The magical world of credit default swaps once again

To think I believed I had seen it all as regards creative uses and abuses of credit default swaps (CDS).  But then came Amherst Holdings.

A credit default swap written on a security (a bond, say) is a contract that pays the owner a given amount when there is a default on that security. In the simplest case, the owner of the CDS receives from the issuer or writer of the CDS the face value of the bond that is in default.  The writer of the CDS sells insurance against an event of default.  The insurance premium is the price of the CDS.  The buyer of the CDS buys insurance against default.  If the default does not occur, the writer of the CDS wins, because he has received the insurance premia, but has not had to pay out on the insurance policy.

An obvious problem with CDS is that you do not have to have an insurable interest to purchase the insurance it provides.  You have an insurable interest, as a purchaser of insurance, if the occurrence of the contingency you are insuring against would not make you better off (even when the insurance pays out).  However, the CDS market is first and foremost a betting shop.  You can buy CDS written on a given class of bonds, in amounts well in excess of the total face value of the bonds you own in that class.  Indeed you may not own any bonds in that class and still buy CDS that pay off in the event a default occurs on bonds in that class.  That is, CDS can be used not to hedge risk you already are exposed to, but to take on additional risk.  CDS can be used to place pure bets.

The morality of gambling, through CDS or any other way

Betting and gambling, including lotteries, are frowned upon by many religions and by many who do not have a religious conviction. Gambling is not explicitly forbidden in the Bible, but it is a vice that goes against many biblical principles.  It sits uncomfortably with the great command “love your neighbour as yourself”, it exploits the poor (gambling is regressive), it undermines the work ethic, it encourages greed and covetousness, it violates responsible stewardship of the resources one is entrusted with, it ‘leads into temptation’, and it can be highly addictive. It is also often associated with deception. Against that, ‘casting lots’ is a common way of making decisions in the Old Testament especially. The phrase ‘casting lots’ is used 70 times in the Old Testament and seven times in the New Testament (including the reference to the soldiers at the cross casting lots for Christ’s garments).

Classical Judaism shares the views on gambling found in the Hebrew Scriptures with Christianity, but also draws on more recent traditions. As I understand it, the classical Jewish tradition says that it is forbidden to make gambling your occupation, but it does not forbid a little friendly gambling every now and then. Islam prohibits gambling. It also prohibits any game or other activity which involves betting, that is, which has an element of gambling in it. The Prophet Mohammed says, ‘He who says to his friend: ‘Come, let us gamble,’ must give charity’ (in penance).

The fact that gambling, including betting and lotteries, is both addictive and regressive in its distributional impact has not stopped governments all over the world from encouraging  and promoting it.  It is just too useful a source of revenue to resist.  Even countries like the UK that do not tax the winnings from gambling (whence the explosion of structures, like spread betting, that turn contingent financial claims into bets), do tax the profits of the gambling industry.  State lotteries are ubiquitous.  Indian reservations in the US, which have a form of sovereignty or extraterritoriality in certain matters, have been allowed to open casinos in states where this is not otherwise legal.  All derivatives trading is, from a mathematical point of view and in economic substance, equivalent to the creation of lotteries.  Sometimes these lotteries are used to hedge risk (when the purchaser of the lottery ticket has an insurable interest; other times and, I would argue, most of the time, these derivative-mediated lotteries are designed and used to take on additional risk – to gamble – generally with other people’s money.  The indulgent attitude of the government towards these activities can be explained, as with conventional gambling, by the important source of government revenue that the profits from derivatives trading represent.

Moral hazard

All these religious and moral objections (including objections based on the addictive powers of gambling and its regressive distributional impact) apply even to bets or gambles where the event that is the subject of the bet or the gamble cannot be influenced by those participating in the bet or gamble. That is, in the context of betting by buying or selling CDS, it applies even if there is no moral hazard involved in the relationship established by the contract.

Traditional moral hazard occurs when the insured party (in the CDS example the purchaser of the CDS) can influence the likelihood of the insured against event occurring (in the CDS example, if the purchaser of the CDS can influence the likelihood of default on the underlying security in a way that cannot be fully reflected in the terms of the contract).  There is asymmetric information in the insured-insurer relationship, and the insured party has the informational advantage – private information.

The standard economics or insurance story of moral hazard involves an informational advantage for the purchaser of the insurance.  With no-fault automobile insurance and third-party coverage, I may drive less carefully.  If I could take out life insurance on a third party, I might be able to expedite the demise of the insured party.

In the CDS world, the most common reported abuse of the instrument involved a party that owned both CDS and the underlying security, but had a net short position in the security.  To be precise, assume I own $X worth  of bonds of type j (at face value) and have purchased CDS on bond j that will pay out $Z if default occurs.  If X < Z, I don’t have an insurable interest in bonds of type j: I am better off if default occurs.

Now assume that, as a bond holder, I can influence the likelihood of a default occurring.  A possible scenario is where the company that issued the bond is in dire straits, but has a good enough chance of recovery and survival, that, from a social  or economic efficiency perspective, it is undesirable to incur the real resource costs associated with a default.  Assume the issuer of the bond has asked the holders of the bond to roll over the bonds, or to voluntarily extend their maturity.  All bondholders but me have agreed.  I am the holdout and the veto player.  By refusing to go along with the voluntary restructuring (which, by assumption, would not be an act of default), I now can trigger a default, making a gain of $(Z-X).  It’s socially inefficient; it may cause unnecessary human misery, but it is profitable and so, as homo economicus, I do it.  Because of my hold-out position, I can drive the probability of default to unity, or 100 percent.  This is the mother of moral hazard.

But now comes the mother-in-law of moral hazard.   This time it is not the purchaser of the CDS (the insured party) who is afflicted by extreme moral hazard, but the writer of the CDS, the insurer.  There is asymmetric information, but the informational advantage is with the insurer.  Assume there is an amount $X of some bond of type j outstanding.  Assume that the issuer of the bond is generally considered to be at significant risk of default.  I now write (sell) CDS on that bond.  Because there is no limit to the amount of CDS I can issue as long as there are willing takers, I can sell CDS to anyone who wants to have a flutter on the default of that bond.  If I price my CDS aggressively (accept a low insurance premium per $ of bond j insured), I may be able to have a revenue from the sale of these CDS, $R, say,  that exceeds the face value of the total stock of bond j outstanding.  This would only happen if the total notional value of the CDS I sell (the total value they would pay out in the event of a default on bond j) is a multiple of the face value of bond j outstanding.

Having received revenue from the sale of CDS written on bond j well in excess of the face value of the entire stock of bond j outstanding, I then buy up, at a price above the prevailing market price (if necessary at face value or even above it!), the entire outstanding stock of bond j.  As long as I can be sure I have the entire stock of bond j in my possession, I can be sure than no event of default will ever be declared for that bond.  I, the writer of the CDS on bond j , and now also the owner of the entire outstanding stock of bond j , could simply forgive the debt I just acquired.  The insurer has, ex-post, reduced the probability of default to zero.   Those who bought the insurance (bought the CDS), wasted their money (their insurance premia).

Instead of buying up the entire outstanding stock of the bond directly and holding the bonds to maturity without calling a default, or forgiving the debt, I could instead, if the bond were some asset-backed security, purchase enough of the assets underlying the bond at prices in excess of their fair value to ensure that the issuer of the bond would have sufficient funds to pay off all the bond holders, should the bond be ‘called’, that is, retired prematurely.  If in addition, I could make sure that the bond would indeed be called, I would again, through this financial manipulation, have reduced the probability of default on the bond to zero.

The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal.

This in essence, is what has been reported to have happened recently, when a small Austin Texas-based brokerage , Amherst Holdings, which had sold CDS (default protection insurance) on mortgage bonds, then purchased the property loans underlying these bonds at above-market prices to prevent a default that would trigger payments to buyers of the contracts.

Some mortgage bonds can be “called,” or retired early, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults.  The mortgage bonds targeted by Amherst fell into that category. So the mechanism through which Amherst made sure enough money would be available to the issuer of the mortgage bonds to pay the obligations due on these bonds, also caused the bonds to be called.  The bonds were paid off in full, and the CDS Amherst had sold on these mortgage bonds became worthless.

Many household names in Wall Street and the City of London were at the wrong end of this transaction.  Amherst has been reported as selling more than $100 million worth of CDS on $29 million of mortgage bonds outstanding – a tidy profit of at least $70 million.  It certainly beats working for a living.

The problem of moral hazard on the holder’s side or on the writer’s side of the CDS market is not a market design problem that can be addressed by creating a central clearing facility and requiring all CDS to be traded on organised exchanges.  Requiring writers of CDS to post collateral or, in the case of an organised exchange, requiring a variation margin or maintenance margin (a daily offsetting of profits and losses between the short and long positions on the exchange, made possible by mark-to-market and the fact that the number of long contracts has to equal the number of short contracts) would not solve the problem that both holders and writers of CDS can, under many circumstances, influence the likelihood of default on the asset the CDS are written on.

The first of the two real-world examples I referred to had the holder of the CDS (the purchaser of the default insurance protection) raise the probability of default on the underlying security to 1, that is, to 100 percent, because he also owned a small amount of the underlying security and was in a position to trigger an event of default.  The second example had the writer of the CDS (the seller of the default insurance) reduce the probability of default to zero, by causing the bonds to be called after making sure that the issuer had enough money to pay off all the bond holders in full.

Both practices and anything like them are unethical and quite likely socially inefficient and harmful.  The way to stop them is to destroy the incentive to issue CDS with a notional value in excess of the underlying securities these CDS are written on.


This post does not lead to a proposal for banning the writing and owning of CDS.  Provided the purchasing party has an insurable interest, CDS are useful instruments for hedging risk.  It is an argument for requiring that a claim for payment of $X under a CDS contract written on security j , when the default event has indeed occurred, is valid and enforceable only if the owner of the CDS can  hand over $X worth of security j when he submits his CDS claim.  The moral hazard that can afflict both sides of the CDS market is such that requiring a CDS owner to have an insurable interest seems the only reasonable response.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website