EXTENDING THE FIELD OF DEDTS AND GUARANTEES
Even if they do not share the same debtor, household, enterprise and government debts may merge, in a manner such that respective governments must act as a final recourse. Of course, this was precisely the direction of economic history in 2008, when the FED in the USA or other central banks had to intervene to re-establish the solvency of the banking systems, through: (1) purchasing defaulted assets via TARP (Troubled Assets Recovery Program); (2) guaranteeing new issuances; and (3) providing increases in capital (Royal Bank of Scotland “RBS”, ING, DEXIA, BPCE, etc.).
DEVIATIONS FROM EFFECTIVE RISK CONTROL: THE CDS CASE
The credit default swap (CDS) – a swap of default risk – allows two players to transfer the default risk attached to an asset or to a group of assets (in general bonds or other types of instruments). Even though one format is dominant (ISDA), such contracts are not standardized and multiple variations exist. In general, CDS contracts are exchanged with a commission expressed in basic points, which protects the buyer against a debtor's or issuer's default. In the case of default, the CDS seller pays the holder of the contract. As may be vividly recalled, the 2008 Lehman bankruptcy gave rise to legal and moral disputes involving contractual consideration for this genre of market contracts. Despite these new trends, however, the CDS market has remained without oversight for some time but is now narrowly regulated with respect to the clearing process.[1]
European Regulation (European Market Infrastructure Regulation “EMIR” 648/2012 of ESMA origin), as a result of the G20 decision made at the September 2009 summit in Pittsburgh, now requires that central counterparties and a trade repository be organized, where derivative instruments will have to be recorded and cleared. The US Dodd-Frank Act provides for the same requirements. We immediately understand that this will bring about the currently missing transparency and knowledge on carried risk of derivative instruments; on the contrary, such centralization increases the systemic character of default risk, which is no longer spread between a previously unknown number of market participants. Nevertheless, to give some flexibility to the requirements, the Council of the European Union has also delegated the implementation (June 6, 2013 10611 and July 22, 2013 published on July 24).
In the USA,[2] the same flexible approach has been adopted by the CFTC and SEC. The list of derivative contracts to be traded on a registered central trading and clearing platform is decided by those agencies; small banks and “end users” that use swaps to cover their commercial operations have been exempt from such obligation. Entities that trade over the counter are to declare the existence of the trade and why they aren't going through a CCP. Issuers and listed companies have to go through their governance committees to have their hedging process approved.
Despite this new regulation, the CDS contract remains independent of the underlying asset class – thereby explaining the extraordinary amounts of affected assets, and the brutal reduction of their inventory in the recent past. Until now, no final resolution has been provided as to the total amount of impacted inventory, especially the equivalent value that should have materialized to meet outstanding warrants during clearance of CDS instruments on the $240 billion Lehman debt. In fact, the final claimed amount seems to have accounted for only $10 billion. One of the explanations provided to date is that the players (buyers and sellers) concurrently showed only the net amount of CDS value, but this point remains to be analysed.
It is also possible that some issuers bought back their own paper but beneficiaries disappeared, in part because of the massively contracted amounts of value remaining to be recovered and by virtue of the unknown origin of some of the underlying funds.
Given this type of uncertainty, how can these types of instrument-based debts be correctly appraised on the balance sheets of concerned entities? Although balance sheets designed for posting such values may be set up with the best and clearest of intentions, they may inevitably raise doubts. It is not the “conduits” of value which are at stake, but the value of CDS instruments' guarantees, and especially the identity and collateral validation of the debtor's counterparty. For instance, managers of some European banks convened for crisis meetings when the validity of the CDS instruments sold by AIG on Lehman Brothers' debt was disputed, albeit for a fortuitously short period of time.
Both the under-appraisal of risk and the time lag between premium payments and the occurrence of default events (including uncertainty about their definition) were identified as the cause of huge speculative movements on all financial markets during the autumn 2008 crisis – the resulting volatility was then linked to a rapid liquidity crisis that emerged concurrently, alongside other risks predictably associated with such market events.
A significant number of sovereign CDS contracts carry a quotation that remains independent of underlying assets. Following the Libor scandal, and given the concentration of the CDS market among only a few major banking hands, a question therefore arose with regard to how the insurance premium (that the CDS quote is deemed to represent) and attendant interest rate fluctuations interacted with the actual sovereign debt instrument that applicable CDS instruments were designed to hedge against. However, because of national tax policies, sovereign debt-based financial markets did not show sensible interest rates – at least of the range that in any eventuality could cover the default risk that made issuance and trading of CDS instruments necessary in the first place.
Even in the absence of suspicion about the role of market makers, if the underlying CDS debt is issued by a financially troubled country then it is axiomatic that the corresponding CDS market for such debt may shrink, and in the process may generate a precipitous rise in interest rates on that debt. By issuing guarantees on sovereign debt in this manner, the CDS system remains a predominant driver for producing capital liquidity, and thus a misleadingly attractive trap for impacted governments. As one example, both the Lehman Brothers and AIG events demonstrated that governments would have to step in and externally monetize their stressed banking and insurance institutions, for instance in case of the latter's impending collapse.
The CDS and other swap markets, where quotes are self-assembled by observation and “modelling” (as if this market were to represent a quotation basis worthy of trust), is in fact a fake construction that supports the issuance of fake sovereign money. CDS instruments and their market constitute a timing game that simply increases the actual risk of sovereign defaults. In the final equation, however, tangible commissions generated by the financial sector organizers are not a fake – as such parties have benefited handsomely from the past absence of regulation, budget discipline and governmental leadership.
- [1] European Market Infrastructure Regulation (EMIR): nude CDS instruments issued on sovereign debt, but released without a hedging basis, are now prohibited on regulated markets in part to avoid speculation. The US equivalent is Title VII of the Dodd-Frank Act adopted on May 20, 2010 with similar approaches. Nevertheless, the allocation of surveillance is different in the USA and EU.
- [2] Visit the Financial Regulatory Reform Center.
