CDS demonization watch, Morgenson/Münchau edition

By Felix Salmon
March 2, 2010
nonsense on credit default swaps and the like is that they read newspapers, and believe what they read. Two different high-profile newspaper columnists confused Greek credit swaps in 2010 with Greek currency swaps in 2001, for instance, on Sunday alone, and I'm not sure which was worse, although I'll give the prize this time to the FT.

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Maybe the reason that politicians spout such nonsense on credit default swaps (CDS) and the like is that they read newspapers, and believe what they read. Two different high-profile newspaper columnists confused Greek credit swaps in 2010 with Greek currency swaps in 2001, for instance, on Sunday alone, and I’m not sure which was worse, although I’ll give the prize this time to the FT.

First, though, the New York Times (NYT), where Gretchen Morgenson devoted an entire column to the evils of CDS, but threw in this confusing paragraph near the top of the piece:

First, Greece employed swaps to mask its true debt picture, with the help of Wall Street bankers, of course. And now it appears that some traders are using swaps to bet that Greece won’t be able to meet its debt payments and will face a possible default.

This is, I think, deliberately misleading to the point of being downright mendacious — especially since she spent the previous paragraph talking about CDS as “such swaps” and “these swaps”. There is simply no way that the average reader of the NYT can be expected to understand that the swaps of Morgenson’s first sentence, above, are entirely different animals to the swaps of her second sentence, and in fact aren’t CDS at all.

And Morgenson doesn’t stop there. She mangles OCC numbers to make CDS revenues seem higher than they are, and follows that up by describing Martin Mayer as “prescient” for writing this:

“In the presence of moral hazard — the likelihood that sloughing the bad loans into a swap will be profitable — the growth of a market for default risks could lead to bank insolvencies.”

Somehow Morgenson manages to declare that this is a “prediction” which has “come true”. But go back to Mayer’s actual article (which Morgenson, of course, neglects to link to), two things are clear. Firstly, he wasn’t predicting bank insolvencies. And secondly, insofar as he was saying that CDS might cause bank insolvencies, he had a very clear transmission mechanism in mind: banks would attempt to diversify their credit portfolios by using CDS to take credit risk from other banks. And as they started selling more and more of their own loans to other banks looking to diversify, they would do less underwriting, and nobody would have the “credit watch”. Eventually, loans could sour en masse, and that could lead to bank insolvencies if the banks had CDS exposure which they thought was diversified but in fact was just badly-underwritten.

Was that “prescient”? Not really: banks simply didn’t use the CDS market to buy loan exposure from each other (there’s a perfectly good interbank loan market for that kind of thing), and they didn’t seek to diversify their credit portfolios by writing credit protection on other banks’ borrowers. Yes, banks did bundle up CDS into supposedly-diversified instruments — synthetic collateralised debt obligations (CDOs) — which they then sold to investors who blew up, but those investors weren’t other banks: very few synthetic CDOs found their way onto banks’ balance sheets. It was the unfunded portion of those CDOs — the risks that banks kept on their own books, and didn’t sell to anybody else — which ultimately proved so incredibly toxic.

And yet we almost expect this kind of thing from Morgenson, which is why I think the worse column, this weekend, was the one in the FT by Wolfgang Münchau, headlined “Time to outlaw naked credit default swaps”:

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

Firstly, Münchau has done exactly the same thing as Morgenson, eliding 2001′s currency swaps with 2010′s CDS. Goldman Sachs, in its derivatives arrangements with Greece, wrote currency swaps, not CDS. And when Bernanke answered a question about CDS on sovereigns, he was not talking about his investigation into Goldman Sachs. Not that you’d guess it from reading Münchau.

But more to the point, Münchau simply asserts at the top of his column that the eurozone is “currently subject to a series of speculative attacks”, without adducing any evidence, and then concludes that the CDS market should essentially be banned. Oh, and he gets CDS very, very wrong:

A typical bundle would be €10m worth of Greek government bonds. To insure against default, the buyer of a CDS pays the seller a premium, whose value is denoted in basis points. Last Thursday, a CDS contract on five-year Greek bonds was quoted at 394 basis points. This means that it costs the buyer €394,000 per year, for five years, to insure against default. If Greece defaults, the buyer gets €10m, or some equivalent. What constitutes default is subject to a complicated legal definition.

“If Greece defaults, the buyer gets €10m, or some equivalent”? Well, yes, but Münchau fails to mention that in order to get that €10 million, you have to give up your bonds. Most CDS are cash-settled, and the amount of money changing hands in the event of default can be a tiny fraction of the face value of the bonds. For instance, when Fannie Mae and Freddie Mac defaulted, the CDS auction ended up at more or less 100 cents on the dollar: people who had bought CDS protection didn’t benefit from it at all.

Münchau doesn’t stop there. Just watch his rhetoric ratchet up:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

I’m going to come out and say that this is simply untrue: I defy Münchau to find me a single “hardened speculator” who thinks that “there is not one social or economic benefit” to a naked CDS purchase. Of course, there are lots of very good fundamental reasons why people might want to buy credit protection on Greece without owning underlying bonds. Maybe you are or will be owed money by an arm of the Greek government. Maybe you have businesses in Greece, and are worried that in the event of a default you won’t be able to repatriate your profits there. Maybe you intend to enter into a contract with a Greek company who you trust and understand, but want to hedge sovereign risk which is out of that company’s control. These are not “purely speculative gambles”, they’re ways of facilitating capital flows into Greece. Yet Münchau dismisses all such arguments without even understanding them:

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber.

No, Wolfgang, it isn’t like saying that at all. A bank robbery involves theft, and the robber leaves the bank with more money than he started with. When an investor buys credit protection, that’s a negative-carry trade: the investor leaves the trade with less money than he started with, and only makes a profit in the event that the underlying credit blows up, or in the event that he takes off his trade, and thereby loses his credit protection, after CDS spreads widen.

But of course Münchau isn’t trying to put together a solid argument here: he’s just trying to fan the flames of anti-banker sentiment, perhaps in the hope that they will help to obscure the real fiscal problems in the eurozone which are ultimately responsible for Greece’s current situation. He should remember that when a house is on fire, the first thing to do is to put out the flames. There will be lots of time later to start asking questions about who stood to benefit from the blaze.

(HT: Sanghvi)

30 comments

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Hey Saghiv, guick correction for you. the greek currency swap with Goldman was only made possible by the CREDIT DEFAULT SWAP executed with a German bank. so, although the loan or currency swap as you describe wasn’t technically a CDS, it was only CDS which made it possible…that is, unless GS was prepared to take billions of Greek exposure (NOT!)

Posted by banval | Report as abusive

one more post…in equity markets investors are limited to how much of a stock they can own or short…why do the same for CDS? say 5% of O/S debt?

Posted by banval | Report as abusive

I’m not sure I understand why Mr. Salmon is taking such pains to defend CDS. If we ever hope to simplify the finanical system, CDS reform seems like a good place to start.

If one bond has more risk of default than another, why shouldn’t it simply have a higher interest rate? Why must we also have “insurance” on the bond?

Posted by silliness | Report as abusive

Mr. Salmon is just one of the happy few still considering CDS socially useful which contribute greatly to economic growth like the best of financial innovation. To him CDS are not “purely speculative gambles”, they’re ways of facilitating capital flows into Greece. Yeah…
What a naive view! I wonder if at least he would like to tax them…

Once upon a time there were three little pigs and the time came for them to leave home and seek their fortunes. Before they left, their mother told them ” Whatever you do , do it the best that you can because that’s the way to get along in the world”
http://mgiannini.blogspot.com/2010/02/no -redress-when-eu-members-break-eu-own.ht ml

Posted by M.G.inProgress | Report as abusive

Felix,

when you say

“people who had bought CDS protection didn’t benefit from it at all.”

you mean they didn’t benefit over and above what they insured against? As in if you have car insurance and it’s stolen and the insurance company replaces it you haven’t ‘benfitted at all’. You don’t mean they got no payout from it, do you?

Posted by mjturner | Report as abusive

Ah Felix somehow I thought your piece might end with some version of the now very familiar …..

” let’s move on” ie “there will be lots of time later to start asking questions” The reality of course is that questions don’t get asked, before we know it we are into the next bubble and as those responsible for these bubbles well know once caught up in the euphoria of the next bubble they have little or no interest in looking back and apportioning blame.

I agree with the comment made by silliness above ie why shouldn’t the bond yield itself reflect the risk – there is no need for insurance if enough care is taken with the initial judgement – did Graham and Dodds feel the need for CDS when judging bonds ?

Posted by crashproof | Report as abusive

@silliness – felix is taking pains to educate the public because an uneducated, angry, misinformed populace results in populist reforms being passed that don’t solve the real problems

@mjturner – yes: that is exactly what felix is saying: the CDS auctions (that determine the payments CDS holders will receive) settled near 100, resulting in very little actual “insurance” value changing hands.

another great piece, felix.

Posted by KidDynamite | Report as abusive

Felix, I am not a finance person, and while I think I understand the general thrust of all of these discussions, I don’t pretend to understand the details.

That said, it seems to me that all of this began when Greece, um, borrowed more than it could reasonably repay in 2001, through a currency swap that served no purpose other than to extract a larger loan. If I can draw an analogy, it sounds like the sovereign equivalent of the option ARM mortgage. And oddly, it seems it was fully permissible under EU rules. You can certainly argue that GS was complicit in the arrangement, but you can argue even more strongly that Greece fully knew what it was doing.

All the rest of this seems little more than a sideshow.

Posted by Curmudgeon | Report as abusive

“Well, yes, but Münchau fails to mention that in order to get that €10 million, you have to give up your bonds.”

– Pretty sure that this is actually quite off the mark. That, to be sure, is one of the ways in which you could do a CDS, but it’s neither the only one nor the predominant one. The naked CDSs are so called precisely because the buyer of CDS does not hold the underlying notional. This allows “naked” bets for or against the default of any given security’s issuers which is gambling pure and simple and has nothing whatever to do with facilitating cash flows in any direction that is socially useful. It also allows the CDS betting to amplify the size of the actual default many times over, because the same amount of notional bonds can be used by an unlimited number of counterparties to a swap in an unlimited number of times.

I agree that Mortenson’s description of the evils of CDSs is rather misguided, but then so is the rebuttal.

Posted by Y.Alekseyev | Report as abusive

@Y.Alekseyev – Felix did not put that felicitously ;-) The point is that the default payout is only the loss amount (1 – Recovery) x Notional, not the entire notional. (Technically, that is not always true, because there are digital CDS. But most CDS work as Felix has described.)

@banval – Nowadays it is normal for banks to manage their CVA charges with all counterparties using CDS. Greece is no exception, but it is absurd to claim that taking on exposure is “only made possible” by CDS. That is manifestly untrue.

@all those who think that cash bonds should be enough for everyone:
1. Bonds are much less liquid than CDS; the average US corporate changes hands about twice a month. Consequently, their bid/ask spreads are quite large compared to CDS and this obscures the size of the underlying spreads.
2. Bond spreads are all-in spreads that account for all factors: tax and liquidity as well as credit.
3. CDS spreads respond far more quickly to changes in the market’s perceptions of creditworthiness. This is what the opponents of CDS are really concerned about: that rises in CDS spreads will reveal the weakness of borrowers like Greece. As though by putting our heads in the sand Greece would magically be made a better credit!

The public would be far better served if CDS were not banned, but rather made mandatory for all bond issues. Then investment restrictions could be formulated in relation to CDS spreads and we could do away with the rating agencies, who are not providing value commensurate with the rents they extract.

Posted by Greycap | Report as abusive

What many of the writes on CDS fail to mention is that before someone speculate on the long side, there must be a willing counter party. After the debacle with AIG, I am of the opinion that the protection seller will be capable of delivering if there is a credit event.
Is speculation a crime? In my book it is not.

Posted by BahM | Report as abusive

@greycap

“Bonds are much less liquid than CDS; the average US corporate changes hands about twice a month.”

Well now I’m not a financier, but are we buying bonds as investments or running a casino? I bet that the news about company X will affect the price of bonds so I’m going to buy today and sell next week. And of course, so many companies go default on their bonds every day so it’s important that we have minute by minute understanding of creditworthiness.

Sorry – that’s just bizarre to investors.

All this time I thought our markets were designed to allocate capital. I’m not a trader so I see no value in CDS. If traders want CDS, then don’t come crawling to the taxpayer to bail out your positions.

Posted by silliness | Report as abusive

Thank you for this ongoing dialogue Felix. As an unsophisticated investor who has every intention of staying such, I have found this very helpful in understanding this very important issue.

Earlier today I was struggling with the notion of who would buy CDS as, at current bond yields versus CDS prices you would be lucky to come out 20 bp ahead, before costs. All I could think of would be bondholders whose positions are so large they would either move markets or threaten the bondholder’s own viability. (And perhaps market makers). I can accept with less enthusiasm some of your examples and the ones mentioned at ftalphaville earlier today.

But I always thought for most bondholders yield was supposed to compensate for risk, so in many cases having a CDS would be or should be redundant.

The more parties we let purchase CDS the more pressure we put on the writers of CDS to adequately fund their potential liability. After all the problems with AIG and the muni insurance market, is it realistic to expect to be expanding that market at this time?

Finally, unless we simply make CDS illegal I guess we have to expect the cleverer boys at the hedge funds will be gaming the system and the big swinging dicks will be behaving like big swinging dicks.

Posted by wpw | Report as abusive

Was it not the case that AIG the biggest of the CDS underwriters couldn’t meet it’s liabilities. It was therefore negotiating settlements at well below 100. At that point the Fed intervened and they were backstopped by the US taxpayer which allowed AIG to settle with Goldman and others at the full 100.
Mr Paulson didn’t forget old friends and colleagues

Posted by crashproof | Report as abusive

Let’s say I’m a firefighter. Let’s say I own insurance policies on houses under my watch. Is that gonna work?

This post is ridiculous. Someone is just doing some nitpicking in order to show off his technical knowledge.

Posted by EmilianoZ | Report as abusive

Felix, you make some fine points here, and yet over and over again I see a real integrity problem on your part, for failing to address the fundamental problem with credit default swaps: no required reserving. This is the elephant in the room and you have run out of excuses:

Really! No reserve requirement? Credit default swaps are a promise to pay if very rare, very bad and very expensive things happen. The bankruptcy of nations in the present instance. Premiums are collected in advance. If the underwriter of a credit default swap does not have reserves to make good on the contract, isn’t the CDS market facetious?

Unfortunately I don’t expect you to address reserving because you are no longer engaged in reporting but have shifted over to advocacy. Will your fairness re-emerge to address this fundamental problem of credit default swaps?

Posted by DanHess | Report as abusive

i can tell you a few things about cds. if not for what most of you people think is speculation, insolvent companies and countries would end up loosing even more money for what is mostly hapless and idiotic interest rating driven investors. how many more billions would icelandic banks manage to borrow if not for people “speculating” on credit? how many more billions would Lehman loose? there are unfair things happening in the cds market, like insider trading, but otherwise there really is no difference between it and say futures on commodities. actually, let me take that back, some idiotic pension fund “allocating” to commodities is actually driving poor people in mostly 3rd world countries into starvation and energy poverty. good job felix, and good luck all you fairy-tale living people.

Posted by chegewara | Report as abusive

@Chegewara, since you can tell us a few things about CDSs, where is the reserve requirement for defaults? I’d could write insurance policies all day long and let the premiums roll in if I didn’t have to have reserves for anything actually happening, God forbid.

Posted by DanHess | Report as abusive

@greycap. In your formula, you have loss amount as (1 – Recovery) x Notional. This is indeed usually correct. But how convenient of you to omit the point that the notional amount frequently has nothing to do with the actual long position, and indeed that there does not have to be a long position! Without the long position, you are no longer hedging your actual risk, you are just gambling.

@DanHess: great point on reserve requirements.

Posted by Y.Alekseyev | Report as abusive

@crashproof, when exactly did the counterparties to AIG even hint they were willing to accept less than 100 cents on the dollar? From recollection UBS agreed to a 2% haircut assuming ALL the other counterparties agreed.

@DanHess, CDSes are margined just like any other swap. Why does swaps on **credit** risk bother you but any other type of swap – some of which are clearly speculative – doesn’t matter at all? It was margin calls that bankrupted AIG not payouts on the swaps.

Posted by Danny_Black | Report as abusive

@Danny_Black

CDS collateral is a joke if it happens at all.
http://www.nakedcapitalism.com/2008/12/s o-do-cds-counterparties-post.html

Would we have seen what we did with AIG if they had to reserve for all the default insurance policies they were writing? Of course not.

As for other types of swaps, yes, it should bother us a lot. In fact I suspect that the next blowup will not be in credit default swaps but in some other type of swap, simply because people are at least aware of the tremendous systemic risk that CDSs pose.

Interest rate swaps will be a doozy when they blow. They have grown is precarious towers to the sky in the most benign of interest rate environments.

Posted by DanHess | Report as abusive

@DanHess, what is a joke is your reference to a blog that claims some kind of knowledge (and btw, that reference is from 2008, so a lot of things changed since e.g. big bang reform of cds last year). THERE IS DAILY MARGIN PROCESS ON CDS, just live with it.

Posted by chegewara | Report as abusive

@DanHess, ah naked capitalism blog, the font of all rubbish about the current crisis. So insurance companies never blow up right? You think that all insurance companies have a load of cash just sitting around waiting for ANY and EVERY claim they have insured? You think for instance FDIC has all the cash for all the deposits that every single depositor has just lying around? How do you think all those regulated monoline insurers with the reserves they put aside are doing?

May I make a polite suggestion and maybe actually do some proper reading about how markets work…

Posted by Danny_Black | Report as abusive

@DanHess – your point is an important one: the problem with CDS lies when people SELL CDS without proper capital. However, the press and the public demonizes BUYERS of CDS with straw man analogies about buying insurance on your neighbors house and then burning it down. these analogies make for great talking points for politicians, but are total red herrings and do not address the actual problem!

here’s a fact: if i buy CDS on Greece, i CANNOT make Greece default on its debt. I cannot “burn down Greece’s house,” so to speak. Greece’s problems are not related to CDS – they are related to budgetary disasters.

Posted by KidDynamite | Report as abusive

@Chegawara –

Margin requirements on CDSs are not the same as loss reserves. There is no regulatory requirement for CDSs on loss reserves. None whatsoever! There were rumblings of that, but its just one more thing the administration hasn’t done.

The margin requirement is a good thing, and it reduces risk a little bit. But margin requirements are a pathetic substitute for real loss reserves. They work fine for day-to-day fluctuations in CDSs, but they do not prove the ability of the counterparty to handle a real default event. Sure, in a liquid market, the counterparty could post collateral and then exit their position, but who in their right mind would take over a CDS counterparty position when default is imminent. No, in reality, the counterparty will be stuck riding that bomb down to earth, cowboy-style. There is an assumption that because the CDS market on X is liquid now, it will remain liquid, but when default is imminent, you can be certain that it will not be.

If CDSs behave well in normal market conditions but fail during actual default events, then that is a pretty fraudulent insurance product.

Can anybody give examples where CDSs actually worked as advertised through an actual default of a large entity?

Thankfully, the credit default swap market has actually declining substantially, from >45 trillion, to perhaps twenty-some trillion, probably because folks began to see that most of these contracts aren’t worth much in the event of actual default, since the counterparties can’t pay for real defaults.

Meanwhile, I am agreeing with Danny Black that greater systemic risks are probably posed with other swaps, and interest rate swaps in particular. While the notional value is north of $300 trillion, the net value is still in the double-digit trillions. Bernanke has offered us the gentlest of interest rate climates, but how long can that continue? At least with CDSs, folks are paying attention. Not so with interest rate swaps.

Posted by DanHess | Report as abusive

@DanHess: you must be joking.

show me at least one case where a BK happens “out of the blue” and the CDS is not at least 1000bps before that. therefore margins are not a “pathetic” substitute in case of actively traded CDS contracts. of course, on the other hand u’ve got MBIAs, Ambacs and AIGs of this world that have been providing “insurance” with “zero loss” policy etc, but again, this is a part of the ratings fraud that CDS market has actually by and large helped to break apart (MBIA would probably end up “insuring” more munis if not for Ackman exposing them and using the CDS market in the process). and FYI, all the margin requirements for CDS trading have gone up significantly over the last 2 years, and in addition contracts with high likelyhood of bk trade points upfront, further reducing risk of CDS “not working”.

as for “worked as advertised” comment, that unfortunately exposes you as an ignoramus. i strongly encourage you to go to this site:
http://www.creditfixings.com/information  /affiliations/fixings.html
and learning about all the cases where cds worked, by and large, “as advertised”.

finally, the size of CDS market that you quote, has decreased largely due to the effort of dealers to “compress” the trades, i.e. netting them out. if anything, volumes in the CDS market are now higher than before.

Posted by chegewara | Report as abusive

@Chegewara –

My question about CDSs working as advertised was re *large entities*. What large entities have collapsed? Let’s see: Bear, Lehman, Fannie and Freddie, AIG…

All but one was backstopped by you and me as taxpayers. In the most prominent example, AIG couldn’t come close to paying and we taxpayers are still waiting for our money back. Good luck to us.

I guess the Lehman bankruptcy is our example of how things should work.

Really, is there anything legally preventing another seemingly credit-worthy firm from pulling an AIG and writing CDSs all day long on what seem at the time to be end-of-world events? Remember, AIG’s CDSs had collateral requirements too and it ponied up for a while. But it sure as heck could not get out of its positions when things began to turn south.

I am getting a feeling that you have a horse in this race! Why not man up and tell us who you are instead of hiding behind your screen name ;-) ?

Look, it’s not just ignoramuses like me (your word) who have issues with CDSs because we are too dumb to understand how markets work.

George Soros called for an outright ban on all credit default swaps well after the dust had settled and we could see what happens with big defaults.
http://money.cnn.com/2009/06/12/news/eco nomy/soros_swaps.reut/index.htm

Buffett sidekick Charlie Munger too called for an outright ban, again, long after the dust had settled and we saw what had happened.
http://dealbook.blogs.nytimes.com/2009/0 5/01/munger-of-berkshire-calls-for-ban-o n-credit-swaps/

I guess that’s just two more ignoramuses who haven’t a clue what is going on.

Posted by DanHess | Report as abusive

@DanHess, Bear Stearns didn’t default or go bankrupt. Neither did Freddie or Fannie. LEH did and the market worked smoothly for that event as it did for Washington Mutual.

And you seem to simply not understand how the insurance market works. I write health insurance for you. I DON’T then keep in cash money to pay for the most expensive possible outcome for you on the offhand chance you may need round the clock medical treatment for the next 40 years. Health insurance companies also have acturial tables just like AIG had loss models for the bonds it insured. This isn’t that complicated and assuming you have more than two brain cells to rub together you should have been able to grasp this. One can only assume you simply refuse to believe how the real world works.

Posted by Danny_Black | Report as abusive

@Danny_Black –

You didn’t get very far before you apparently ran out of ideas and had to resort to insults. Not very impressive.

Modeling car insurance, life insurance and health insurance is easy and predictable. There are thousands or millions of insurable events and they are not correlated with each other. If Geico insures 20 million drivers they have a decent idea of how many will have an accident, give or take. So you know what to set aside.

Financial events do not lend themselves well to such modeling since default events are highly correlated. You don’t get any defaults for a while until you suddenly get a whole bunch.

You wrote “just like AIG had loss models for the bonds it insured”

Thank you for proving my point. AIG’s bond default models, as we have seen, were completely worthless. AIG had been modeling traditional insurance for many decades quite nicely. It didn’t help them at all for bonds.

The models unfortunately give misplaced confidence to folks who are easily impressed with technology.

I graduated in computer science and physics from Cornell and I can write models that look very impressive. A number of my former classmates went to Wall Street to do just that. That doesn’t make the models valid, especially when events are rare and highly correlated.

There isn’t a lot more say since we both are pretty nicely dug in. We just have to wait to see what the future holds. I expect that swaps will give us another spectacular blowup in the next few years, especially interest rate swaps. Nothing more to do but watch and wait.

Posted by DanHess | Report as abusive

@Dan_Hess, easy and predictable? Asbestos nearly wiped out Lloyds in 1980s. HIV was predictable? Plenty of insurance companies go bankrupt as they underprice risks.

The default events are not “highly correlated” and most of the bonds AIG insured didn’t default. What happened is a mix of AIG’s rating being cut – triggering more collateral payments – and the mark to market **prices** of the bonds going down – triggering more collateral payments – and the ratings on the bonds being cut – triggering collateral payments. What **was** highly correlated were prices as everyone tried to ditch illiquid products for liquid ones – nothing to do with default rates or cash flows.

The point about the loss models is that the basic underlying mechanism is identical to any other insurance and other insurance uses the same methodology to calculate loss reserves, were you suggesting some sort of magical new way to calculate loss reserves?

What is amazing is that you managed to completely and utterly miss the point of why there are these crises which is that we simply have positive feedback in these systems as we always have had in banks. It is simply a fundamental part of the banking system which at its base is about selling liquidity, ie being long illiquid instruments and short liquid ones and maturity mismatches in assets and liabilities. The issue wasn’t that AIG was actually losing alot of money on the swaps it was that liquidity was being sucked out of the company at the very same time it was not able to raise more cash which is usually when liquidity is getting sucked out of companies. All the ignorant nonsense you have posted about this regulation and that is just irrelevent just like your academic history – I graduated in Middle East Languages and the most effective models i ever saw were not that technically impressive.

Posted by Danny_Black | Report as abusive