Betting on yourself

by John Quiggin on September 28, 2008

Robert Waldmann of Angry Bear has a fascinating post exploring the possibility that sharp movements in the value of Lehman senior debt could be explained by the possibility that Lehman had sold Credit Default Swaps on itself. Since a CDS is insurance against the possibility of default on debt, this is a no-lose bet for Lehman. If the firm survives, they collect the premiums and pay nothing and, if it doesn’t the losses are borne by the creditors. And, as Waldmann points out, it’s not crazy to buy such a CDS, since it will retain some value in bankruptcy. If you’ve already sold a lot of Lehman CDS yourself, there’s a significant hedging benefit. So both parties benefit, and the losers are the existing bondholders. Waldmann has an interesting optimization exercise to show that optimal (for Lehman) use of the CDS option could explain the collapse in the value of Lehman bonds.

Thinking about this, I’m more and more convinced that Warren Buffett’s description of derivatives as financial weapons of mass destruction applies in spades to CDSs.

For a start, it seems obvious that allowing firms to sell CD swaps on themselves is a terrible idea, but Waldmann says it’s not illegal and has happened in the past. But even if you could stop the most obvious version, there are plenty of ways around it. Suppose for example that Bank A and Bank B sell lots of CD swaps on each other. Then if one gets into trouble so does the other, and both default, so the CDS are reduced to their bankruptcy value. As long as both banks survive, it’s money for jam.

What this means is that it’s not possible to value a CDS (and therefore any kind of debt for the issuer) simply by looking at the risk of default for the insured firm, and then considering the risk of default for the issuer. You need to know the correlation between the two, and this requires not detailed knowledge of the entire asset position of both parties, including their correlations with other parties.

Presumably, at some point, bond markets will start to anticipate this risk. But, in the absence of detailed knowledge of all the counterparty risks involved, the only real option is not to buy corporate bonds of any kind. That’s pretty much what’s happened in recent months.

A centralized CDS clearinghouse might address these risks to some extent. Alternatively, if the risks were ignored, it could create yet more systemic risk by allowing arbitrage between supposedly identical CDS instruments with radically different counterparty risk. I’ve seen a bunch of proposals for such a market to be established and some announcements that its coming Real Soon Now, so perhaps we’ll get more information on this point before long. Then again, perhaps not.

{ 33 comments }

1

John Emerson 09.28.08 at 3:35 am

No one was interested over at DeLong, but I’ll repeat my theory.

1. Sophisticated financial interests provide a windfall profit for whoever first figures out how the details of they work, sometimes at the cost of collapsing the system. 2. Maybe the eventual collapse of the system is not only possible, but likely or even inevitable. 3. Maybe this is not only inevitable, but the purpose of sophisticated financial instruments.

2

Stuart 09.28.08 at 3:46 am

As soon as I heard about the way CDS could be set up by third parties it seemed immediately obvious that they had a high probability of contributing to some disasterous scenario. It seems entirely analagous with, say, allowing me to take out a fire insurance policy on your house, or life insurance on you. If I tried, the insurance company would be rightly very suspicious about my motives.

3

John Emerson 09.28.08 at 3:54 am

“Sophisticated financial instruments”. Alzheimers, I guess. Or maybe auto-fill in my brain.

4

a 09.28.08 at 6:04 am

I imagine if people were buying CDSs on Lehman from Lehman, it might have been because their profit/loss calculation system didn’t care from whom the CDS was bought from. That is, the profit/loss system valued “CDS on Lehman” and didn’t factor in who the counterpart was. Counterpart risk was handled in a different system, where there was a limit on the amount of risk that one could be held vis-a-vis any bank.

So Bank A sold CDS on Lehman to Bank B @, and then Bank A bought CDS on Lehman from Lehman, discharching a profit at Bank A, which could be booked immediately (or preventing a loss which would have had to have been booked immediately). It only goes badly if Lehman goes bankrupt, but hey the government is there to stop that, right?

5

ROYT 09.28.08 at 9:45 am

The central assumption in “AngryBear’s” speculation is this: “Lehman could have made their senior debt worth 12 cents on a dollar in case of default by selling CD insurance on their own debt — lots of it. This would not require any false accounting as they are not required to report this fact.”

The AngryBear couldn’t be more wrong. Reporting of such a CDS would indeed be required.

6

John Quiggin 09.28.08 at 10:26 am

As I’ve already pointed out, ROYT, any such requirement would be easy to avoid.

7

HH 09.28.08 at 4:17 pm

Goldman Sachs gave the world a classic example of irrational local optimization by shorting the toxic mortgage-backed securites that it had previously sold. What the Goldman wizards didn’t grasp is that achieving profitability by precipitating the extinction of your own industry (investment banking) is a dubious strategy.

Capitalism does not optimize globally, and that is its fatal flaw.

8

Lex 09.28.08 at 6:12 pm

As I recall, it’s been illegal for about 200 years in the UK to take out life-insurance on unrelated third parties, for exactly the kind of reasons Stuart imagines. As usual, it’s not “nobody knew”, but “nobody cared”.

9

ehj2 09.28.08 at 7:02 pm

HH,

Greed optimizes globally, and that is its fatal attraction.

10

rdan 09.28.08 at 7:20 pm

Barney Frank and NYT article listed offer insight on third party involvement with Goldman Sachs large exposure to AIG through third party deals.

11

ehj2 09.28.08 at 8:58 pm

The Wall Street Journal ran an article in December on Goldman shorting CDOs while hustling customers to buy them.

http://online.wsj.com/article_email/SB119759714037228585-lMyQjAxMDE3OTE3NDUxOTQ3Wj.html

12

ehj2 09.28.08 at 9:28 pm

I’ve been waiting for someone to quip that a corporation is a legal “person,” and it’s only responsible that it have insurance on itself.

A full service casino will take either side of any bet, and your true capitalist will draft a creative structured product on himself right up to the moment when you pull the lever on the gallows.

WSJ killed the above link … this is good enough.

http://mgx.com/blogs/2007/12/16/how-goldman-sachs-made-billions-betting-against-mortgages/

13

ROYT 09.28.08 at 9:33 pm

Thanks John. But you where did you actually say anything about existing reporting requirements? You didn’t.

Waldmann did — and what he said was wrong.

Also, your Bank A/Bank B scenario would require reporting under existing requirements as well.

Do you know why?

14

ehj2 09.28.08 at 10:30 pm

Royt,

Reporting didn’t work with the IBanks, the SEC has closed shop and the IBanks are gone.

http://www.nytimes.com/2008/09/27/business/27sec.html?_r=2&em=&pagewanted=print&oref=slogin&oref=slogin

The new instruments remain, however, and no one really understands them. My problem is the one John Emerson articulates — the first guys to figure these things out make a killing and leave everyone else dead.

And arguing from the other side, we have (and I have to agree at some level, I just want you smarter guys to figure out how to regulate it) Robert Merton, a 1997 Nobel laureate in economics:

Financial innovation and “engineering” are widely blamed for causing, or worsening, the current crisis, and in a sense, they have, Merton said. Innovations inherently involve the risk that some ideas will fail, and inherently outrun existing regulatory structures. But rather than clamping down so severely that financial innovation is choked off, he argued that regulation must allow for further, future innovation as an engine of growth, because the functional needs—consumers’ need to finance their retirements, developing nations’ ability to fund economic development—remain intact.

Harvard Panel on Current Financial Crisis

http://economistonline.blogspot.com/2008/09/harvard-panel-on-current-financial.html

15

vkrishna 09.28.08 at 11:55 pm

Isn’t this the same Merton who nearly went to jail over the LTCM fiasco? I love this statement from him:
“But the solution for society would not be to rid financial institutions of highly trained, innovation-oriented financial engineers. Rather, he insisted, management teams, boards of directors, and regulators needed much more such expertise in their own ranks so they could understand the products they were offering and acquiring—as they so apparently did not in the recent past.”
Sure, all the banks were acting altruistically and trying to maximize the returns on people’s retirement funds. I love that he has no problem saying at the same time that the banks did not understand the products they were offering.

16

Stuart 09.29.08 at 12:15 am

It seems odd that banks, which rely on confidence for their very existence, consider that innovating some new product that no-one clearly understands the fully implications of, and then converts a significant portion of their assets into these before they have truly been tested in the marketplace for a significant period of time (especially at least one downturn of the asset on which the derivative is based). If I had the same attitude about testing our products at work I would have been sacked a long time ago, and my work has only limited implications to our customers in most circumstances.

17

ehj2 09.29.08 at 12:17 am

Well, key words there include “regulators” and “acquiring” …

Through lack of regulation, the AAA rating became a sham:

http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo&refer=home

And flim-flammed ratings on complex instruments coupled with opacity make for asymmetrical information and hazardous acquisition. But the economy spins off tons of money that has to be invested somewhere — and to the brink we went, not realizing how much failure of “due diligence” was packed into every layer.

18

John Quiggin 09.29.08 at 12:20 am

ROYT, it would be helpful if you could point to a source giving more detail on reporting of CDS positions held by investment banks. It is widely asserted that no such reporting is required, for example, here:

http://westonpolicy.wordpress.com/2008/09/19/credit-default-swap-clearinghouse/

19

John Quiggin 09.29.08 at 12:44 am

Better still, perhaps you could point to the report showing Lehman’s CDS position, which would resolve the factual question raised by AB.

20

virgil xenophon 09.29.08 at 12:46 am

HH@7: “Capitalism does not optimize globally, and that’s it’s fatal flaw.”

Maybe not fatal, but surly HH’s statement provides insight into one of the major insights of decision-making theory, i.e., that seemingly rational decisions made at one level of bounded rationality often paradoxically produce irrational results at the level of larger systems “en grosso mondo.”

21

virgil xenophon 09.29.08 at 12:50 am

Note to vkrishna and Stuart:

It seems to me the problem was NOT that Banks didn’t understand these exotic instruments (which they indeed did not) but that they indeed thought that they understood them very well. “Too clever by half” is the phrase the British would use, I believe.

22

Bush pilot 09.29.08 at 2:21 am

Wall Steet’s success is taking a new idea that is effective and innovative, and then expand it until it blows up. The idea of CDS’ are great for some specific situations – there is benefit for a lot of non-financial players and shorting debt is not easy or effective.

As an example, if your company is working for Ford or GM, you may be on the hook for a significant amount of revenues, both as A/R and future work from these companies. Should they go bankrupt, your firm is very low on the creditor list and could cause you to go under. Buy some protection against your biggest customers and you may live if one of them goes under. Buying a CDS from Lehman was easier/cheaper than the alternatives (shorting debt, factoring future receiveables).

That investment banks set their compensation system up to reward people for 12 months revenue generation without regards to risk is pretty silly. I’d say the owners of the stock were stupid, except employees tended to own 25-30% of the stock.

23

nick 09.29.08 at 2:24 am

“the functional needs—consumers’ need to finance their retirements, developing nations’ ability to fund economic development—remain intact.”
–ok, but financial instruments already existed to meet these needs; the persistence of such needs over time doesn’t seem like an argument for “innovation” in financialization…..why is “innovation” here not simply a deceptive metaphor? ought the development of finance to be understood in the same terms as the development of technology?

24

ROYT 09.29.08 at 7:41 pm

At your link to Weston Policy we have: “There are no legal reporting requirements…” This is getting muddy indeed. Reporting requirements aren’t laws. Nevertheless, they are followed, as ignoring them would have disastrous results — one’s auditors would balk for a start.

I asked above, Why would CDS positions such as have been theorized by Waldmann (and further speculated upon here) be required to be disclosed? One answer is, Materiality. Another is Concentration.

Lehman did not, in a recent reported quarter-end have any such position. We know this because we can read their May 31 10-Q. We can peruse their footnotes for extraordinary transactions (which E&Y would surely have regarded these as being), we can search the MD&A, examine disclosures on liquidity and concentration… in vain.

25

Robert Waldmann 09.30.08 at 4:18 pm

Stuart, I just thought of the analogy which is brilliant. It is certainly possible to buy a CDS without any exposure to the risk of default. It is, indeed, like me buying fire insurance on your house.

Thanks Royt. I admit I am fairly ignorant about accounting standards and don’t know what is in the Lehman May 31 10-Q. Could you provide a link ?

This seems relevant
“SEC Info – Lehman Brothers Holdings Inc – 10-Q – For 5/31/08 – E”…
is
http://www.secinfo.com/d11MXs.t1C1k.c.htm seems relevant

I search for concentration
I get “Concentrations of Credit Risk
[snip] The Company’s exposure to credit risk associated with the non-performance of these clients and counterparties”

Not relevant. That is risk related to Lehman assets not liabilities.

something in a section on valuing securities which is not relevant

“geographic concentrations” (not relevant)

more on concentration of assets (not relevant)

something on risk management thinking about concentration (not relevant)

Concentration appears to be a word related to assets and counter party risk. It has nothing to do with Lehman liabilities which require payment only if Lehman defaults on its debt (the topic of my post).

The word “materiality” does not appear in the 10-q report entitled “Lehman Brothers Holdings Inc · 10-Q · For 5/31/08″

I’ll keep looking

26

Robert Waldmann 09.30.08 at 4:30 pm

I’m searching for “credit default” a relevant entry just shows the current market value. This is not the issue. The issue is the value of liabilities if Lehman is in liquidation

I quote

“Fair Value of Derivatives and Other Contractual Agreements”
this includes credit default swaps as liabilities. They are booked at current market value. This is not relevant.

It also appears in a section entitled

“LEHMAN BROTHERS HOLDINGS INC.
Notes to Consolidated Financial Statements
(Unaudited)”

There is another entry about credit default swaps with SPE’s again in (Unaudited). Again just amounts at fair value. Nothing about the correlation with bankruptcy of Lehman brothers and typically in unaudited notes.

I don’t see how I can tell if Lehman wrote CD swaps on its own debt from this document (but I repeat I am ignorant).

27

John Quiggin 09.30.08 at 7:54 pm

ROYT, it appears from your explanation that any requirement to disclose is very limited, and that the disclosure is far from continuous.

28

J Thomas 10.01.08 at 4:11 pm

Reporting requirements aren’t laws. Nevertheless, they are followed, as ignoring them would have disastrous results—one’s auditors would balk for a start.

We could use this argument to claim that Enron reported everything correctly. As it turned out, Enron instead had disastrous results.

So, did Lehman Brothers do entirely correct reporting in order to avoid disastrous results? I guess we can wait and see….

29

ROYT 10.01.08 at 11:26 pm

John: Right, limited — but in ways similar to all these types of rules. Not every transaction will be reported, but those that rise to a level judged material will be. Not every accumulated position will be reported, but those that rise to a level judged material, or those resulting in overall extreme concentration in one industry group or company will be.

And Right, not continuous. Quarterly for public cos. But the immediate establishment of such a position in-between reporting periods would likely be a hard thing to hide from other players and might well be mentioned in the business press (and necessitate an interim SEC disclosure as well). There really are a lot of good reasons why one would not expect Lehman or others to attempt a “play” like this…

Robert: We shouldn’t expect to see if Lehman had written any specific amount of CD swaps on itself, but we would expect to see disclosure of positions material enough to have the specific consequences that were originally under discussion.

JT: If you’re hearing an argument from me that companies never either err or intentionally misstate results, you’re hearing something I didn’t say.

30

floopmeister 10.02.08 at 3:26 am

virgil xenophon:

Maybe not fatal, but surly HH’s statement provides insight into one of the major insights of decision-making theory, i.e., that seemingly rational decisions made at one level of bounded rationality often paradoxically produce irrational results at the level of larger systems “en grosso mondo.”

Seems pretty analogous to the Tragedy of the Commons…

31

Hank Roberts 10.02.08 at 4:59 am

> Seems pretty analogous to the Tragedy of the Commons…

As Garrett Hardin remarked later, he should have named the essay “Tragedy of the _Unmanaged_ Commons”

Owning a market, or a bull, requires having a good fence. Otherwise you have a free market, or a free range, and nobody has much of an idea who owns what after the stampede has happened.

First they invented branding irons, but those were easy to fake.
Then they invented barbed wire.

Surely the financial industry can do as well as the cowboys.
Eventually.

32

Robert Waldmann 10.03.08 at 2:31 pm

ROYT “Lehman did not, in a recent reported quarter-end have any such position. “

ROYT “Robert: We shouldn’t expect to see if Lehman had written any specific amount of CD swaps on itself, “

Evidently zero is not a specific amount. I guess any such doesn’t mean “any self CDSs” but “enought self CDSs to drive liabilities up to 1/0.12 times assets.” This forced interpretation would imply that ROYT has not fallen into contridiction. It seems to me impossible to understand why the word “any” was included in the earlier comment under the interpretation which makes the two comments other than contradictory. It is necessary to argue that “didn’t have .., any” means something other than “had zero” and that the word “any” was superfluous. No big deal in any case (it’s a comment not a contract).

ROYT is also unclear on “required” which would normally mean “legally required” but evidently not in this case.

More importantly, concentration, as described in the 10-q refers to concentrated counter party risk which could cause bankruptcy. Self insurance can not cause bankruptcy as it only implies liabilities after bankruptcy.

If Royt wants to argue that Lehman’s 10-Q is inconsistent with the amount of self insurance which I discuss (as a conceivable possibility) he or she would have to divide dollar fair market value of such liabilities by the market price of insurance of Lehman debt as of May 31 2008. I would guess that this would give a very high face value.

ROYT’s argument, in the end, is that a serious accounting firm would have drawn attention to anything horribly bad for bond holders (even if the only reporting is in a section of the 10-Q which clearly says “not audited”). If so, how can Lehman debt be selling for 12 cents on the dollar ? Something went grossly wrong. Whatever it was, if the auditor could detect the possibility (ROYT’s assertion) then the auditor should have warned.

I mean why doesn’t ROYT’s argument against the hypothesis prove that Lehman’s debt isn’t trading for its current price ?

33

Suther 10.03.08 at 7:39 pm

“If so, how can Lehman debt be selling for 12 cents on the dollar ?”

Lehman (and most human-capital oriented businesses) only have value as a going concern. All the clients and counter-parties of Lehman are now doing business with someone else. Take away the people and the clients and there is no way to pay the senior debt holders, let alone shareholders.

As for the whole thesis, I guess it doesn’t stand my smell test – hundreds of lawyers are pouring through the filing as we speak. If I were a lawyer for another creditor, LEH selling CDS on itself would be something to object to – certainly I would view it as suspious, probably criminal (you are accusing LEH of conspiring pre-bankruptcy to transfer assets post-bankruptcy to a different party). The fact that this has surfaced, but lots of other more mundane issues have makes this look like a non-issue AFAIK.

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