Shorting America Rocks!
Lower credit risk means a lower price for protection. Zero implies zero risk. The higher the basis points, the higher the implied risk. When U.S. credit default swaps were first introduced, the price of protection was around two basis points. According to Bloomberg, the price for five-year protection was around 38 basis points (per annum) on Friday. But the price in the over-the-counter market — where this stuff actually trades — was almost double or around 75 basis points.
Since most traders in U.S. credit default swaps don’t think the U.S. will default any time soon, why are they trading U.S. credit default swaps? They are speculating on price movements the way a day trader buys and sells stocks to speculate on stock price movements.
via Janet Tavakoli: Washington Must Ban U.S. Credit Derivatives as Traders Demand Gold.
Another Janet Tavakoli piece, this one about the market for CDS on the United States.
I’d like someone to explain to me how trading a credit default swap on a U.S. Treasury note isn’t gambling. This is purely betting on crowd behavior — after all, nobody really thinks the U.S. will default.
It’s weird enough living in a country where a man can legally own an arsenal of machine guns, but his neighbor growing a pot plant will send a team of DEA agents kicking his door in with a no-knock warrant. But this goes even beyond that. If I go online today to HaveNoLifeAndBetOnSports.com and bet fifty dollars on the Bucks against the Celtics tonight, I’m a criminal. But some gazillionaire firm in New York can legally bet against the United States of America in unlimited amounts in a trade that has nothing to do with anything, but a guess about how many other people will make the same bet.
Jesus, are we a weird country.
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“I’d like someone to explain to me how trading a credit default swap on a U.S. Treasury note isn’t gambling.”
While they are at it, perhaps this same person can explain what is difference between investing and gambling. Warren Buffet no less described his purchase of Burlington-Santa Fe an “all-in bet on America”, that sort of speaks for itself.
Buying protection on the US, that’s economically the same trade as shorting treasuries and surely no less legitimate than taking the other side. Speculative? Sure… but what isn’t?
You’re right…it is a very very bizarre country. What’s amazing is how the American people really did take this lying down. Something tells me that had this happened in France, the youth would have been out in the streets shutting down the city until some sort of justice was dealt. Instead, we lost out to apathy while the people who did make their voices heard were the nutjobs that were worked up by the likes of Santelli and Beck.
It’s been made clear that, as you point out, being a “criminal” only applies to certain people and certain actions. Also, it reminds of what Kurt Vonnegut once wrote to a struggling immigrant writer: “The America you find yourselves in is the America I have tried to describe in my books. It makes no sense. Nobody knows what it is. Anything can happen.”
Cheers to you, Kurt.
Matt, Naked swaps were illegal, at least, until the CFMA passed. Below is an essay I wrote about the subject months ago.
Enron 3.0
You probably haven’t thought about Enron in a while – I know I haven’t. In the first version of Enron, they stole billions from Californians and helped create the State’s blackouts in the early 2000’s by manipulating electricity prices. In the second version of Enron, they famously went bankrupt when it was revealed that they had very few actual assets and were criminally inflating earnings. Then finally in the third version of Enron, which only recently came to light, they indirectly helped create our current financial crisis.
In a December 2000 email to Ken Lay and Jeffrey Skilling, Enron Lobbyist, Chris Long, said the following about the Commodity Futures Modernization Act of 2000 (CFMA): “Enron was a leading advocate of the passage of this legislation.” You know, if Enron was involved, this will not end well. But I am getting ahead of myself.
The CFMA is a little known, and little debated Act signed into law by Bill Clinton in December 2000 that exempted financial derivatives from government regulation by the SEC or anyone else for the matter. While I am not an economist or expert on the subject, I did stay at a Holiday Inn Express last night so I will try to explain how all this fits together.
The CFMA opened the door to unregulated trading of “credit default swaps,” one of the financial instruments blamed by many for creating our current crisis (the other is collateralized debt obligations, such as mortgaged-back securities). At their simplest, “credit default swaps” are insurance contracts bought to protect against losses of the underlying asset. For example, those financial institutions that bought the mortgage backed securities hedged this risk of default of the underlying assets (i.e., mortgages) by buying a contract that would make them whole should the asset suffer loss.
Bailout king and insurance giant, AIG, sold these credit default swaps like cans of soda. Indeed, many experts believe that without the creation of the market for credit default swaps, that mortgage backed securities, would not have grown to a $60 trillion market, nearly twice the size of the Stock Market.
Put another way, without these “credit default swaps” Wall Street would not have been able to grow this new market because mortgage-backed securities would have never received AAA or AA ratings. This in turn fed air into the housing bubble as risky borrowers were now allowed to obtain mortgages, even without a job.
But like everything on Wall Street, the whiz kids took it one step further, taking this insurance contract and selling it on the open market. They called this new breed of credit default swaps, “naked” swaps. It was a naked swap because unlike an insurance contract where the person buying it has some risk or exposure, i.e., they could lose money on the deal; the “naked” credit default swap was really just a bet against someone else’s failure. Indeed, it was the ultimate form of shorting.
And, ultimately, “naked” swaps dominated this new credit default swap market. In most States, “naked” swaps were considered gaming and therefore either regulated or prohibited entirely. Of course, had it not been for the CFMA preventing the States from regulating this market, “naked” swaps would have still been considered gambling. After Clinton signed the CFMA into law in 2000, the betting began in earnest and the market grew from $900 billion to $60 trillion (remember a trillion is a thousand billion and a billion is a thousand million).
So at the end of the day, these credit default swaps that were designed to hedge risk, instead ended up multiplying the risk as people placed bets about the credit worthiness of certain bonds and loans, including mortgage backed securities. Of course, once the housing bubble burst, these huge profits quickly turned into huge losses. The losses mounted and triggered the credit default swaps which triggered another round of huge losses.
So how and why did Enron get the CFMA passed? Enron did what all big, successful companies do, it bought itself access through deregulation-champion, former Senator Phil Gramm, who threw his considerable political weight around to get the CFMA attached to an 11,000 page appropriations bill with virtually no debate at all. What started out as a way to deregulate certain electronic trades ended up deregulating these new financial instruments? So as a new millennium began, the ticking time bomb had been set.
The fact that Gramm’s wife was on Enron’s Board should have set off alarm bells in Washington that the fix was in and someone should have put a stop to it. At the very least, there should have been a debate and a vote on the 262 page bill by itself. But this is the way the game is played and Gramm was a master at playing it. While, I am sure that Gramm did not intend on creating the pathway to our current crisis, had there been any debate at all; maybe this deregulation may not have happened. Indeed, I do not understand how conservatives can have a lack of trust in big government while at the same time completely trusting big business. This seems logically inconsistent. Here’s a conservative principle: How about we don’t trust either?
Your not going to like the explanation you seek…
A bond’s yield (or nominal return) is comprised of two rate components, a real rate of return, or what the US government should pay, plus a risk premium, of which the largest component is inflation. Most people erroneously substitute inflation for the risk premium. There are other risks, like illiquidity and default. Historically, these risks were nil, so inflation was the only other risk to consider for USTs.
Now say you are an institutional investor in US treasuries and for some reason you don’t want to own some or all of them anymore. But they cannot sell them in the cash market because a) they don’t want to hurt the remaining value of the holdings, or b) they don’t want the public to know they were a seller of Uncle Sam, or c) they don’t want to pay taxes on their gains (if they had any).
But buying protection (or being short) in a US CDS, they are in essence neutral US treasuries without selling their cash holdings. Long cash, short CDS, equals zero.
That’s on paper. In reality, they are long the US, and long a private counterparty. If the US did default, the private counterparty may encounter a shitload of problems, and they may not be able to make good on their commitment to your CDS trade. If that happens, the investor who hedged out his US treasury exposure would lose twice, not have the zero exposure as intended. In other words, hedging a US treasury default is flawed, because it assumes the system will continue to function under such a cataclysmic scenario.
O course there are speculators in the market, and that is just that: A bet on the risk premium.
Errata: I should have said “they don’t want to book a gain”. Institutions may want to avoid an accounting gain or regulatory gain, because of how they are represented in the firms financials.
“are we a weird country.” Not really a country. More like a tax code; a bunch of professional sports franchises; people who would be mental patients in other countries commanding the radio.. all in the same area geographically. But not a country.
Matt, you should buy Treasuries and sell CDS to get and extra .75% on your money every year. The thing is, nobody in Pre WWI Germany would have predicted the path that their country followed but it happened. In Weimar Germany the burden of debt led the difficult choice between two poor economic outcomes: austerity (great sacrifice to pay off the onerous debt)and inflation (to disguise the true debt burden to the people). They chose the latter and the economic hardship that followed led to the rise of Socialist idiots on The Left and angry National Socialist (Fascists) on The Right.
If you don’t see the parallel in the US you’re not looking. This administration is advocating a duel social and corporate (bankers, health insurance co’s, GM, etc.) welfare agenda. There are those on The Left that want only the Social Agenda who are angry and those on The Right who want only the Corporate/Nationalist agenda who are equally angry. In the middle you have the group that has to fight for control of the dialog to prevent the Weimar like schism from developing. Take the Ron Paul tea party movement as an example- Matt pointed out how the more fascist (neocon) elements of The Right are attempting to co opt what is a generally benign movement. You can also see the reception that Ron Paul supporters get from the likes of the Glen Beck crew. On the other side I think even the most hard-core Leftist will admit to being put-off by the likes of Acorn, etc.
So as a trader looking at history I see how you can view the economic path as being a choice between successfully inflating away the debt burden starting now or waiting for the interest cost to become unmanageable politically (say 40% of the budget) to the point that the choice is between defaulting or creating money out of thin air to buy the debt burden away, which will probably be inflationary as well.
I can see a fund manager acting on behalf of clients who rightfully seek to preserve their hard earned wealth putting a trade on that is half treasuries (to secure against deflation) and half gold (to protect against inflation) and now buying CDS to protect their Treasury exposure in the unlikely (~.75%) chance of default.
Now I don’t think this economy is as bad a Weimar Germany (we may even be in good shape) as the real productive capacity hasn’t been eroded in the same manner (no war and lost territory) but the entrenched interests may be in worse shape and more determined to screw the people in order to preserve the wealth accumulated over the last 3o years.
yossarian,
I think you have an interesting perspective, but check this point:
>”Now I don’t think this economy is as bad a Weimar Germany (we may even be in good shape) as the real productive capacity hasn’t been eroded in the same manner (no war and lost territory) but the entrenched interests may be in worse shape and more determined to screw the people in order to preserve the wealth accumulated over the last 3o years.”
No lost territory – but we are in 2 bad wards that are draining our economy. So we’re closer to *that* aspect of world war Germany.
>”If you don’t see the parallel in the US you’re not looking. This administration is advocating a duel social and corporate (bankers, health insurance co’s, GM, etc.) welfare agenda. There are those on The Left that want only the Social Agenda who are angry and those on The Right who want only the Corporate/Nationalist agenda who are equally angry. In the middle you have the group that has to fight for control of the dialog to prevent the Weimar like schism from developing. Take the Ron Paul tea party movement as an example- Matt pointed out how the more fascist (neocon) elements of The Right are attempting to co opt what is a generally benign movement. You can also see the reception that Ron Paul supporters get from the likes of the Glen Beck crew. On the other side I think even the most hard-core Leftist will admit to being put-off by the likes of Acorn, etc.”
The anger of both sides is maddening from my perspective, because there’s so much posturing to stir up emotions that there’s almost no time for debate. Speaking of fool Glenn Beck, his sole guest today is Eric Massa. Conspiracy to oust him or not? You decide. (rolly eyes)
In response to another comment. See in context »Sports betting is bad because the players lack the moral character to withstand bribes. Fortunately, we don’t have that problem with our top economic and political players.
It’s not gambling if you “own the house.” These fuckers have the weight of Uncle Shame behind them to manipulate markets, treasuries etc.
Interesting.
Can we set up a CDS on the turn of a Roulette Wheel in Monaco?
Theoretically, why not?
The basic premise of the piece is flawed: given enough leverage, anyone can go broke. Anyone. Including the United States of America.
All trading is speculating on human behavior because all markets are governed by human behavior. Speculating on the price of movements of the U.S. Treasury market is only gambling if you’re stupid and don’t know what you’re doing. A trader doesn’t gamble; he speculates.
This betting on crowd behavior happens every single day and will continue to happen as long as there are markets to trade. The only difference is that the CDS market is totally unregulated which makes it almost completely nontransparent. Speculation aily and intraday price movements in the Treasury markets occur every day at the CBOT in the futures markets. This market is traded on an exchange, however.
To think that trading or investing is only intelligent or responsible when done in a long-term manner, based on sound principles of value and fundamentals is to totally miss the point. Value is ALWAYS subjective and is ALWAYS based on human behavior, because value is determined by the perceptions of human beings.
The smart traders do not assign an objective value to something. Instead, they understand that value is determined by the crowd and so they speculate on which way the crowd will push a market, whether it’s day trading or longer-term trading. Those who insist on an objective value for something are playing a sucker’s game. How many of those folks got their asses absolutely handed to them in 2007-2008 because they insisted the market wasn’t assigning a “fair” value to their investments.
There’s no such thing as fair. It’s all human behavior. The great traders probably knew more about crowd psychology that just about every psychologist and psychiatrist – and certainly every investor – in existence.
I follow your point but think you weight the psychological factor too heavily. The objective value does matter — eventually. One of my favorite examples is John Templeton at the peak of the dotcom mania. Sensing the party could not last forever, that values were way above the “objective value,” he began shorting dotcoms — all of them — 30 days before their waiting periods ended and employees could start selling. He made (another) fortune.
What’s the saying? Short term, the market is a voting booth, long term it is a scale. Granted, it’s complicated by currencies and inflation and many other factors, but I think there is something that could be reasonably called an objective value for most assets. (Not that anyone has all the information needed to assign it accurately.)
In response to another comment. See in context »I’d like to see the Mafia turn the tables on the Feds and bring a lawsuit against them for NOT prosecuting organized crime in our hallowed financial institutions. Smacks of discrimination to me, doesn’t it to you?
yeah, you know? that seems so absurd and surreal. i mean if the US defaults, what exactly are the gains? who the fuck is supposed to bail them out then?
“It’s weird enough living in a country where a man can legally own an arsenal of machine guns, but his neighbor growing a pot plant will send a team of DEA agents kicking his door in with a no-knock warrant.”
I like that quote. I guess this is where we kind of disagree. I think that guy should be allowed to own as many machine guns as he wants. I also find it ridiculous that we waste so many resources chasing guys who grow and smoke a plant. Freedom is a two way street and should not discriminate.
I agree- as long as they’re not the same guy. I don’t want to see someone working a .50 BMG and a bong at the same time.
In response to another comment. See in context »True indeed. There is no guarantee whatsoever that the US can not go bust. As a matter of fact, with total liabilities (incl. off-balance sheet) of more than 500% to GDP that notion is not so far-fetched as Matt seems to believe.
And if you see what John WILLIAMS of ShadowStats has to say, then the minimum that will happen to this beautiful country is hyperinflation
A story about weird…
A long time legendary, hip record store in PDX began selling a “Keep Portland Weird” bumper sticker several years back. The idea was borrowed from Austin, a truly weird place for Texas.
The owner was asked about by the local establishment rag, did he really think Portland, OR was weird? He replied he simply thought it would be a good selling item so he did it. And it does sell, you can see it on cars all around town.
In reality PDX is not weird at all.
Everybody sits in coffee houses with their laptops all day, or micro brew pubs with their cells on the table top all night. They’re decked out in fleece + cargo shorts in Winter, baggy denim, beards, tattooed all over and eating great, over priced, “local, sustainable” food.
Meanwhile roads filled with potholes are being converted to bicycle avenues by a mayor who lied to get elected, takes funds from sewer projects, road maintenance, yearly city street clean-up projects, and anywhere else. All this being done to further his $600+ million (labor not included) bicycle plan to “encourage” 25% of the the PDX population to ride their bikes to work in a place where it rains aprox. 60%-75% of the year.
The moral may be… “weird” has lost its meaning. Or has become the new normal.
The reality being it’s become just another commodity catch phrase in a shotgun attempt to sustain our unsustainable way of life and an economic system built on consumption for consumptions sake.
As far as “shorting” goes….the biggest name behind shorting is CALPERS….which loans out $1 billion per year in state government owned stocks to short sellers
Remember that controversy about a year ago, where New York State was going to close the off-track betting places, because they don’t turn a profit? I remember reading that and saying, “WTF–my state government is operating OTBs at a loss?! My taxes are subsidizing gambling addictions in a state where people get arrested for gambling (when they do it outside an OTB)?” That was (and is, because the state decided to keep throwing money at OTBs) simply astounding. Like I wonder whether I dreamed it.
It’s serfs-and-lords out there these days.
Not only can’t the US regulate the financial industry that just lit the country on fire, the US can’t even get its citizens health care.
Did you see Marcia Angell on Bill Moyers the other day talking about the health “care” bill? She laid it all out there, and she was right. Neither party is looking out for the people they ostensibly represent.
Marcia Angell is great. I first heard of her through her book, “The Truth About The Drug Companies.”
Here’s a link to her on Moyers:
http://www.pbs.org/moyers/journal/03052010/watch3.html
In response to another comment. See in context »Wow, Cruss, thanks for posting this. Is there a way to make this required viewing for each and every American? Between Ms. Tavakoli and Ms. Angell, I am now convinced that we must elect a smart, strong woman as the next President. Unfortunately, Hillary Clinton was really just a man in a skirt so that didn’t count.
In response to another comment. See in context »It’s weird enough living in a country where a man can legally own an arsenal of machine guns, but his neighbor growing a pot plant will send a team of DEA agents kicking his door in with a no-knock warrant.
Beyond the fact that there is no explicit right to bear pot plants, I actually agree: Machine guns and pot plants for all citizens in good standing! Keep Der Staat out of my bedroom, my medicine cabinet, my cookie jar, my gun closet, my car and my computer!
wait wait…I thought I was fighting for my right to arm bears! Dammit.
In response to another comment. See in context »Matt,
Credit default gambling (while semi-opaque)is no the half it; three reasons why this country is deteriorating faster than people realize into LET IT RIDE tables at the Venetian:
1) Now, they talk about legalizing the chronic
2) Every major US city is at three hours away from a casino
3) People play the Lottery to Fund Financial Education (nobody seems to bring up this is a tax on the mathematically challenged) but its for education then its all good….
I have more but I don’t want to steal Jacob Hacker’s thunder (The Great Risk Shift)
The Rake!
P.S. I am putting 50K on Wright State to win the NIT!
or as Yakov Smirnoff would say,
“What a Country!”
[...] Rhetorical question, eh? [...]
Speaking of weird rules: Essentially, prostitution is always illegal… unless you FILM it. (leaving out Nevada)
If you film yourself having sex with a prostitute (correction: “future potential porn star”) and have her sign something saying that you have the right to sell the recording for profit, it’s no longer prostitution, it’s “adult entertainment”.
Not all porn shoots become available for sale, so you’re under no obligation to actually publish the footage. So:
Having sex with a prostitute: illegal
Having sex while filming a prostitute: entrepreneurial
Now that’s what I call News You Can Use!
In response to another comment. See in context »this is a distraction from the topic at hand, but…
thomas friedman is running his mouth again…
http://www.salon.com/news/opinion/glenn_greenwald/2010/03/10/friedman/index.html
we look forward to your input.
Looking forward to checking out the derivatives invented once cap and trade gets started.
Will the dealers in those securities be able to buy insurance against alternative energy sources being developed or utilised?
Bet on how high the oceans will rise?
Will the locals in the sub Sahara spontaneously combust?
Ah, you’ve gotta laugh…
Whenever I hear the tired argument that the military as we know it would implode if straight men were “forced” to serve alongside gay men, I can’t help but wonder if the people making this argument realize that we ALREADY have straight men serving alongside gay men. Did these people not get the memo? They behave as if repealing DADT would miraculously cause gay people in the military to exist despite the fact that gay people in the military ALREADY exist.
Since straight men and gay men are already serving side-by-side, and the military considers the current system to be functional, I can’t help but wonder why there would be a radical change if we simply allow these people to admit that they’re gay. Do they think the gay men in the military can only “control” their “urges” if they pretend to be straight? Do these people honestly believe that a good soldier is suddenly going to transform into a mindless, out-of-control lech simply because he can admit that he’s gay without fear of losing his place in the military?
My mistake, I meant to post this under “Rush on ‘Massa’” where it actually has relevance and not here where it is completely non sequitur.
In response to another comment. See in context »Those swaps are tools for risk management. Suppose you are an investor/company that is ‘exposed’ to a potential US default(ie you stand to lose unknown portion of your investment in case the event happens). Then you can ‘hedge’ against the risk by betting that US will default. Financial institutions merely sell these instruments.
The comparison to sports betting is completely wrong. There a better doesn’t stand to lose anything tangible if one sports team wins or another- he is just trying to get lucky, like in a lottery.
This post is horribly misleading and does a disservice to readers not informed about finance/economics.
Janet Tavakoli is the female anti-christ†
Shorting America is something Canada’s been doing for centuries; if it worked, howcum we’re not rich?
In what way (that matters) is Canada not rich?
In response to another comment. See in context »“….after all, nobody really thinks the U.S. will default.”
Doesn’t this imply that, if one person (or a dozen, or a hundred) really believes (however irrationally) that there is a real risk the US could default, then there is nothing wrong with their wanting to insure themselves against that risk?
The article implies that buying a credit default swap is inherently unpatriotic: a “bet against the United States of America.” But wouldn’t that make SELLING a CDS a noble vote of faith in our government and way of life?… See More
What is the real problem? Taibbi isn’t clear here. Is it that the price of portfolio insurance through a CDS has doubled in the recent past? Or is it that this market exists at all?
Let’s stipulate: Some people are going to make financially risky bets in arcane markets, whether short-selling stocks, selling flood insurance, or buying pork belly futures. And they’ll end up either making or losing money on the deal. That’s not a problem per se, at least not for me.
The chief problem comes when one side loses more than they thought they could, then demands (and gets) a bail-out from the government to cushion their losses. At that point, the public has a real right to complain. So, to the extent there is an assumed government backing of one of the parties, that IS a real problem.
Another real problem with portfolio insurance (of all kinds) is that it is riskier than it looks. We should have learned that after the 1987 stock market crash, or in the wake of the junk bond collapse of the early 90s — and we should certainly have learned the inherent riskiness of credit default swaps from the AIG fiasco. Taibbi is right to point out that portfolio insurance, when practiced on a large scale, can easily become a market with a wildly unstable equilibrium, where everyone is betting based on nothing more than their expectations of other people’s expectations. (But note, this is an argument that insurance through a CDS probably costs not too much but too little; and this is at odds with Taibbi’s apparent belief that the risk of a US credit default is effectively zero.)
IF we are going to allow people to trade in credit default swaps, we need to regulate the market — at least to the point of making sure that the people who “naked sell” a CDS have the means to make good on their potentially huge losses, and that everyone understands that the function of government is not to pick up the pieces when someone’s investment goes sour.
Where is Vincent Bugliosi when you need him? Get him and Elliott Spitzer to team up to go after the long line of elected officials and Goldman, JP, Citi, et al execs who created this ponzi scheme. It will take an army of prosecutors to confront this group and withstand the armada of special interests and Fox news cronies who would scream persecution to distract the masses from giving a damn.
Chris Dodd’s performance on Monday was pathetic. No wonder he is not running again, because he’s been in on the scam from the start.
I am still waiting for the creative/inventive lawyer – Bugliosi would be my man, but he is retired and just writes books – who starts bringing together the investors who were scammed into a mass class action suit against each of the participants. There is an enormous amount of anger out there. It just takes someone who can channel it properly to bring these sorts of Ponzi schemes to s just end.
Enron was the tip of the iceberg of corporate scams. Madoff’s are born from this environment and you have to know there ar emany more Madoff’s out there who have yet to be discovered, but will soon.
Obama hates to look back, but if these crooks go unpunished, no amount of regulation and dopey speeches like Dodd’s will restore institutional trust in the markets. People laugh at Ralph Nader today, but he was last great consumer rights defender. We need more of them today.
Now that is what I call some news. I’m with you Matt. (Response to comment above) But I think anyone can go broke. Anyone. Thats means the US. End of the American Empire as David Simon would say.
http://www.myspace.com/virginhook