What's so bad about Credit Default Swaps?

[blazespinnaker]

I have to admit, I really like reading EJ and EJ's friends, but I am having a hard time making the leap here to look down upon credit default swaps.

Maybe I just don't understand.

EJ makes the case that derivatives, tell me if I am wrong, are creating system risk by diluting it throughout the economic environment.

By holding all these derivatives, the risk of a particular company failing is no longer significant because we are insured against that risk.

However, we have these huge companies that have huge amounts of CDS and so a systemic shock will 'rattle' the pollution drum and all hell will break loose. Or, at least, this seems to be the theory.

EJ's guest writer seems to follow up on that idea, and says that we are at peak risk and that a lack of spread between Baa bonds and AAA bonds indicates that something really bad is about to happen. He quotes the number of October/2002, a time when the fed had gone manic in its loosening as a relevant data point.

I can see his point, somewhat, that people are paying far too much for Baa bonds. There should be a greater risk premium.

I completley agree with this. The central banks, I believe, are pumping too much liquidity into the system to prop up the US economy and dollar. That can only end badly.

However, don't CDS derivatives help us *deal* with that? Haven't we taken out all this insurance and spent all this capital in smoothing out the volatility of a inevitable bust that will occur as the world has to pay the piper?

I guess I just happen to feel that insurance is a good thing, it's stocking the nuts away for the winter. Admittedly, people may start feeling *too* safe because of CDS, but that's not the problem of the particular instrument but rather the attitude of the people.

Please note, I am only refering to credit default swaps here. Other derivatives which allow for kinky accounting, are obviously a Bad Thing.

But taking out insurance if a company defaults on its bonds doesn't seem a bad thing to me.

[bart]

Its not the insurance aspects that are the issue, since in theory that's a good thing as you note. Its both the large leverage and the unknown stability of all the various parties involved.

Insurance companies are regulated and their investments and positions are generally conservative. That can not be said about the all companies that are involved in the derivatives area, whether in the CDS market or others.

The basic concern is the domino effect, ala LTCM - one default on one side could multiply and create havoc and a system shock. And yes, the Fed and/or other central banks and/or governments would step in and try to fix it - if they're successful, it bakes even more inflation into the cake and if they're not, we have a repeat of the '30s or similar.

[jeffolie]

Bart

One can not even trust the major US bank to be truthful about their handling of derivatives.

BofA Hedges Spur Five-year Restatement

A company review unearths mistakes in derivatives accounting and spawns a switch to mark-to-market reporting.

Stephen Taub, CFO.com
May 30, 2006

Bank of America Corp. will restate financial reports dating back to 2001 as a result of missteps in its accounting treatment for derivative deals.

In their review of the bank's hedge deals, officials found that some didn't comply with SFAS 133. Since Bank of America couldn't apply hedge accounting for those transactions, it marked them to market on its income statement and entered no related offset for hedge accounting. Thus, changes in interest rates and currency rates that affect the fair value of derivatives "have had a direct impact on our Net Income," the bank stated.

[bart]

True Jeff, and I'm actually a proponent of the idea that part of the poor reporting game isn't intentional.

Not only is 133 complex by itself, but the valuation of many of the derivatives is even more complex and subject to (valid) opinions... which can turn out wrong or not.

[blazespinnaker]

I'm not sure I buy the 'stability' issue. I assume that credit rating agencies have the in house talent to analyze these derivatives or are at least rapidly hiring such talent.

The leverage is an interesting point - however that leverage goes both ways. if things go really bad, there will be winners and losers. . However that's the whole point. There will be winners and losers - unlike in the 30s when the stock market tanked there were only *losers*.

Derivatives are taming the cycles of boom and bust.

I think one of the real problems is the complexity and how the old players are having a hard time reconciling it all and are having to give way to the PHds and computer scientists with their AI computers.

Also, there was this guy floating around saying that the world is becoming too complex for individuals to grasp it all, and this may put us in a situation where things may happen that no individual expects. A scary thought.

I also think the problem with derivatives is that they are making the market *more* effiecient, which unfortunately means that the central banks can't get away with their shennanigans anymore.

Basically, derivatives are going to force us to pay the piper and face up to the truth of our spendthrift ways.

[jeffolie]

Derivatives are very complex and broker analysts have no clue.

Worst yet, about 40% of derivatives are not exchange traded. So, they have no 'transparency'. Most derivatives are traded beyond the control of the Fed and are overseas.

There could be a financial system scam and no one would catch on until the consequences blew the systematic risk sky high. There is so little margin on some of these derivatives that they can be called options squared.

The song and dance is that the credit swaps etc make the system safer. If so how did the credit derivatives on GM improve the safety when GM has precious metals derivatives in its accounts. How did the derivatives on Fannie Mae mortgage backed bonds improve the systematic risk when it was exposed that Fannie Mae was cooking the booking to provide huge stock performance bonuses unethically.