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Arnold Kling on credit default swaps

Arnold Kling at EconLog wrote the clearest explanation I’ve heard yet of what a credit default swap is and how it could have led to so many financial losses in our current recession. It sounds like a correct explanation. Maybe it’s too simple to be true; it seems impossible to imagine that I haven’t encountered an equally clear and simple explanation before, but that shows you how unable and/or unwilling most economically-knowledgeable people are to explain things really clearly for banking-and-finance dummies like me.

A B-rated bond has higher default risk than a AAA-rated bond. There are lots of institutions that could hold AAA-rated or AA-rated bonds but which are precluded from holding B-rated bonds. However, if it were not for regulation, those institutions might be able to do better with B-rated bonds than with AAA-rated bonds. Suppose that a B-rated bond has a default probability of .01, and a AAA-rated bond has a default probability of .0001 (note: those are strictly hypothetical figures, that I pulled out of the air–not based on the actual relationship between ratings and default probabilities.)

If two B-rated bonds are independent of one another, then the probability that both of them default is .01 times .01, or .0001, which is the same as the probability of a default on the AAA-rated bond. And if you have three independent B-rated bonds, the default probability gets even lower. Where this is leading is that with enough independence, a diversified portfolio of low-rated bonds can be created that has lower risk and a higher return than a AAA-rated bond.

The regulatory anomaly is that a bank or pension fund cannot take advantage of this. The regulators will see B-rated bonds in the institution’s portfolio and penalize the firm for taking risk. The regulators overlook the diversification.

Into the breach steps a AAA-rated insurance company, selling credit default swaps on B-rated bonds. The bank can buy a B-rated bond, protect it with a credit default swap from the insurance company, and have the regulator treat the bond as at least AA. The insurance company performs the diversification function, selling swaps on a boatload of different bonds. The insurance company gets to keep most of the extra return that is created by having the banks take on low-rated bonds.

It turns out that at least two things can go wrong here. First, the bonds may turn out to be more highly correlated than was thought. It could be that if some of them go bad, then a lot of them go bad. Second, even if defaults stay under control, an increase in the probability of default can force the insurance company to put up more margin (collateral), and this can put the insurance company in dire straits.

The regulatory issue is this: why are banks not allowed to take the risk of (a) holding a diversified portfolio of low-rated bonds, when they are allowed to take pretty much the same risk by (b) purchasing credit default swaps? If they do (a), then if the bonds turn out to be highly correlated, then the portfolio will not be so well diversified and the strategy will fail. However, if they do (b), then if the bonds turn out to be highly correlated, then the seller of CDS is unlikely to be able to perform as promised.

Regulators have to take a point of view on the issue of how highly correlated are bond defaults. If they take the view that they are not highly correlated, then banks should be allowed to take on diversified portfolios of low-rated bonds. If they take the view that bonds pretty highly correlated, then banks should not be allowed to claim that the purchase of credit defaults swaps provides insulation from risk.

The inconsistency in regulation is what accounts for the rise in the credit default swap market.

I think if you are going to regulate, you have to be really careful to trace through all of the consequences of regulation. If you see a financial innovation taking off like crazy, there is a good chance that it is being used to exploit a regulatory anomaly.

Effective regulation is really easy after something blows up. In real time, it strikes me as a darn hard problem.

A commenter, Grant, gave some input that I found equally as helpful:

I’m wondering if the scenario played out something like this:
Financial institutions want to purchase lower-rated bonds and diversify their risk. Ideally they’d be able to buy bonds with different rates of defaults. The risk levels here would be relatively transparent, because the bond holder and the bond issuer would be the only financial intermediaries involved.

Regulators prevent this from occurring, so the financial institutions have to purchase lower-rated bonds that have been insured and turned into higher-rated bonds. This adds an additional intermediary to the whole process: the insurer. This reduces transparency, and the ability of the bond holder (and bond rater) to estimate the default correlation of their bonds (as they can’t know how diversified the bond’s insurer is).

This makes me wonder: Why didn’t the holders of insured bonds tread more carefully due to the uncertainty of their insurer defaulting? I can understand that laxer lending standards and low interest rates caused an increase in supply of mortgage bonds with a high default rate (presumably making their price more attractive), but I don’t understand why investors would not try to estimate the correlated risk of their insurer.

Of course, mortgage bonds can be highly diversified over many small housing markets. Only a widespread downturn in home prices could cause defaults across all those markets and put the insurers and bond holders in trouble. Naturally that is exactly what happened, but again I find it hard to believe that bond holders did not at least try to estimate the counterparty risk from their insurers.

Why did the buyers of insured bonds systematically underestimate the risk of their insurer defaulting? Was it really as simple as not believing a nation-wide downturn in home prices could occur?

Seems like the case. If you have a bunch of bonds, or mortgages, or 20-sided dice, or just hypothetical computer algorithms, that each are only moderately likely to return a certain result, then multiplying them all together in the same “game” makes it very unlikely that a high percentage of them will give that result, other things being equal. So, you won’t be as well off as if you were playing with bonds, mortgages, dice, or computer programs that were very unlikely to return that result, but you should still be in pretty decent shape, especially if you got them for cheap, other things being equal.

But, I can think of at least two parameters in this “game” that would convert your moderate-likelihood game into a near-certain failure—parameters that cause the “other things” to stop being equal. First is if there’s something in the “game” that makes prior outcomes affect future outcomes, e.g., one default makes a second default more likely, or two defaults in close proximity make, say, five or ten more defaults more likely. Something like that. I don’t know if this relates to what happened in the real world, in the housing market or elsewhere. But I do know another game breaker that did happen in the real world and, if Grant and I (and many others) are right, is the primary reason so many credit default swaps lost money (turned “toxic”) and financial institutions lost billions: some outside factor caused nearly all home prices to plummet, destroying equity and causing many of these moderate-likelihood-of-default mortgages to become near-certain-to-default mortgages. This outside factor was the housing bust that followed the housing boom.

Austrian economics predicted the housing bubble and predicted its burst. Austrian economics says a bust must be preceded by a boom and that a boom can only end in a bust. (Or hyperinflation.) One of the main reasons so many houses were built, and so many mortgages were bought, and so many unreliable borrowers were sold mortgages, and so many houses rose in price (not value) was the artificial credit boom created by the Federal Reserve. This, along with the New Deal–esque home-ownership obsession that professional criminals in Washington, D.C., promoted and pushed on Fannie Mae, Freddie Mac, and private banks, created the housing boom. The Federal Reserve and the Imperial Federal Government intentionally created the housing boom by specifically distorting the real estate market, and all the non-Austrian economists and short-term thinkers and greedy high-time-preference investors out there went along with it, rarely questioning a thing.

Posted in Economics