One Easy CDS Fix

March 30, 2009

I’ve had my share of disagreements with Arnold Kling on the subject of credit default swaps in the past, but he has a good idea today:

Regulators and accountants could require firms that are net sellers of credit default swaps to translate those positions into bond holdings and put these synthetic bonds on their balance sheets. My guess is that had such a policy been in place in 2000, the CDS market would not have taken off.

My guess is that Kling’s guess is wrong: there were actually very few net sellers of CDS, and in any case for most of this decade the stock market seemed to think that ever-expanding financial balance sheets were a good thing, not a bad thing. But yes, definitely: if you’re a net seller of protection, then the notional amount of credit that you’re exposed to should be considered an asset on your balance sheet, just as it would be if you owned that credit in bond form.

It is conceivable that the the monolines — which were by far the largest publicly-listed net sellers of protection — might have thought twice about continuing their escapades in the CDS market if there would have been such an enormous effect on their balance sheet. Doing so would have brought them more into line with the buyers of synthetic CDOs, who were the other large net sellers of protection, and who invested up front all the money that they could possibly lose.

Kling’s other point is that it’s hard to buy long-dated derivatives on the big exchanges in Chicago: if you want something with a maturity of three years or longer, you need to buy it in the OTC markets. That’s true, but he’s wrong that "it is quite difficult to take a position of any size" in long-dated options: those OTC markets are huge, and in many cases substantially larger than the exchange-traded markets. And they seem to work pretty well, in the absence of massive players like AIG taking large net positions (on the order of hundreds of billions of dollars) in the market.

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