying health insurance.
I can see it now – Goldman-Sachs-Capone
Except this is a global threat.
Of course, Wall St. and O admin would refute that by pointing to the profits that they make. In economics, profits are “value.” But then, the other “of course” is that they never deduct for all the value outside of Wall St. that Wall St. destroys. Netting negative value.
Thanks for the article.
Part of the CDS defense that I’ve read in blogs seemed to be about liking the idea that buying a CDS allows the purchaser to change the risk, via a third party, for bonds were the risk was mis-priced during purchase. Buy some relatively inexpensive bonds where you really expect a default and use a CDS get a payoff when they fail. Your sentence “There is every reason to think it may be more profitable to force a bankruptcy than to participate in a workout, even if the workout is more profitable for the non-protected bondholder.” being at the heart of the matter. An interesting thing about a CDS is that the contract can be sold to a third party. This puts that CDS holder in the position of wanting to see a default for a company in which they might have neither stocks nor bonds. How that makes business transactions anything other than more chaotic is hard to determine. So long as the swaps are unregulated the people with the best inside information, which is to say mostly the members of the ISDA, can potentially use what they know to make money based on information not publicly available.
The ISDA would loose their golden goose if regulation and transparency were introduced. You made a good attempt to show both sides but if investing is not going to simply be a rigged roulette game manipulated by an unknown number of insiders then the CDS market must be transparent to everyone.
OTOH, it’s not quite as ghoulish.
A very sad part about this scenario is there are millions of ex-GM employees and present employees whose life savings were and are tied to GM . But many of them are becoming road kill because of how Wall Street and Congress has gamed the playing field to the advantage of the high rollers . The people that were involved in the deregulation of the banking system (and you know who you are) are criminals to have allowed the life savings of millions of poor Americans to be used in a game in which the poor Americans knew nothing about or the jeopardy their life savings were in . Most people (including retirement fund managers) do not know how a stock or security value can be manipulated even by a small trader . Unless they are gamblers they should stay away from Wall Street with their money .
Whatever happened to only gambling what you could afford to lose?
This is a direct result of abandoning actual value for “gambling” value.
Prior to Graham-Leach-Bliley, there were about 8 or so very big REITs (Real Estate Investment Trusts) who routinely purchased mortgaged backed loans. Fannie & Freddie’s role was to facilitate those sales to the REITs.
Prior to Graham-Leach-Bliely, everybody understood that a REITs yeild was going to be in the 6,7,8% yeild range. That wasn’t good enough. Greed is good yanno. Never mind the old wisdom of diversification – bet on some high risk, mid risk, and low risk to whatever proportion your risk could stomach.
So we abandon Glass Steagall, and make ALL STOCKS perform at their highest risk level! Actual mortage value? BE DAMNED!
This is unsustainable; all industries will not yeild 30/20/even 10% returns. I view it as nearly impossible to truly diversify under today’s market conditions, as long as banks-can-be-insurance-can-be-securities.
Restore Glass-Steagall!
While you know better than I do, I’d say their audience is the folks that might want to regulate them. Write a couple of papers from various sources and see if one of them floats for a little while. Refine them and find a couple politicians to front the results. Folks like Barney Frank have mentioned more than once that this stuff is not for mere mortals. Just got to make it sound plausible. Maybe they’ll do better next time.
You can afford to lose trillions if you can count on the U.S. taxpayer to pay you when you lose.
It ain’t gambling when the dice are loaded.
EOH, you might enjoy reading the SunTrust case, In BKB Properties, LLC v. SunTrust Bank, 2009 WL 3169677 (M.D. Tenn. 2009). Judge Trauger granted summary judgment to the bank on a fraud count arising from a swap transaction. Here’s a sample:
So we fall back on “let the buyer beware” as a business motto.
Yes, that’s the problem.
Duuhh ya think so… That repeal has caused this Country more damage than meets the eye… We will be paying for this debacle for a generation …
Talk about taxing the future…
Even then, in ’97 & ’98, prior to GLB (Graham-Leach-Bliley as opposed to GLBT!) there was still the problem of “hot money.”
You gotta remember 10 years ago; DOW going bonkers on Tech Boom (which was the result of overselling internet capacity, much less promise of revenue. At the bank, we called them “DotCommunists” !)
People with housing equity were trying to get better yield, so they refinanced, took max cash out and put in the market. The market bottoms and lo, now that GLB is gone there is a Second Coming! Let’s Try Again!
So now there are these NINJA loans, and many were deceptive.
I specifically bought a shredder in 2002 to destroy all the refi-cashout offers Mr. B and I got. (They were deceptively in the form of checks, which if you endorsed them, you agreed to a refi or 2nd) We’d keep them till they added up to a million, then laugh and shred them.
The bottom line is this; since we didn’t play that game, guess what? We are not underwater in value, even in a slow market. There is no way if I had to sell this house tomorrow that I’d be underwater.
Thank you masaccio. Once again, you clearly present thought provoking and challenging material.
Excellent post, Masaccio, refuting the illusion that our financial system had some cracks between which the economy slipped through. In fact, the entire foundation was laid by two famously enterprising swindlers … Goldamn Sucks.
If you haven’t figured out where the real economy ends up, read to the end of the story.
http://www.mindfully.org/Reform/Emperors-New-Clothes.htm
Hey nahant – thanks for the jokers
Pretty much. I have to agree with the Judge that the swap agreement is difficult, but sticking the problem on the borrower instead of the bank is tough indeed.
So you saw the stories today on Geithner’s NY Fed two (faced) step with AIG, eh?
typically strong piece masaccio.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aXIvW4igKV38
The audience is somebody who is already bought-off and needs some kind of explanation, anything they can tell the public/investors/etc. It’s like the Bushie idea of explaining things with lies because the truth is too horrific.
Why go into Iraq? 15 reasons, all lies, but somehow the MSM bought it. Well, we don’t have to and an economy based on that is doomed to crumble as ours tried to do in late 2008.
And once you have an incentive structure which values bankruptcy above $.80 on the dollar payoffs or if you have naked CDSs where bankruptcy is the only thing of value, then you’re bound to have forces pushing for the maximum pay-out and utter destruction for everybody else — even if it’s the nation’s or the world’s economy. In that structure (established by gov’t) the actors are entirely amoral and innocent of evil when they destroy. It’s the gov’t which set that structure and it’s dynamic into place which is corrupt.
Now, if you simply had a stupid or otherwise disinterested government (not even corrupt) and you had a devious conniving industry which set this up over time, so as to not draw attention…
Consider the idea that a business owner claims he has an interest in his employee’s health, so insurance on them isn’t ‘naked’.
The employer pays premiums on the insurance and the person doesn’t die, so that over time there’s an investment with no obvious ‘return’. Whatever can be done to get a payoff or to at least return the maximum to avoid any ‘loss’?
It’s a bad incentive structure.
Consider a homeowner who buys insurance and nothing goes wrong, but they keep paying premiums. They normally wouldn’t consider harming their own home because it has value. What happens when there’s a huge bust (the first major loss of housing value ever)? If the value of the house drops below the amount their insurance would pay-out…
It’s a bad incentive structure.
Expand your view for a moment.
What happens if we’re not just talking about the market of stocks in America, but the world economy (not stocks, the real economy)? If you consider the same techniques they use with CDSs and destruction capitalism to run down the value of one thing, so another appears more valuable, then what if you run down America’s economy and entire industries to make your investments in foreign companies/stocks appear more valuable? What if you destroy the dollar, so other currencies seem more valuable?
The entire idea of gaining wealth by destroying somebody else’s is destruction capitalism and it’s disgusting and a threat to America and the world economy (as we’ve seen this past year).
In warfare this concept is somewhat valid, but in commerce it’s poison.
well said
What we need gov’t to do is watch the game and when it disintegrates act as an insurance backstop, but start sending out bills to those who brought this on and who benefitted from it. Charge them as though the bailout was a high-interest loan and maybe, over time, they will see there’s no way around the taxing power of gov’t.
It seems the entire idea of pre-qualified credit cards and re-fi loans in the form of checks should probably be made illegal.
Is there any socially redeeming value to those things which should be preserved?
Off Topic to site moderators:
I love to send awesome posts like this to my twitter feed. This post couldn’t translate (-43 units too many and too many to crop). Is there any magician on FDL staff who can look into this function in general? I don’t know why Dayen doesn’t have this function and some of the other contributors.
It is a great way to earmark the post and distribute FDL content so I would hope that maybe FDL can look into upticking its twitter icon functionability, especially for my selfish and wanton purposes!
Exactly.
And it will never end as long as Wall Street owns Congress.