Saturday, September 04, 2010

Economic Consequences of Speculative Side Bets

The following column was written jointly with Yeon-Koo Che and is crossposted from Vox EU with minor edits and links to references.
There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang M√ľnchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance. In sharp contrast, John Carney believes that any attempt to prohibit such contracts would crush credit markets, Felix Salmon thinks that they benefit distressed debtors, and Sam Jones argues that they smooth out the cost of borrowing over time, thus reducing interest rate volatility.
One reason for the continuing controversy is that arguments for and against such contracts have been expressed informally, without the benefit of a common analytical framework within which the economic consequences of their use can be carefully examined. Since naked credit default swaps necessarily have a long and a short side and the aggregate payoff nets to zero, it is not immediately apparent why their existence should have any effect at all on the availability and terms of financing or the likelihood of default. And even if such effects do exist, it is not clear what form and direction they take, or the implications they have for the allocation of a society's productive resources.
In a recent paper we have attempted to develop a framework within which such questions can be addressed, and to provide some preliminary answers. We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice.
A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information. Individuals receiving the same information can come to different judgments about the meaning of the data. They can therefore agree to disagree about the likelihood of default, interpreting such disagreement as arising from different models rather than different information. As in prior work by John Geanakoplos on the leverage cycle, this allows us to speak of a range of optimism among investors, where the most optimistic do not interpret the pessimism of others as being particularly informative. We believe that this kind of disagreement is a fundamental driver of speculation in the real world.
When credit default swaps are unavailable, the investors with the most optimistic beliefs about the future revenues of a borrower are natural lenders: they are the ones who will part with their funds on terms most favorable to the borrower. The interest rate then depends on the beliefs of the threshold investor, who in turn is determined by the size of the borrowing requirement. The larger the borrowing requirement, the more pessimistic this threshold investor will be (since the size of the group of lenders has to be larger in order for the borrowing requirement to be met). Those more optimistic than this investor will lend, while the rest find other uses for their cash.
Now consider the effects of allowing for naked credit default swaps. Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it. However, pessimists also need to worry about counterparty risk - if the optimists write too many contracts they may be unable to meet their obligations in the event that a default does occur, an event that the pessimists consider to be likely. Hence the optimists have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives. The borrowing requirement must then be met by appealing to a different class of investors, who are neither so optimistic that they wish to sell protection, nor so pessimistic that they wish to buy it. The threshold investor is now clearly more pessimistic than in the absence of derivatives, and the terms of financing are accordingly shifted against the borrower. As a result, for any given borrowing requirement, the bond issue is larger and the price of bonds accordingly lower when investors are permitted to purchase naked credit default swaps.
This effect does not arise if credit default swaps can only be purchased by holders of the underlying security. In fact, it can be shown that allowing for only “covered” credit default swaps has much the same consequences as allowing optimists to buy debt on margin: it leads to higher bond prices, a smaller issue size for any given borrowing requirement, and a lower likelihood of eventual default. While optimists take a long position in the debt by selling such contracts, they facilitate the purchase of bonds by more pessimistic investors by absorbing much of the credit risk. In contrast with the case of naked credit default swaps, therefore, the terms of lending are shifted in favor of the borrower. The difference arises because pessimists can enter directional positions on default in one case but not the other.
While this simple model sheds some light on the manner in which the terms of financing can be affected by the availability of credit derivatives, it does not deal with one of the major objections to such contracts: the possibility of self-fulfilling bear raids. To address this issue it is necessary to allow for a mismatch between the maturity of debt and the life of the borrower. This raises the possibility that a borrower who is unable to meet contractual obligations because of a revenue shortfall can roll over the residual debt, thereby deferring payment into the future.
As many economists have previously observed, multiple self-fulfilling paths arise naturally in this setting (see, for instance, Calvo, Cole and Kehoe, and Cohen and Portes). If investors are confident that debt can be rolled over in the future they will accept lower rates of interest on current lending, which in turn implies reduced future obligations and allows the debt to be rolled over with greater ease. But if investors suspect that refinancing may not be available in certain states, they demand greater interest rates on current debt, resulting in larger future obligations and an inability to refinance if the revenue shortfall is large.
A key question then is the following: how does the availability of naked credit default swaps affect the range of borrowing requirements for which pessimistic paths (with significant rollover risk) exist? And conditional on the selection of such a path, how are the terms of borrowing affected by the presence of these credit derivatives?
For reasons that are already clear from the baseline model, we find that pessimistic paths involve more punitive terms for the borrower when naked credit default swaps are present than when they are not. More interestingly, we find that there is a range of borrowing requirements for which a pessimistic path exists if and only if such contracts are allowed. That is, there exist conditions under which fears about the ability of the borrower to repay debt can be self-fulfilling only in the presence of credit derivatives. It is in this precise sense that the possibility of self-fulfilling bear raids can be said to arise when the use of such derivatives is unrestricted.
The finding that borrowers can more easily raise funds and obtain better terms when the use of credit derivatives is restricted does not necessarily imply that such restrictions are desirable from a policy perspective. A shift in terms against borrowers will generally reduce the number of projects that are funded, but some of these ought not to have been funded in the first place. Hence the efficiency effects of a ban are ambiguous. However, such a shift in terms against borrowers can also have a more subtle effect with respect to project choice: it can tilt managerial incentives towards the selection of riskier projects with lower expected returns. This happens because a larger debt obligation makes projects with greater upside potential more attractive to the firm, as more of the downside risk is absorbed by creditors.
The central message of our work is that the existence of zero sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic about the future revenues of borrowers, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic about the borrower's prospects, and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns.
James Tobin (1984) once observed that the advantages of greater “liquidity and negotiability of financial instruments” come at the cost of facilitating speculation, and that greater market completeness under such conditions could reduce the functional efficiency of the financial system, namely its ability to facilitate “the mobilization of saving for investments in physical and human capital... and the allocation of saving to their more socially productive uses.” Based on our analysis, one could make the case that naked credit default swaps are a case in point.
This conclusion, however, is subject to the caveat that there exist conditions under which the presence of such contracts can prevent the funding of inefficient projects. Furthermore, an outright ban may be infeasible in practice due to the emergence of close substitutes through financial engineering. Even so, it is important to recognize that the proliferation of speculative side bets can have significant effects on economic fundamentals such as the terms of financing, the patterns of project selection, and the incidence of corporate and sovereign default.


  1. Naked CDs can shift the terms of financing against the borrower on a micro level. But what about macro? If pessimists are allowed to buy naked protection, they might be inclined to save more. If some projects are unfunded, this will shift terms for other projects.

  2. It's an interesting idea - theoretically possible but do you really think that it is empirically significant? What you are saying, in effect, is that unrestricted gambling of any kind should increase savings because the available outlets for that saving have increased. Should be testable. Interesting possibility but I'm skeptical.

  3. Simply fantastic insights into the credit default market, but I have one question.

    On first impression, it seems like the introduction of *new* zero-sum side bets would cause the marginal creditor to become more pessimistic and to increase rates/collateral requirements for loans to borrowers. This would increase the likelihood for default of current borrowers, as interest rates and collateral requirements would jump--particularly in cases of refinancing and roll-overs.

    However, what if the zero-sum contract or close substitutes have been in existence prior to or during the entire life of the debt issuance? As you note, wouldn't the existence of such side-bets simply reduce lending to inefficient projects and risky borrowers at the outset? Wouldn't the prior existence of CDOs decrease the possibility of default in the future by restricting credit to more creditworthy borrowers & projects?

    Amol Shelat

  4. I'm not really sure about the empirical significance but if there is a study that has investigated how household spending/investment decisions changed after the introduction of National Lottery in the UK, I'd be interested to see the results.

    For me the most important empirical issue is whether CDS trading is driven by absolute or relative pessimists. If CDS trading is driven by relative pessimists (who are more pessimistic than average about some projects but more optimistic about others) then the aggregate level of investment doesn't change, but different projects get funded. As GDP grows, poor investment results should hurt absolute pessimists and drive them out from business. It might well be the case that all those dedicated short funds are held by investors who are net 100% long and are using short funds to improve risk/return profile of their portfolios.

  5. 123, Rajiv,

    I suspect you might find empirically that increasing the opportunity for gambling might actually go with lower savings.

    A simple Ramsey-Solow growth model would appear to imply that high consumption volatility should go with high savings (precautionary savings) and thus with high growth (due to more investment). In fact it's the opposite.

    Presumably this is due to some sort of financial accerlartor type effect (Bernanke-Gertler stuff). It would then, presumably, follow that anything that increases financial fragility should actually end up lowering growth and the lower incomes would lead to lower savings.

  6. Amol, the answer to your question is "not necessarily" for at least two reasons. First, it depends on the distribution of beliefs among investors relative to those of borrowers and policy makers - the effect you describe works best when investors are highly optimistic and willing to fund too broad a range of projects. Second, there is an "agency problem" or conflict of interest between management and shareholders that can induce the former to select projects with greater upside potential and lower expected return especially when debt levels are higher. We argue in the paper that the presence of naked CDS can make this problem worse. But I should add that our analysis of these efficiency issues is very preliminary and the effects you have in mind can certainly also arise.

  7. 123, Adam: this gambling/savings connection is very interesting and I've never really thought about it before. Restricted gambling is a form of market incompleteness which shrinks the set of outlets for savings and also results in less consumption volatility as you have noted. Someone should really look at the theoretical effects of this on efficiency and growth. It's linked to the CDS question but is in some ways much broader.

  8. Professor Sethi, perhaps misaligned incentives and even simple model-miscalculation play a role in the number of marginal pessimists which participate in purchasing CDSs. Money managers who sell CDSs have an incentive to under-price the instrument as long as the yield is deemed acceptable for their investors (Such as AIG). If these instruments are perennially under-priced (i.e. tail risk is underestimated) it may bring in more marginal buyers of CDSs who do not necessarily have to be extremely pessimistic of the prospects of the company.

    Or perhaps a cognitive bias towards optimism of the individuals selling naked CDSs, through a selective process in which pessimistic individuals leave large firms - while optimistic ones who find yield are kept, especially during times of stock-market booms, can explain an inherent underpricing in complex pessimistic derivative contracts, once again bringing in more marginal buyers.

    Forgive me for not understanding or repeating something which you already stated.

  9. Yes, I agree on both points. From an evolutionary perspective it's easy to see why tail risk might become systematically underpriced over time as long as disaster is averted. I have written about this in earlier posts, and you'll also find interesting perspectives on the Macroeconomic Resilience blog, linked in the sidebar.

  10. I don't see why these concepts should be so unintuitive. Ignore counterparty risk for a moment. If someone is bullish on mortgages, he is basically indifferent between writing a new mortgage and making a long side bet on existing mortgages by writing a CDS. If we have more bearish investors in the market, then more capital will be able to be allocated to side bets rather than to writing mortgages.

  11. Kevin, we are not looking at the price effects of changes in beliefs, we are looking at the price effects of changes in the menu of available contracts for a given distribution of beliefs. Also, the indifference you mention will not hold because of differences in leverage between the two strategies.

  12. For some reason Mark Thoma decided to pass on this one, and only Yves Smith posted it for comments.

    But the paper strikes me as rather abstract from actual business practices, as if detailed information isn't wafting from downtown up to Morningside Heights.

    One question I'd have is what is the actual functionality of a covered CDS, since bond prices/interest rates are supposed already to be compensating for estimated default risks. The obvious answer is that they permit ongoing price arbitrage between CDS and secondary bond markets, but given the opacity of OTC markets and the practices of aggregating contracts in CDS indexes and synthetic CDOs, that channel would seem only very partially effective in raising or lowering bond prices accurately, and the added "liquidity" coming from an additional node might just as well tend to lessen credit analysis and monitoring, while introducing an additional source of variations in prices. Besides which the seller of CDS protection is always in a sense "uncovered", no? And then again how does one exactly detect naked CDSs unless the notion outstandings do in fact exceed the actual bond outstandings?

  13. CDSs were invented in 1993 by a rogue IB operation with the ironic legacy name of "Banker's Trust", which specialized in inventing exotic new derivatives, only to have them blow up and trigger a flurry of lawsuits, until the remnant of the company was bought up by Deutsche bank in 1997. But it was only in the last cycle in the naughties that they really come into their own, going from a notional $900 billion in 2001 to a notional $62 trillion in 2006, according to BIS figures. It seems that explosion must have involved a forward flight phenomenon, whereby older contracts a lower prices needed to be hedged by other newer contracts at higher prices and so on, in a self-perpetuating dynamic, regardless of any actual functionality. And, of course, protocols for margining were being developed on the fly and crash settlements in place of physical ones developed, leading to inconsistencies in settlements and in the actual protection CDSs afforded. It strikes me as an outsider as a huge mess heading for disaster, even if a cascade of counter-party defaults causing a melt-down like an electricity blackout didn't exactly occur.

  14. There are many other issues your paper doesn't seem to touch on. There's the effects of CDSs potentially on bankruptcy settlements. There's their role in arbitraging regulatory capital requirements and thus building up huge amounts of implicit embedded leverage in the financial system. (Consider "negative basis trades", most famously those super-senior tranches that remained on IBs books insured by AIG. For 20 bps of "free" money to be meaningful, tens of millions had to be drawn into such a structure). But I think the two biggest issues of CDS dysfunctionality are 1) the way that short positions can send an opposite signal to the markets than what a short should, raising rather than lowering prices in establishing a short position and draining rather than adding liquidity from the market in the event of default. (I've little doubt that CDS margin calls played a large role in the massive liquidity drain in Q3 2008). And 2) the way that CDSs contribute to greater connectivity between different asset markets through an unfathomable diversity of strategies. A seller of CDS protection on junk bonds, for example, might be funding a stock market short on the same company.

    So, in short, for your model to be convincing, agents shouldn't just be differentiated as optimistic or pessimistic on single name cases. A large diversity of different agents' strategies are operative, which might not be simply optimistic or pessimistic, would be in play across interconnected markets. The issues of embedded leverage, information loss and misaligned short price signals, excessive liquidity drain and market interconnectivity need to be modeled to address the issue of the functionality or dysfunctionality of CDSs.

  15. John, one reason we posted a summary of the paper was to get comments such as these, so thank you.

    Yes, it's an abstract model that deals with just a couple of aspects of the functionality issue. But there has been considerable confusion and dispute surrounding even these limited questions and this is what motivated us to develop the model. The hope is that we have at least clarified some of the collateral and rollover risk effects.

    While the questions you raise are all worth exploring formally, building them into a single model would be neither feasible nor clarifying. There is work by Bolton and Oehmke on the bankruptcy settlement effects of covered CDS, and Ross Levine has looked at the issue of capital requirements (I'll discuss his very interesting financial autopsy paper in a subsequent post). Liquidity drain and perverse price signals have not yet been explored formally as far as I am aware, and this is certainly worth doing.

    When we looked around at the literature in economics and finance it seemed that there was very little that could shed light on the debates that were raging at the time. Our paper is a tentative step in the direction of bridging this gap, and is by no means intended as the last word on the topic.

  16. The collateral assumption seems inconsistent with the way that CDS issuers acted and wrong conceptually.

    A naked CDS issuer will issue one or more CDS obligations related to many different bond issues. The odds of default on even relatively high grade junk bonds is much less than 100%. The odds of every CDS in the portfolio covering many bond issues going bad at once is extremely low, particularly if there is some diversity in the portfolio. Yes, collateral would be required, but the collateral required for the portfolio as a whole would still be only a fraction of the aggregate CDS face values in the portfolio, even in the face of very conservative counterparty risk assumptions. Conceptually, the problem is similar to setting reserve requirements for commercial banks, but with obligations very different, larger and less statistically independent of each other than the loans in a commercial bank loan portfolio.

    A look at page 15 of the paper seems to assume that collateral amounts will be much larger than they would be in practice.

    Less collateral means fewer funds stolen from the direct bond purchase market, which could change the macro-implications considerably, turning a strong first order effect, into a tertiary second or third order effect dominated by other considerations.

    I'd also concur with the notion that any regulatory limitation could be circumvented by close substitutes. Letters of credit and simple guarantees of debts come to mind. This isn't rocket science. Today's paper featured the rapid organic development of a co-signer market in the college student credit card market, now that they can't get credit cards without them. The only way to really shut down naked CDS transactions is for the market to lose faith in the soundness of the deals for the people who participate in them.

  17. Andrew, we certainly make a very extreme assumption about collateral requirements (effectively ruling out counterparty risk) but this is really not critical because there is no limit on the extent to which such contracts can be written. Less restrictive collateral requirements per unit notional will end up resulting in a larger number of contracts written. I don't believe that the result will be a second or third order price effect, or that less capital will necessarily be diverted to support speculative positions in the aggregate.