CDS were bought more for their capacity to reduce equity requirements for banks, than as insurance against defaults.

Sir, I refer to Joe Rennison’s report “Wall St looks to revive niche CDS” May 20.

It states: “single-name credit default swaps, a derivative contract that tracks the risk of default by a company that sells bonds. Regulators sought to clamp down on the market after the crisis because it was widely blamed for helping to inflate the credit bubble”.

That is not telling it like it really was!

According to Basel II, if a bank wanted to hold a bond that for instance was rated BBB+, it needed to hold 8 percent in equity… meaning it could leverage about 12 to 1.

But, if it bought a CDS for that bond from an AAA rated company, like from AAA rated AIG, then it needed to hold only 1.6 percent in equity and could therefore leverage about 60 to 1.

And that is what really drove the incredible artificial demand for these CDS that helped to inflate the credit bubble.

If CDS are to work, as they should, they need to be traded on their own merits of how they provide insurance against defaults, and not because of regulatory distortions.

Do not let failed regulators get away with their own favorite version of history!

@PerKurowski

AIG, instead of suing those who bailed them out, should sue those who got them in problem, namely the bank regulators.

Sir, Tom Braithwaite reports that “AIG considers suing US over bailout terms” January 9, something that sounds indeed a bit surrealistic.

Basel II’s 8 percent basic capital requirement for banks allowed a 12.5 times to 1 leverage of bank equity. But it could be reduced to a minimal 1.6 percent, pushing up the allowed leverage to 62.5 to 1, if the bank exposure could be construed as guaranteed by something possessing an AAA rating.

Therefore, had bank regulators not turned the AAA-rating of AIG into an amazing magical capital requirement for banks shrinking machine; something which created an insatiable demand for AIG's credit default swaps, absolutely nothing bad would have happened, as even the whole 2007-08 financial crisis would have been avoided.

Therefore, if the AIG board absolutely must sue someone, because it feels that is the only way it can discharge its responsibilities, according to current traditions, then instead of suing those who bailed them out, they should sue those who got them in problem, the bank regulators.... and perhaps even the US tax-payers would join them in order to turn it all into a class action.

“Misunderstanding Financial Crises”... Indeed Professor Gorton

Sir, Gary Gorton a Professor of financial economics at Yale, and consultant for over ten years to AIG Financial Products writes “Banking must not be left to lurk in the shadows”, November 21, in which he concludes with “we know now… privately created bank money is subject to runs in the absence of government regulation”. 

"Absence of government regulation”, what does the Professor mean?” Does he not understand that there never ever have been such intrusive and distortive regulations as when regulators took upon themselves to play the risk managers of the world, and ordered risk-weights to be applied when calculating the effective capital banks needed to hold against individual assets? 

Does the consulting Professor not know that the sole reason for AIG getting into trouble selling an extraordinarily excessive amount of credit default swaps, was that bank regulations allowed banks who bought such product, when issued by an AAA rated entity, like AIG was, to hold that asset against only 1.6 percent of capital, a mindboggling authorized leverage of over 60 to 1? 

In his recent book, “Misunderstanding Financial Crises”, Professor Gorton briefly refers to “risk-based capital requirements” in the context of forcing “banks with low capital ratios to increase them”. He is wrong. What the risk weights mostly produced was a reduction of the capital banks had to hold. Basel II, required 8 percent in capital, but, when a risk-weight of 20 percent was present, like when lending to Greece, banks needed to hold only a meager 1.6 percent in capital. Clearly when the Professor writes “The commercial banks that failed in the recent crisis held on average more capital than Basel III required” is because he is not really ware of how the risk-weights weighted. 

But what really gets me up in arms is when a Yale Professor in finance, several years after this crisis has started, can write in a book:”There is no evidence that links capital to bank failure”. 

Professor Gorton should know that the correlation between all bank assets that ran into troubles and caused the current crisis, with the fact that banks were allowed to hold these assets against extraordinarily little capital, and therefore allowed the banks to earn extraordinarily high expected risk-adjusted returns on capital on these assets, was 1. And I guarantee the Professor there was causality involved. 

Yes Professor Gorton, I agree that regulators should have looked to the history of financial crisis. If they had done so they would have noted that these are never ever caused by excessive exposures to “The Risky” these are always the result, no exclusions, of excessive exposures to “The Infallible”.

If you can pay out on a credit default swap you are not naked.

Sir Wolfgang Münchau opines that it is “Time to outlaw naked credit default swaps” arguing that “the case for banning them is as strong as that for banning bank robberies”, March1. I must say that the simile provided is quite unfortunate not only because it is not more bank-robbery than the robbery that can be carried out by the bankers inside a bank but also because though bank robberies have always been banned that has not prevented them from happening.

The real risk with naked credit default swaps is that it permits someone to collect upfront the insurance premiums without necessarily having to capacity to pay up when the incident occurs, in other words the counter-party risk. If all those who are now selling a five years CDS contract covering Greek Bonds for €394.000 per year could immediately pay out the €10m they had obliged themselves to do then nothing would have happened except for a redistribution of moneys… and of course there would be no robbery involved.

In this respect we should not outlaw the CDS but instead assure these CDS are traded through clearing houses that apply rules which really guarantee the payouts, and make sure that our banks are required to have so large capital requirements against their CDS positions so as to remain banks instead of becoming bookies. AIG went wrong not because of its bets but because of the unlimited credit that because of the AAA-ratings it received as a bookie.

Sincerely, what could be more naked that the fact that our banks can hold zero capital when lending to sovereigns rated AAA to AA-? That has helped to cause the huge public debt overhangs much more than any consequential CDS trading has done and so, if something real is to be done about it, let us go for the jugular.

The value of the CDS depend a lot on who contracts them

Sir Henny Sender in “CDS derivatives are blamed for role in bankruptcy filings” April 17 reports on how this type of instrument changes the behavior of creditors. One way I have found useful explaining the pro and con of the CDS is with a simile to life insurance.

Supposed Henny Sender took out a life insurance for a million quid to take care of her loved ones in case anything would happen to her. That should be a quite good responsible and tranquilizing thing to do. Now imagine instead that many of Henny Sender’s extended family and friends and even some total strangers took out million quid life insurance policies on her. Not so tranquiliz, baning eh?