CDS - What a Mess

Before I get to my discussion of the CDS market I haved to admit, my new goal in life is to understand everything being discussed in the linked post.

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

I get the direction of things and generally understand it, but I would love to understand in detail the specifics. Keep in mind, I am a lawyer, not an economist, so I focus on the macro side of economic life, yet I find the micro of great interest and my personal goal is to educate myself to understand it. Yes, you can teach an old dog new tricks.

In any event, they point to the credit default swaps as a continuing problem in this rescue. I have written about these at some length and will not repeat it here. Nevermind, I will repeat it. CDSs are quite similar to reinsurance spirals I litigated over, so this part I understand somewhat intimately - perhaps better than the linked authors. I have spent 25 years litigating mostly over insurance and this part I know.

What I did find of most interest is the fact that those providing CDS protection bought reinsurance, which if you are unfamiliar with it, it is insurance to protect insurance. For example, let's say I insure you for $10 million against a loss, in this instance a financial loss, for a premium of $100,000. But I am unwilling to take all that risk, so I reinsure that risk and pass on part of my compensation to someone who takes on part of the risk. I may pass on $9 million of the risk and hopefully pass on less than 90% of the compensation I received. There are likely middle-men here, like lawyers or brokers, skimming off some of the profit, so the reisurer is taking on a percentage of the risk for a proportionally smaller premium. And that reinsurer may pass on part of the risk to another reinsurer, now a retrocessionaire, who in turn does the same and so forth and so on - each probably getting less compensation, less premium, for the risk they are taking (proportionally speaking). That is a problem if it happened in the CDS market, and now I think it did. Unwinding these contracts is near impossible, and on this scale it probably is impossible. At a minimum, with reinsurance and retrocessions, rest assured we will spend decades unwinding the mess.

Now I am not sure it happened as much in the CDS market, but in the insurance market I dealt with, you had a number of regular players who continually layed off the reinsurance to each other and you often had company A being reinsured by company B, who is reinsured by company C who in turn is reinsured in part by company A, and so forth and so on. This created what we called spirals, sometimes tight spirals and sometimes looser. Eventually the loss got dumped out of the spiral to the fall guy. I suspect this very well may have happened in the CDS market too, at least to some extent.

To give some perspective, the reinsurance spirals I dealt with arose out of workers compensation insurance in the U.S. All told, a few billion of dollars were at stake, which for most of the players were big dollars. The company I represented was put into run-off because of it. We had a year long trial in England (one of the longest commercial trials in English history) that resulted in over a thousand page decision. (By the way, due to the decision, which is a major paper-weight in my office, all that I am saying here is quite public and, if you want, I can give you citations) We had about 130 contracts and ended up in a lot of disputes on those contracts. And all this was over very little in exposure compared to the CDS market. Now multiply this scenario to arrive at what at one point was an estimated $62 trillion in CDS obligations. I know there has already been a major effort to cancel off-setting obligations, i.e. cancelling out the spiral, but if - say - $20-30 trillion in contracts remain to be resolved, this is quite serious. How serious depends on how many default events trigger these CDS contracts. Based on the past two months, I think it will be a fair amount. In any event, even if I leave my company I expect to have a fair amount of work I can do until I retire (I hope).

Now I might add that the vast majority of CDS contracts are insuring something that the insured does not own. The trillions in dollars of contracts beat the global GDP by a few factors, so there is no conceivable way that this insurance, by and large, protects actual exposures. Rather, for the most part, it is gambing. A company (A) with no exposure to another company (B) or its bonds seeks to bet that company B cannot pay on bonds. So company A buys a CDS from company C, which for a premium is willing to take that bet. And when company B defaults, company A gets paid by company C even though company A had no company B bonds or other exposure to company B losses. Trillions of dollars tied to little more than a financial bet - that is good business. No wonder we are in a mess of trouble. We do not know who is on the point for these obligations -yet!

Meanwhile, the bank bailout is already being complicated by CDS contracts. Oh what a wicked web we weave.

http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

Disclosures: None other than my involvement in reinsurance spirals as discussed above.