Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

From: "Savage, Christopher" <ChrisSavage () dwt com>
Date: October 17, 2008 5:03:05 PM EDT
To: <dave () farber net>
Subject: RE: [IP] Re:  Fears of Lehman's CDS derivatives haunt markets

Dave, I’d appreciate it if you could pass this on to IP and see if  
anyone has any thoughts.

As I understand it, CDSs are basically a form of insurance, where the  
insured-against event is that XYZ Co. will default on some obligation.

What would happen if any and all CDS contracts were declared void as  
in violation of public policy, except, possibly, for CDS contracts  
purchased by someone who lent directly to XYZ Co.?

It seems to me that if the contract is held by the entity that lent  
money to XYZ Co., they would be deprived of something that they could  
reasonably be looking for – protection against a loss on a loan they  
themselves made.

But I have heard that one could buy, in effect, speculative CDSs, so  
that Acme Speculators, Inc., could buy what amounts to “insurance”  
against XYZ Co. defaulting on its loans, even if Acme Speculators has  
no direct exposure to that loss.

Would anything really bad happen if all of these speculative CDSs were  
just declared void?

Chris S.


Begin forwarded message:

From: Newmedia () aol com
Date: October 17, 2008 9:37:42 PM EDT
To: dave () farber net


Dave:

Credit Default Swap (CDS) are, as the name says, a "swap" (i.e. shift  
of risk) in the case of a default on a credit obligation.  They are  
not "insurance" but instead a private contract.  Because there is no  
underlying obligation for "reserves" (i.e. gold in the vault) and no  
direct attachment to the original credit issuance (i.e. they are  
derivative instruments), there is no limit to how many of these  
contracts can be written.

The global CDS volume is estimated by the derivatives trade  
association to be $60-70 Trillion.  There are many other kinds of  
derivatives, all of which may total $500T+.  Most of these are  
interest rate and currency derivatives and they have been around for a  
long time.  The CDS business is fairly new (i.e. the past 5 years)  
and, therefore, has never been tested.  Until now, of course.

All these derivatives cannot and should not be "outlawed" or summarily  
declared "void."  While you can debate how good or bad they may be,  
they are integral to the current global financial system.  They are  
simply business contracts, so they are valid and legal.

The "problem" is not that they are bad that they are hidden.  No one  
knows who did what with whom and, therefore, who is really at risk.

The regulation that is certainly coming will most like be to try to  
make them "transparent" -- which means that governments will require  
reporting on who is on the hook for what.  Since banks and other  
financial institutions are regulated businesses, the rules will likely  
define how much of what kinds of derivatives each sort of business can  
own, issue, etc.

Hope that helps.  There is a great book on how derivatives got started  
-- written by a ex-trader -- that pulls no punches on the stupidity  
and greed of those involved called "Traders, Guns and Money."  It is  
also well written, so I recommend it for anyone who is interested.

Mark Stahlman
New York City




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