Are CDS a good thing?

April 24, 2009

Kevin Drum asks whether I’m “still as bullish about credit default swaps as I have been in the past”. It’s a good question: after all, a large part of my speech to the regional bond dealers (more of the actual speech than of the notes) comprised me explaining that I was very wrong about a lot of this stuff.

On the subject of CDS specifically, yes I think I was entranced by the shiny-new-toy aspect of them. They were so elegant, they were such efficient ways of moving risk around the markets, that they had to be a good thing, right?

I’m still no fan of the CDS demonizers, who generally have no idea what they’re talking about: if they are remotely right, they’re right for entirely the wrong reasons. But I will admit that I did rather jump in an unwarranted manner to the conclusion that because the CDS critics were so very wrong, then the CDS market must have been largely benign.

The fact is that AIG could never have blown up if it wasn’t for CDS. UBS and Citigroup could never have suffered their billions of dollars in super-senior losses if it wasn’t for CDS. And therefore the CDS market was intimately involved in some of the most systemically-devastating events of the crisis.

That said, CDS had nothing whatsoever to do with the failure of Bear Stearns. The fact that CDS allowed you to effectively short a credit you didn’t own was not particularly harmful. The the CDS market was incredibly useful in terms of price discovery, and it remained impressively liquid even as virtually all other credit markets froze up altogether. Etc etc.

So right now I’m vacillating on this one. I’ve recently finished reading Gillian Tett’s new book, and although she tells a good story, I don’t think she really succeeds in making her case that the creation of the CDS market was the proximate cause which “unleashed a catastrophe” on the world.

On the other hand, I don’t think I can really add credit default swaps to the list of undeniably positive financial innovations, like ATM cards. CDS are powerful instruments, which can be — and were — misused, most egregiously by AIG. I’m not happy about that. But I’m not remotely ready to start banning them, or to start trying to require that any buyer of protection have an “insurable interest” before being allowed to do the deal.

Update: The comments, in general, are well worth reading. It’s true that in an enormous zero-sum market, you’re going to find situations where both buyers and sellers are booking profits, and that can’t be good. I’m also still pondering the excellent question asking why price discovery is a good thing. And less specifically but just as importantly, CDS encourage a certain kind of laziness on the part of the buy side — not just in bankruptcy situations, but more generally too. The easier it is to hedge your position dynamically, the less homework you’re likely to do before entering into that position. Which is a recipe for trades getting very crowded very quickly.


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