Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

From: Jon Urdan <jon () lambeaucap com>
Date: October 20, 2008 2:06:06 PM EDT
To: "'Savage, Christopher'" <ChrisSavage () dwt com>, <dave () farber net>
Cc: <dpreed () reed com>
Subject: RE: [IP] Credit Default Swap (CDS) question and answer


The Black Swan concept is partly behind the current financial crisis,  
but is
different from what Einhorn is talking about.

There are two groups of 'quants' on Wall Street.  The first group  
usually
have University PHDs and develop trading strategies based on  
sophisticated
models.  At this point, everyone's models go beyond bell curves to  
include,
at minimum, "fat" distributions and discontinuity.  Despite their  
apparent
sophistication, almost everyone seems to have underestimated the  
volatility
in the mortgage market.

Einhorn is talking about the second group of 'quants.'  This group is
probably not what you would consider 'quants' at all.  They are
practitioners in charge of risk management.  They may be PHDs, but are  
more
likely to be accountants (at corporate level) or MBAs (line managers or
department level).  These practitioners employ models developed by the  
first
group of quants, but don't have responsibility or the skills to  
critique the
models.

If you look at the banks that did not get crushed in the panic (e.g.,
Goldman Sachs), it is usually because their risk managers ignored the  
models
and decided to hedge or reduce their exposure to mortgages.

-----Original Message-----
From: Savage, Christopher [mailto:ChrisSavage () dwt com]
Sent: Saturday, October 18, 2008 8:36 PM
To: Jon Urdan; dave () farber net
Cc: dpreed () reed com
Subject: RE: [IP] Credit Default Swap (CDS) question and answer

I'm not a quant by any means but this sounds like the kind of thing that
Nicholas Taleb has been griping about for years in books like The Black
Swan.  His basic point is that market swings obey a power law
distribution but that the models essentially assume a normal Gaussian
bell curve.  If he's right then the models will work great, until they
inexplicably (to the model builders) blow up.

Is that part of what's going on here?

Chris S.

> -----Original Message-----
> From: Jon Urdan [mailto:jon () lambeaucap com]
> Sent: Saturday, October 18, 2008 8:44 PM
> To: dave () farber net
> Cc: Savage, Christopher; dpreed () reed com
> Subject: [IP] Credit Default Swap (CDS) question and answer
>
> I don't think this is for IP generally, but I thought the two of you
might
> want to see this speech by David Einhorn from April.  Despite what
Lehman
> would like you to believe, Einhorn is one of the good guys and is
revered
> in
> the community of value investors.
>
> The "mathematical models" that investment banks used to measure risk
were
> actually pretty simple.  If a risk was too small, it was assigned a
value
> of
> zero.  If you leveraged your balance sheet thirty times with AAA
credits,
> your risk was still 30 x 0 = 0!
>
>
>
>
> -----Original Message-----
> From: David Farber [mailto:dave () farber net]
> Sent: Saturday, October 18, 2008 5:04 PM
> To: ip
> Subject: [IP] Re: Credit Default Swap (CDS) question and answer
>
>
>
> 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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