Arnold Kling has an article on credit default swaps at Econolog. Kling offers a theory that credit default swaps create systemic risk. If you aren’t familiar with the term, Kling also has a primer on systemic risk. The short version is a hedging strategy that works for one or a small number, doesn’t work for large numbers.

Kling’s theory:

One strategy for people who sell swaps is to use dynamic hedging, the same approach that was notoriously used to provide portfolio insurance in 1987 and which helped cause the big stock market crash on October 19th of that year. With dynamic hedging, you create a synthetic put option by selling securities on the way down. If you sell fast enough, the money you make on the short sales is enough to offset the cost of making good on the swap.

Suppose I have sold a credit default swap on Sallie Mae. That means that if Sallie Mae defaults on its bonds, I will have to pay some of the bondholders a big chunk of money. One way I can hedge that risk is to sell short Sallie Mae securities. I can sell short their debt, or I can sell short their equity. The closer they are to default, the more I need to sell in order to execute the hedge. However, the more short-selling takes place, the closer they get to default. It is a vicious cycle. Ordinarily, I do not believe that short-selling affects the price, but when there is massive short-selling that is driven by dynamic hedging, I can see where the short selling would drive down prices.

So you could get a vicious cycle: doubts form about a company’s soundness; creditors want more protection, so they try to buy credit default swaps; sellers of swaps engage in short-selling to hedge their own exposure; the company’s stock and bond prices lose value; creditors get even more worried; etc.

He further explains how this is affecting the credit markets:

At this point, if the government tries to curb short-selling, all that does is cripple the credit default swap market. It becomes costly to sell default swaps, so now creditors cannot get them at affordable prices. The only way they can reduce exposure is to sell their munis and their corporates and flee to Treasuries. I’m not saying that the curbs on short selling make things worse, but such regulations certainly don’t solve the problem–at best, they shift it.

If my theory is correct, then the credit default swap protection is somewhat of a delusion. The contingency plans of individual sellers of swaps cannot be executed collectively. Just when you need to sell short in order to manage your risk, everybody else is trying to do the same thing, and it doesn’t work.

Kling concludes that credit default swaps are a delusion and that the bond market is adjusting to reflect reality.

I think Kling is missing a step in his equation. One of his commenters, Jacob Wintersmith points out:

Interesting. It seems that this vicious cycle could just as easily occur in the absence of CDSs if the creditors themselves engaged in dynamic hedging. Is the operative theory here that the sorts of firms selling CDSs are more likely to engage in dynamic trading than the original creditors are?

Secondly, there’s a big question that you neglected to ask: Why doesn’t anyone step in to buy these troubled stocks and bonds on the cheap when the vicious cycle starts to push the market price below their fundamental values? After all, it is precisely this countervailing force which ordinarily leads to the existence of an equilibrium market price. How does the stable equilibrium become unstable?

Wintersmith is right it seems to me. Cetainly, at least some of the creditors have the ability to hedge the risk themselves. Why are creditors buying credit default swaps based on the movement of the stock price? A falling stock price, absent news, would generally be dismissed by a bond holder as market noise.  And why aren’t stock buyers stepping up? The market says that a buyer should recognize the value and step in.

Here’s an alternative scenario:

A trader shorts the stock of the target financial company. The stock market is very liquid so the effect on the stock price is negligible. The trader then moves to the CDS market and buys swaps on the underlying credit. The CDS market is relatively illiquid and is therefore easier to manipulate. Theoretically the buyer could drive up the price of the swap. That’s how the chain gets set in motion. Now other creditors see the swap price move and buy more protection. The seller of the swap now needs to hedge more and shorts the stock. Stock traders are also watching the CDS market and sell when the swap price rises. If enough traders are doing this, you get your vicious circle. The original trader can profit not only on the short stock sale but if he is successful in forcing the company’s stock down far enough, he could trigger the default and collect on the swap as well.

Something had to knock the system out of equilibrium. In this case it is knocked out of balance by the manipulation of the CDS. The short sale by itself should not be enough to drive up the price of the CDS. But if the stock is falling and the CDS price is rising, alarm bells start going off. That’s when the cascade starts and works to drive the stock price down. This limits the company’s ability to raise more capital since it doesn’t want to sell equity at a depressed price. Or the equity may fall so far that selling equity is too dilutive to raise the necessary capital. Then you get, well, Bear Stearns and Lehman.

This scenario would be less succesful targeting a healthy company, but if you have a wounded company looking to raise capital, it is a death sentence.

There is at least one big unknown about this theory. Is the CDS market illiquid enough to be manipulated? I think that is likely since the market is not centralized on an exchange and is probably relatively ineffecient. I can’t prove that inefficiency and I have no evidence that this was happening, but it seems logical. Anyone have any other thoughts?