On Sun, Nov 16, 2008 at 9:39 AM, Julia Thompson <[EMAIL PROTECTED]> wrote: > It seems perhaps that credit default swaps aren't the boogeyman that > they've been painted by some. > > The Meltdown That Wasn't > > http://online.wsj.com/article/SB122670411909729683.html > .... > Anyway, I'd like to hear what other people interested in the economic > debate here have to say about it.
Like most derivatives, a CDS can be used to hedge your position (i.e., lower risk) or to take a position, possibly highly leveraged (i.e, greater risk). The article claims that for many players, they were hedging with the swaps: "Also, the large dealers generally make their money facilitating trades for customers, not betting one way or another on corporate defaults. So if they sell a lot of credit protection to one customer, they will seek to buy it from somebody else." That is why it is meaningless to quote the notional value of outstanding derivatives contracts, in tens or even hundreds of trillions of dollars. Many holders may be largely hedged, which can make their net exposure a tiny fraction of the notional value of the contracts. However, the articles states that not everyone was hedged: "AIG, by contrast, was almost entirely a seller of CDS. By selling credit protection on mortgage-backed securities, the firm used CDS to make a big bet on housing, which again is the cause of this crisis. Meanwhile, the search continues for the major counterparty that would have been destroyed by AIG's collapse." In other words, AIG took a long position on the housing market by selling CDS, but not hedging by buying CDS to offset. Selling a CDS is typically a highly-leveraged transaction, since in the event of a default, you are on the hook for a large payout, but the margin requirements (amount of capital that must be held) is only a fraction of the possible payout. So, when the housing market tanked, AIG could not pay (technically, could not meet the additional margin requirements) and would have gone bankrupt. But some people in government panicked. They imagined a scenario where AIG's bankruptcy would lead, by some vague CDS linkage, to the collapse of all financial markets, and so they bailed out AIG to avert the imagined disaster. According to the article, subsequent events indicate that the fears were overblown. My view is that I would like to see an organized CDS exchange, if only because it may help prevent clueless politicians from panicking in the future and instigating more wrong-headed bailouts. But I have zero confidence in the government to be able to organize such an exchange. I think the best thing that could happen would be for a private exchange, similar to the Options Clearing Corporation, to be formed. If the politicians can use their influence to encourage that to happen, then they may actually be useful for a change. _______________________________________________ http://www.mccmedia.com/mailman/listinfo/brin-l
