Re: Credit Default Swap (CDS) question and answer

[David Farber <dave () farber net>]

Begin forwarded message:

From: "David P. Reed" <dpreed () reed com>
Date: October 18, 2008 11:39:44 AM EDT
To: dave () farber net
Cc: ip <ip () v2 listbox com>, "Savage, Christopher" <ChrisSavage () dwt com>
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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