On December 28, Prof. Scott Richard published an article in the Financial Times advocating the use of credit default swap spreads in setting of deposit insurance rates. This letter to the editor explains why such an idea, attractive in theory, would be extremely dangerous in practice.
1 Southwark Bridge
Ladies and Gentlemen:
On December 28, 2011, Prof. Scott Richardson argued in his article “A Market-Based Plan to Regulate Banks” that the credit default swap market should be used to price deposit insurance. He states, “How can the FDIC determine the correct price for its insurance? The answer is to use the large and active market in bank insurance via credit default swaps.”
My firm, Kamakura Corporation, has long been an advocate of using market information to assess risk in general and credit risk in particular. Kamakura offers daily default probabilities based on market inputs, macro factors, and financial ratios for 31,000 firms in 37 countries. Kamakura’s director of research, Prof. Robert Jarrow, also serves as senior fellow at the Federal Deposit Insurance Corporation and was co-author of the FDIC’s Loss Distribution Model (December 2003) which captures several market inputs in assessing both individual bank risk and systematic risk. That study specifically cited home prices, interest rates and bank stock prices as key market inputs.
Unfortunately, there are several very practical reasons why the credit default swap market cannot be used as Prof. Richard suggests.
- There is no “large and active market” in bank credit default swaps. Using data reported by Depository Trust & Clearing Corporation, during the 77 weeks ending December 30, 2011, there were credit default swaps traded on only 13 reference names among U.S. banking firms:
ALLY FINANCIAL INC.
AMERICAN EXPRESS COMPANY
BANK OF AMERICA CORPORATION
CAPITAL ONE BANK (USA), NATIONAL ASSOCIATION
CAPITAL ONE FINANCIAL CORPORATION
CITIGROUP JAPAN HOLDINGS CORP.
ISTAR FINANCIAL INC.
JPMORGAN CHASE & CO.
THE GOLDMAN SACHS GROUP, INC.
WELLS FARGO & COMPANY
These 13 reference names represent 11 consolidated corporations, four of which would not be considered banking firms by most observers prior to the recent credit crisis (American Express, Goldman Sachs, MetLife, and Morgan Stanley). During the 77 weeks of data on all live trades in the DTCC credit default swap trade warehouse, there were no other trades on any other of the 6,453 banks insured by the FDIC in the United States as of March 31, 2011.
- Even on the firms listed above, there was an average of only 2.3 non-dealer credit default swap trades per day during the 77 weeks ended December 30, 2011. None of the banks listed above averaged more than 5 non-dealer trades per day over the 77 week period studied.
- Six of the 11 firms listed are in a conflict of interest position as major dealers in the credit default swap market: Bank of America, Citigroup, JPMorgan Chase, Morgan Stanley, Goldman Sachs, and Wells Fargo. Dealer-dealer trades made up 81.68% of live trades in the DTCC over the 77 week period studied. The dealers would be setting deposit insurance rates for themselves if Prof. Richard’s proposals were adopted.
- Credit default swaps, to the extent they trade, represent supply, demand, probability of default and the probability of rescue, not the probability of failure alone. My September 29, 2009 blog “Comparing Default Probabilities and Credit Default Swap Quotes: Insights from the Examples of FNMA and Citigroup” showed how credit default swap quotes for both firms were far below their probability of failure because senior debt holders correctly anticipated that the depositors of Citibank and the senior debt holders of Citigroup and FNMA would be rescued by the U.S. government. This rendered the credit default swap spreads on both failing firms severe underestimates of their probability of failure.
- Because of the thinness of non-dealer trading and the very small number of dealing firms world-wide, there is high risk of collusion. Indeed, on April 29, 2011 the European Union launched an investigation of possible collusion among dealers in the credit default swap market. This lawsuit by Charles Schwab accuses 12 firms of colluding to manipulate U.S. dollar libor, naming 3 of the banks on which CDS were traded: Bank of America, Citigroup and JPMorgan Chase. Nine of the 12 firms named in the lawsuit are also dealers listed by DTCC in single name credit default swaps:
This recent article by Cate Long on Reuters summarizes the repeated legal violations stemming from collusion in the market for municipal bonds in the United States, including 5 of the 11 firms above. Six of the 8 firms named as “serial offenders” are also dealers in single name CDS that were listed by DTCC in 2010:
For these reasons, Prof. Richard’s proposal to use credit default swaps to price deposit insurance would not work given current market conditions and the lack of competition in the market for credit default swaps.
Dr. Donald R. van Deventer
Chairman and Chief Executive Officer
Honolulu, January 10, 2012