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By: HBC Mon, 08 Mar 2010 20:15:00 +0000 Yebbut, imagine how much better the NYT will be when they have a paywall…

Then imagine how much better CDS could be without regulation holding back the worst Yep, you’re getting warmer.

By: DanHess Mon, 08 Mar 2010 20:06:07 +0000 cbk —

A nice discussion, thank you.

I just think of how Goldman and other smart banks played CDSs in a way that allowed them to securitize and sell vast amounts of the most toxic of CDOs to the world.

The thing is, these smart banks used CDSs perfectly. They have excellent risk management, they understood that they did not want to be long these awful MBSs, and they saw the bubble for what it was, and acted safely. If they could ‘turn back time’ their fixes might be mainly on the PR side.

I do actually agree with Felix that CDSs can potentially have positive value (price discovery, leaning against bubbles, etc), but three crucial and presently missing conditions would have to be met:
– real reserve (and not just margin) requirements for counterparties demonstrating an ability to really pay (because the market will surely sieze up for that CDS and some unlucky counterparty will have to ride that sucker down because the CDSs will be unloadable) if and when they are holding the bag in the event of a black swan
– an exchange for all CDSs, showing where counterparty risks are building. AIG was a terrifically wonderful company with one bad unit that ruined things for hundreds of thousands of employees and hundreds of millions of taxpayers.
– a requirement that bonds can only be insured once, corresponding to rules as old as insurance itself

These rules would bring safety to CDSs and transform them from liabilities to assets in our economy.

By: csissoko Mon, 08 Mar 2010 18:53:47 +0000 Oops. Careless math in post above. In terms of fair value in Q1 08 CDS were 18% of OTC derivatives and in Q3 08 CDS were 25% of OTC derivatives.

See Table 6 in the reports here:

By: chibondking Mon, 08 Mar 2010 18:15:46 +0000 @DanHess –

I by and large agree.. There is definitely plenty of blame to go around on all sides. But securitization of risk is nothing new as you know. I’m not an expert on human psychology by any stretch of the imagination, but I would suggest that something drastically changed on both sides between the time the first securitizations came to market in the early 80’s and where we find ourselves today. Taleb, in his book Fooled By Randomness, put it quite succintly in explaining a story of traders (homeowners) being in the right place at the right time, riding a wave to riches and glory, casting aside any memory of recent financial pains. Those who lived during the recessionary periods in the early 80’s and with the mortgage crisis in the early 90’s should remember the pains of those crises. The same goes for the banks.

The instruments themselves are not what is dangerous, it is the people who overindulge in their use and lack the foresight, as silliness said. I would be willing to bet my lunch that if, in the words of Cher, we could ‘turn back time’ and have in place the risk management methodology that existed previous to the bubble created in the early 00’s, these instruments would have been helpful to a point, but not pose such a risk. Nobody had skin in the game, which is one thing that changed between then and now.

Apologies for the rant,

By: csissoko Mon, 08 Mar 2010 17:47:59 +0000 Greycap:

First I apologize for the delayed reply — didn’t get online til this morning.

What I left out of my quick blog comment was that after Bear Stearns the NYFed forced the dealers to jumpstart the move to central CDS clearing. And the infrastructure built in the six months after Bear is probably the only reason the CDS market was able to handle the Lehman collapse. Dudley’s comment together with the fact that the NYFed jumped on the CDS market point to its involvement in the Bear crisis.

Secondly you seem to be confusing notional values of OTC derivatives with their fair value (i.e. gross negative plus gross positive value). The OCC derivative reports make it clear that the fair value of CDS varied from 20% of the OTC fair value (Q1 08, Bear) to 33% of the OTC fair value (Q3 08, Lehman). Over this period the fair value of CDS increased by 20%, even as the fair value of interest rate swaps fell by 2%. Also because CDS values jump (unlike interest rate swaps), counterparties to CDS tend to be more concerned about holding an unmargined claim on a bankrupt counterparty — so they have a much stronger reason to novate their claims.

By: silliness Mon, 08 Mar 2010 10:49:22 +0000 I respectfully disagree with DanHess and throw my weight behind the argument of chibondking. It does take two to tango. That lesson is critical to making any proposed regulation work. All the free money in the world isn’t going to create a crisis if, as chibondking pointed out, financial illiteracy and greed aren’t running rampant in society. Your neighborhood real estate agents, mortgage brokers, appraisers, developers, and condo flippers are as much to blame as the bankers.

If we are all to blame, then the fix is different than if only the bankers are to blame. If CDS are the wonderful innovation some claim, but our own weaknesses make them dangerous, then you ban CDS like you ban illicit drugs. If everyone can be trusted to act responsibly, then derivatives and the like are perfectly reasonable innovations.