IM Outtake of the Day, CDS Edition

March 17, 2009

From an IM conversation between me and Jesse Eisinger, in the wake of my post earlier today:

Jesse Eisinger: Of course a cause of the financial meltdown is the CDS market. Just because it didn’t START there and that there are OTHER causes doesn’t mean the CDS market functioned fine and didn’t fail. Of course it failed. Miserably. And if the government didn’t have its head up its ass, it would have given all those wildly irresponsible AIG counterparties a massive haircut.

Felix Salmon: The CDS market failed (only) insofar as triple-A monolines wrote more protection than they were able to cover — AIG being by far the most egregious offender in this respect. The US government stepped in to backstop the insurance that AIG wrote, and as a result there were no further systemic consequences of AIG’s irresponsibility.
What’s more, AIG’s CDS contracts were generally large bespoke deals with commercial banks; they didn’t conform to ISDA documentation and were pretty much outside what most of us considered to be the two-way CDS "market". That market didn’t fail at all. In any case, I fail to see how the CDS market — even broadly understood to include AIG — was in any way responsible for the financial meltdown. Maybe it would have been, had AIG not been bailed out. But AIG was bailed out, so it wasn’t.

I have a copy of Gillian Tett’s new book in galleys; I’m reading it right now, and I’ll have more on this subject when I’m done. Tett and Eisinger are both smart and astute journalists who are convinced that the CDS market really did cause a large part of the financial and economic crisis that we find ourselves in today. I can half see it: is it that the existence of the CDS market gave banks false confidence that they could lay off credit risk in huge quantities, even while nominally keeping hundreds of billions of dollars worth of assets on their books? But I’m not fully convinced. More anon.

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