Wednesday, October 29, 2008

CDS: The Less You Know, The Worse They Look

(Felix Salmon) For those of you who like your CDS exposés presented in the mellow tones of Leonard Lopate and Jesse Eisinger over the course of a leisurely half-hour, here you go.

This is a sober public radio progam, not a finger-pointing piece of populism like the awful 60 Minutes piece on the same subject. But it's worth noting a broader dynamic, wherein the least informed commentators are also the most alarmist.

Think of a spectrum of opinion, with "credit default swaps are the root of all evil" on the left, and "credit default swaps are a brilliant invention which helped spread risk and mitigate the effects of the financial crisis" on the right. I'm a right-winger, on this spectrum, albeit not a rabid one: I think that a large part of the financial crisis was caused by unfunded super-senior CDO tranches, which were made possible only by misusing CDS technology.

Jesse's to the left of me; I'd say he's center-left in terms of financial journalists generally. Most market participants are to the right of Jesse, somewhere in my neighborhood. But Lopate is clearly to the left of Jesse: he keeps on wanting to lay enormous amounts of blame on credit derivatives and the people who structured them, drawing unhelpful parallels with Bankers Trust and generally asking leading questions of Jesse who then finds himself having to tell Lopate that it's really not as egregious as all that.

60 Minutes, of course, went further still, and entitled its segment "Financial Weapons of Mass Destruction", making the now-common claim that Warren Buffett had described credit default swaps thusly. But Buffett wasn't talking about CDS when he used that famous phrase, he was talking about common-or-garden derivatives which no one seems to be worrying about at all.

Or rather, everybody seems to be using the term "derivatives" interchangeably with "credit default swaps" -- which is just plain weird. Are CDS dangerous because they're derivatives? Well in that case there are much bigger problems than the CDS market, which is a small fraction of the total derivatives market. Are they dangerous because they're not exchange-traded, instead changing hands in the OTC market? Again, just look at interest-rate derivatives, where the OTC market dwarfs any exchange.

60 Minutes is probably the worst offender here: it claims that the CDS market "blew up Wall Street", for all the world as if we would have been just fine with falling housing prices, just so long as no mortgages were hedged with CDS. But no one ever seems compelled to mention that CDS, like all derivatives, are a zero-sum game with just as many winners as losers -- unlike mortgages, where it's entirely possible for everyone to be a loser. If the losses in the economy are widespread, and they are, then that can't be due to CDS: if the only winners you can find are a couple of smart-or-lucky hedge fund managers like John Paulson and Andrew Lahde, then total losses on credit default swaps simply can't have been all that big.

I had lunch yesterday with Shane Akeroyd of Markit, and he had a more sophisticated take on what we're seeing. The problem isn't CDS specifically or even derivatives in general, he said: the problem is that the world had an enormous amount of leverage, and all that leverage is now being unwound at once. Do CDS make it easier to firms to lever up? Yes -- but if CDS hadn't been around, some other instrument would have been found which had the same effect. Blaming CDS for the market meltdown is like blaming Microsoft Word for a magazine article you don't like: it might have made things easier, but it was hardly necessary.

Credit existed as an asset class long before CDS came along. That's one of the reasons that the Treasury and rates markets are so liquid: anybody wanting to make a pure credit play would take a position in corporate bonds, say, and then hedge their interest-rate exposure. But corporate bonds can be illiquid, and hard to find or short, so the arrival of the CDS market made it much easier to trade credit. That's a good thing -- as I've said before, if it weren't for the CDS market, none of the the credit world would be functioning right now, and we'd be in an even worse situation.

But it's always easier to look for someone to blame than it is to really try to understand the dynamics of a highly complicated financial crisis. If that blame can be laid at the feet of a market no one's ever heard of, and especially if you can put huge scary numbers like $58 trillion in headlines, no matter how misleading notional numbers are in the world of derivatives, then few editors are going to complain.

And one final note on big scary numbers: Elisa Parisi-Capone asked last week what happened to all the missing Lehman Brothers CDS. The DTCC saw only $72 billion of the $400 billion in outstanding Lehman CDS, she says: where's the other $328 billion?

The answer is that there never was $400 billion in outstanding Lehman CDS. That number was a quick-and-dirty Citigroup estimate which became conventional wisdom very quickly, even though it was later revised down substantially. In general, the media loves to latch on to the biggest number it can find, and so the $400 billion gained a lot of currency even though it was pretty much pulled out of thin air.

As a general rule, then, it's worth taking anything you read or hear about credit default swaps with a very large grain of salt. It's not an easy subject to understand, and it's much easier to jump to conclusions than it is to do laborious homework and end up with a nuanced position. Besides, bankers who weren't involved in the CDS market love it when people start blaming CDS, because doing so implicitly leaves them with less blame for themselves. They should take more responsibility, and journalists shouldn't be so quick to let them off the hook.

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