Re: Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

From: "Savage, Christopher" <ChrisSavage () dwt com>
Date: October 18, 2008 12:40:26 PM EDT
To: "David P. Reed" <dpreed () reed com>, <dave () farber net>
Cc: "ip" <ip () v2 listbox com>
Subject: RE: [IP] Credit Default Swap (CDS) question and answer

David,

Well, if we step back from the "everything should be unregulated"
mantra, which seems, in the Grand Scheme of Things, to have pretty much
just played out its dominance of public policy debates, I'm still at a
loss to understand why -- if exposure to what I'm gathering are the
casino-like aspects of CDSs is a problem for the overall economy -- we
can't just call the game off.

("I'm SHOCKED to discover that gambling is going on on Wall Street...")

The two choices seem to me to be that CDSs are either (a) essentially a
form of insurance, that we could declare void because the issuers were
not properly regulated, etc. (and then, if we are so inclined, set up
reserve requirements, etc. to allow them to go forward) or (b)
essentially a form of wagering contract, which we can declare void on
the same theories that various states have declared wagering contracts
void since time out of mind.

Barry suggests that if we do this we are somehow violating the sanctity
of the Rule of Law, but I have a hard time seeing why that would be
true.

Am I missing something?

Chris S.

> -----Original Message-----
> From: David P. Reed [mailto:dpreed () reed com]
> Sent: Saturday, October 18, 2008 11:40 AM
> To: dave () farber net
> Cc: ip; Savage, Christopher
> Subject: Re: [IP] Credit Default Swap (CDS) question and answer
>
> Revoking gamblers' lottery tickets?  Nice move, unless the gamblers
fund
> your campaigns, as they do in this case.
>
> I'm sure Milton Friedman would have argued that the more gambling
there
> is, especially unregulated, the better for the economy.  The
> mathematical models prove it, by the way.  There has never been a
> mathematical economic model that demonstrates that contingent
securities
> harm economies, and lots of "evidence" that "prediction markets"
"always
> work".
>
> A mathematical economist who stood up to say that "prediction markets"
> are a bad idea (or even might not always be wonderful) would be
laughed
> out of the profession, unless they came up with extraordinary proof.
> It's a career limiting move for anyone entering the math side of US
> economics profession to be skeptical of the idea that price doesn't
> reflect information perfectly.  You have to pay homage to the holy
writ.
> David Farber wrote:
> > Begin forwarded message:
> >
> > *From: *"Savage, Christopher" <ChrisSavage () dwt com
> > <mailto:ChrisSavage () dwt com>>
> > *Date: *October 17, 2008 5:03:05 PM EDT
> > *To: *<dave () farber net <mailto: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 <mailto:Newmedia () aol com>
> > Date: October 17, 2008 9:37:42 PM EDT
> > To: dave () farber net <mailto: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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