http://www.pimco.com/LeftNav/Featured+Ma rket+Commentary/IO/2008/IO+January+2008. htm

Here’s one gem:
“Our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever. Financial derivatives of all descriptions are involved but credit default swaps (CDS) are perhaps the most egregious offenders. While margin does flow periodically to balance both party’s accounts, the conduits that hold CDS contracts are in effect non-regulated banks, much like their hedge fund brethren, with no requirements to hold reserves against a significant “black swan” run that might break them.”

The whole article lays out a hypothetical doomsday scenario with derivatives and particularly CDSs at the center. By the end of the year, it had played out and we found ourselves living in the People’s Republic of America.

Hello? The shadow banking system actually did collapse. By the middle of 2008, Uncle Sam, through Fannie and Freddy, was suddenly almost alone in home lending.

The event risk embedded in bonds and other credit assets was very difficult to reduce prior to the evolution of credit default swaps. In the brief decade since their inception, credit default swaps have become not only a tool that effectively hedges event risk but also a flexible portfolio management tool that far exceeds that single benefit.

http://europe.pimco.com/LeftNav/Bond+Bas ics/2006/Credit+Default+Swaps+06-01-2006 .htm

Sounds like they appreciate the benefits of CDS…

I think Pimco handling of bonds is instructive. The world’s largest bond fund uses virtually no CDSs (a miniscule amount in relation to their size). They just study like hell and if they like the risk/reward they buy. They earn their keep by their hard evaluation of risk. If there is a default, they absorb it and they are diversified. In 2008 they saw a positive return with on the order of a trillion dollars under management.

To say that lending would have collapsed were it not for credit default swaps is not accurate. Lending by the big players in swaps actually did collapse quite drastically and the ones who stepped into the breach were the US government and the unleveraged PIMCOs of the world.

Given that MS knew it could cause a default by calling their loan, hedging such as this would create a perverse incentive to make the company default and get paid several times for the same loan.

Though the CDS issuers might be able to call fraud, given the end result, but litigation such as that is expensive and piercing the corporate veil is always a pain in the ass.

I recognize that there have been major changes in risk management in the past half-century, but I’d say that most of these had a very positive effect on the availability of credit. You can argue that we’ve overlended recently, but I don’t think you can claim that a prohibition against hedging wouldn’t create a major credit contraction.

More to the point, what would be the benefit from prohibiting hedging (other than to “man up”, whatever that means)? For every story of hedged banks refusing to cooperate with borrowers, I’d guess there are 100 untold stories of banks lending because they have that hedging ability.

Your rudeness is only matched by your ignorance of history.

With all due respect, there was a time in the not-too-distant past when banks didn’t hedge their every risk. Banks still lent and the economy did just fine, better indeed, than it has recently.

These bankers need to man up like bankers of their father’s generation and assume some risk, after doing the boring work of analyzing things themselves.

How did anything of size ever get built or any product come to market over the last few hundred years?

Felix, this is not a lunatic fringe. Have you taken too much of the KoolAid? Warren Buffett has been shouting from the rooftops on certain financial weapons of mass destruction for seven years and CDS have absolutely covered themselves in glory ever since.

An unsurprising headline:
“Berkshire’s Munger Favors ‘100% Ban’ on Credit Swaps”:
http://www.bloomberg.com/apps/news?pid=2 0601103&sid=aKIC60dEOH2U&refer=news

Hey banks, assess risk. That’s your job. That’s why you get paid. Banks are the ones that meet with the borrower, they are the ones that can see on a case-by-case basis where they are making money or how they are using it.

Banks outsourcing risk assessment through CDSs is like a surgeon outsourcing the cutting and stitching parts, or a police department outsourcing the arresting part, or a fire department outsourcing the parts involving heat and smoke. Risk assessing and assuming is their main task.

The only reason banks earn the big bucks is to assess and assume risk. If it’s just about the mechanical processing of accounts and transactions, my Federal Employee Retirement System does that at a cost of a few hundredths of a percent per year.

How is this legal?

If I cause a default on X, I’ll be sued by X and the person who sold me the CDS, as well as probably be investigated by the govt.

We have lots of regulations that prevent people from causing themselves harm (like laws against using drugs), why can’t we have regulations that prevent companies from doing really stupid things?

The folks selling that insurance didn’t know about that extra liability

Isn’t that like trading on inside information?

Or were the insurers responsible for understanding the risk they were taking? The game was rigged and MS collected and hurt the whole country (world?) by their actions.

And they come out whole in this mess? This is not right.