Charles Davì

Credit Default Swaps And Mortgage Backed Securities

In Politicized Economy, Systemic Counterparty Confusion on February 2, 2009 at 9:53 am

Also published on the Atlantic Monthly’s Business Channel.

Like Your Grandsire In Alibaster

In this article, I will apply my usual dispassionate analysis to the role that credit default swaps play in the world of Mortgage Backed Securities (MBSs). We will take a brief look at the interactions between the issuance of mortgages, MBSs, and how the concept of loss plays out in the context of derivatives and mortgages. Then we will explore how the expectations of the parties to a lender/borrower relationship differ from that of a protection seller/buyer relationship and how credit default swaps, by allowing markets to express a negative view of mortgage default risk, facilitate price correction and mitigate net losses. This is done by applying the concepts in my previous article, The Demand For Risk And A Macroeconomic Theory of Credit Default Swaps: Part 2, to the context of credit default swaps on MBSs. This article can be considered a more concrete application of the concepts in that article, which will hopefully clear up some of the confusion in that article’s comment section.

The Path Of Funds In the MBS Market

Mortgage backed securities allow investors to gain exposure to the housing market by taking on credit risk linked to a pool of mortgages. Although the underlying mortgages are originated by banks, the existence of investor demand for MBSs allows the originators to effectively pass the mortgages off to the investors and pocket a fee. Thus, the greater the demand for MBSs, the greater the total value of mortgages that originators will issue and ultimately pass off to investors. So, the originators might front the money for the mortgages in many cases, but the effective path of funds is from the investors, to the originators, and onto the borrower. As a result, investors in MBSs are the effective lenders in this arrangement, since they bear the credit risk of the mortgages.

This market structure also has an effect on the interest rates charged on the underlying mortgages. As investor demand for MBSs increases, the amount of cash available for mortgages will increase, pushing the interest rates charged on the underlying mortgages down as originators compete for borrowers.

Loss In The Context Of Derivatives And Mortgages

I often note that derivatives cannot create net losses in an economy. That is, they simply transfer money between two parties. If one party loses X, the other gains X, so the net loss between the two parties is zero. For more on this, go here. This is not the case with a mortgage. The lender gives money to the borrower, who then spends this money on a home. Assume that a lender and borrower entered into a mortgage and that before maturity the value of the home falls, prompting the borrower to default on its mortgage. Further assume that the lender forecloses on the property, selling it at a loss. Since the buyer receives none of the foreclosure proceeds, the buyer can be viewed as either neutral or incurring a loss, since at least some of the borrower’s mortgage payments went towards equity ownership and not just occupancy. It follows that there is a loss to the lender and either no change in or a loss to the borrower and therefore a net loss. This demonstrates what we have all recently learned: poorly underwritten mortgages can create net losses.

Net Losses And Efficiency

You can argue that even in the case that both parties to an agreement incur losses, the net loss to the economy is zero, since the cash transferred under the agreement was not destroyed but merely moved through the economy to market participants that are not a party to the agreement. That is, if you expand the number of parties to a sufficient degree, all transactions will net to zero. While this must be the case, it misses an essential point: I am using net losses to bilateral agreements as a proxy for inefficient allocation of capital. That is, both parties expected to benefit from the agreement, yet both lost money, which implies that neither benefited from the agreement. For example, in the case of a mortgage, the borrower expects to pay off the mortgage but benefit from the use and eventual ownership or sale of the home. The lender expects to profit from the interest paid on the mortgage. When both of these expectations fail, I take this as implying that the initial agreement was an inefficient allocation of capital. This might not always be the case and depends on how you define efficiency. But as a general rule, it is my opinion that net losses to a bilateral agreement are a reasonable proxy for inefficient allocation of capital.

Expectations Of Lender/Borrower vs. Protection Seller/Buyer

As mentioned above, under a mortgage, the lender expects to benefit from the interest paid on the mortgage while the borrower expects to benefit from the use and eventual ownership or sale of the home. Implicit in the expectations of both parties is that the mortgage will be repaid. Economically, the lender is long on the mortgage. That is, the lender gains if the mortgage is fully repaid. Although application of the concepts of long and short to the borrower’s position is awkward at best, the borrower is certainly not short on the mortgage. That is, in general, the borrower does not gain if he fails to repay the mortgage. He might however mitigate his losses by defaulting and declaring bankruptcy. That said, the takeaway is that both the lender and the borrower expect the mortgage to be repaid. So, if we consider only lenders and borrowers, there are no participants with a true short position in the market. Thus, price, which in this case is an interest rate, will be determined by participants with similar positive expectations and incentives. Anyone with a negative view of the market has no role to play and therefore no effect on price.

This is not the case with credit default swaps (CDSs) referencing MBSs. In such a CDS, the protection seller is long on the MBS and therefore long on the underlying mortgages, and the protection buyer is short. That is, if the MBS pays out, the protection seller gains on the swap; and if the MBS defaults, the protection buyer gains on the swap. Thus, through the CDS, the two parties express opposing expectations of the performance of the MBS. Thus, the CDS market provides an opportunity to express a negative view of mortgage default risk.

The Effect Of Synthetic Instruments On “Real” Instruments

As mentioned above, the CDS market provides a method of shorting MBSs. But how does that effect the price of MBSs and ultimately interest rates? As described here, the cash flows of any bond, including MBSs, can be synthesized using Treasuries and CDSs. Using this technique, a fully funded synthetic bond consists of the long end of a CDS and a Treasury. The spread that the synthetic instrument pays over the risk free rate is determined by the price of protection that the CDS pays the investor (who in this case is the protection seller). One consequence of this is that there are opportunities for arbitrage between the market for real bonds and CDSs if the two markets don’t reach an equilibrium, removing any opportunity for arbitrage. Because this opportunity for arbitrage is rather obvious, we assume that it cannot persist. That is, as the price of protection on MBSs increases, the spread over the risk free rate paid by MBSs should widen, and visa versa. Thus, as the demand for protection on MBSs increases, we would expect the interest rates paid by MBSs to increase, thereby increasing the interest rates on mortgages. Thus, those with a negative view of MBS default risk can raise the cost of funds on mortgages by buying protection through CDSs on MBSs, thereby inadvertently “correcting” what they view as underpriced default risk.

In addition to the no-obvious-arbitrage argument outlined above, we can consider how the existence of synthetic MBSs affects the supply of comparable investments, and thereby interest rates. As mentioned above, any MBS can be synthesized using CDSs and Treasuries (when the synthetic MBS is unfunded or partially funded, it consists of CDSs and other investments, not Treasuries). Thus, investors will have a choice between investing in real MBSs or synthetic MBSs. And as explained above, the price of each should come to an equilibrium that excludes any opportunity for obvious arbitrage between the two investments. Thus, we would expect at least some investors to be indifferent between the two.

path_of_fundsDepending on whether the synthetics are fully funded or not, the principle investment will go to the Treasuries market or back into the capital markets respectively. Note that synthetic MBSs can exist only when there is a protection buyer for the CDS that comprises part of the synthetic. That is, only when interest rates on MBSs drop low enough, along with the price of protection on MBSs, will protection buyers enter CDS contracts. So when protection buyers think that interest rates on MBSs are too low to reflect the actual probability of default, their desire to profit from this will facilitate the issuance of synthetic MBSs, thereby diverting cash from the mortgage market and into either Treasuries or other areas of the capital markets. Thus, the existence of CDSs operates as a safety valve on the issuance of MBSs. When interest rates sink too low, synthetics will be issued, diverting cash away from the mortgage market.

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  1. Hi Charles,

    You’ve been really helpful at sharpening my understanding of CDS and the many ways in which they misunderstood. But as you know I disagree with many of your views. So I just wanted to post a link to my response to your post:

    http://idiosyncraties.blogspot.com/2009/01/putting-demon-back-in-cds.html

    I hope you enjoy the back and forth as much as I do!

  2. Surely there is also a volume issue. If I were to buy a $500K house with a mortgage of $400K (3 x household income), then the bank could either hold the risk or buy a CDS on me to protect itself.
    Suppose moreover that the bank has four similar clients. Clearly it could buy CDS on each one, but let’s suppose that its credit department feels that I am the weekest credit and so they go out and find 5 counterparties each prepared to take a CDS on me for $400K. That means that five counterparties have each “synthetically” lent me $400K, so that out there my situation is supporting $2 million of debt. The problem is that no sane person would lend me $2 million, so there is no reason why five people should independently lend me that sum.
    Taking this out to the macro level, if there are $x billion of RMBS securities out there but $3x billion of CDS on the same, has the whole economy seen the default risk multiplied by 3?

  3. Bold Un,

    CDSs create zero sum games. So if everyone performs, there are no net losses. Money simply changes hands. So no matter how many people reference the debt obligation, there will be no net losses.

  4. Bold Un, The bank has overhedged its position. If you pay out well the bank loses some money that the CDS seller gains ( no net loss ). If you donot pay out the money, all the CDS sellers pay the bank and bank would make a big gain. Again, no net loss in the economy. Although that can result in CDS premiums to rise and hence indirectly increase MBS rates since the hedging costs go up. Economy loses money because of inflated asset prices, the perception of wealth being destroyed when they come down not because of derivatives. Derivatives allow participants to spread out the risk to multiple investors.

  5. if the borrower continues paying the mortgage, the banks continue paying premiums on the CDS. if the borrower fails to continue paying the mortgage, the banks are now owed the notional amount of the contract…if this happens in mass…Would there not be mass loss in the economy – since there were more CDS written than the “insurers” have capital to pay? is this not the issue? that it becomes an implosion of nuclear proportion? The positive wealth that would be transferred does not exist on that level by the “insurers” of these contracts in total?

    also could someone clarify this concept of Netting? How can broad statements about netting of contracts be made? since they are insurance contracts – what they are insuring is variable and dynamic to say the least and are they of varying trigger dates – since failure to pay would be random – with multiple counterparties? – I don’t understand when I read things about netting out receivable and payable contracts- that they seem to be applying apples to oranges like comparing this to being long and short the same stock?

    lastly – hedging of the mortgages to this degree – created failure of the contract as a new active opportunity for gain for the lender – beyond recapture of collateral…

    • Bailey Sum,

      Here’s an article on netting: http://derivativedribble.wordpress.com/2008/10/24/netting-demystified/

      As for your statement losses, there will likely be substantial reliance costs (I spend money/increase book value based on the assumption that you will pay me) if people don’t pay out as promised on their CDSs. But there is still no investment losses, because there is no initial investment. But that’s not unique to CDSs. That’s what occurs whenever people fail to meet their obligations. The point of the article is that there is no inherent loss created by a CDS when both parties perform.

  6. Ok, thanks. My questions were more general questions I had after reading the OCC Q3 08 report and have been is search of your clarity.

    On a less technical note:

    I think there is a moral loss in the assumption that the party – direct borrower – and the counter party – the insurer – will perform – it allows for leveraging up into oblivion. And brings us to where we are. It also allows for the notional values to be so astronomically overwhelming that if 2% were to default top banks, majority derivative holders/ees, would go bust and in the meantime we walk on egg shells – figuring out how to thread this along until the positions can be unwound.

    There is, indeed, a great risk when parties perform and endless insurance can be written on every part of the deal to remove risk from partakers: overconfidence and belief that the system is so large that there is room for wealth extraction and space enough to be isolated from those who are being extracted from…not much room for what Investment is supposed to be all about.

    Risk serves a positive role, it keeps investment prudent.

    • BaileySam,

      Your arguments ignore the other side of the CDS: the protection seller. Your arguments would be quite compelling (that CDS create a care free environment of unlimited leveraging) if it weren’t for the case that the protection seller is on the hook. That fact will provide an incentive to to keep the protection seller’s activities prudent.

  7. :)

    Are the seller’s on the hook? And who are they? Are they Now ultimately the equity shareholders of these companies that employ these sellers?

    I agree with your facts. But they are just facts. And like a dark room with 5 people each describing a part of the same elephant, the facts separately don’t necessarily point to the truth….

    All market “participants” are Not equal players. The protection sellers are a highly concentrated group of participants, eventually this concentration weakened the “protection”. Now concentration is exposure. (but past the tipping point these derivatives were created for speculation not protection anyway)

    The real issue is in Relation to the CDS sellers and the ultimate CDO holders, who are clawing on to the validity of any possible protection to attempt to uphold a semblance of value.

    The real buyers of the underlying securities in question are a “more securitized” group of market participants such as pension funds, endowments and other important institutional investors…or more succinctly put, the public.

    It seems that since this concentrated group of protection sellers happen to be our primary banking
    institutions, they wear a cloak called “Too Big To Fail”…
    while the public, instead, is left with the burden called the ever emptying pail…

  8. Good basic article on how MBS and CDS should work. This is the current spin, “zero sum” so no one has lost anything? But you forgot the role of the bond ratings firms in giving MBS containing subprime mortgages a AAA rating. Or necked CDS contracts, this is where the buyer of the CDS has no investment in the underling derivative. These two things upset the balance. If the cost of the CDS is low and anyone can buy them not just the original investment is at risk but many times that risk. About 50:1 by Nov., 2008. 1.1 Trillion dollars in at risk or foreclosed mortgages and 50+ trillion dollars in debt to pay off the CDS contracts due. Zero sum? Accident? Or some bone headed action by the consumer? How could those necked buyers of all those CDS contracts know the contract would not just run out of their time period? In Feb. 23,2004 Alan Greenspan gave a speech to the Credit Union meeting on TV. Near the end Mr.Greenspan told the nation to buy their next home with an ARM, the prime was 1%. 2 1/2 years later the prime was 5.25%. That home the buyer, who listened to Greenspan, now cannot pay his higher mortgage payment. Too bad. Now the investment banks have to pay the CDS contracts due, until they are broke. The bailout? It goes to the banks to pay off the remaining CDS contracts. I know that is not possible, we don’t have 50 trillion dollars and we never will. But those lucky guys who bought those necked CDS contracts, weren’t they smart. Lucky or criminals? What can we do? I’m trying but no one cares they had all their money stolen and their country destroyed. What you still have money? Just wait we are still paying until it is all gone or we wake up and take it back. When a stock goes down, money is lost. When a CDS contract is payed off the money changes hands and is still somewhere. If that is a crime we can take it back.
    Bill

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