Arnold Kling  

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Two Thoughts... Getting to Bet...

I look like a cornered criminal, but this episode of Free Will gives me good exposure to explain how we got where we are today. Find out why Will Wilkinson considers Arnold Kling "The most sober crackhead I've ever met."

That dialog is slightly over an hour. If you want to spend another hour and a half with me, listen to this podcast. The audio quality is much better, and I look better (there is no video), but the Wilkinson dialog is more current in terms of substance.

I strongly recommend the dialog with Wilkinson. I've actually listened to it a couple times now, and I think it really captures a lot of my thinking. The podcast goes into more depth in some areas, so if you find yourself overwhelmed by everything that gets thrown at you in the video dialog, I would recommend listening to the podcast.

One thing that I make clear in the podcast that I failed to do in the video is that the trading strategy involved in protecting a credit default swap could involve short-selling. That raises all sorts of interesting issues, including the possibility that the ban on short sales effectively destroyed the CDS market.


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COMMENTS (4 to date)
ErikR writes:

John Hussman continues to be the only real advocate for handling the financial sector in a free-market manner under current laws. We already had an excellent model for how to handle large banks failing, but apparently the new plan is designed by people who don't know how to read a balance sheet:

You Can't Rescue the Financial System If You Can't Read a Balance Sheet

What the financial system has needed most has been for Congress to streamline the bankruptcy process for investment banks, so that in the event of failure, the “good bank” (assets and liabilities, ex the debt to bondholders) could be cut away quickly and liquidated to an acquirer, leaving the proceeds as a residual for the bondholders. Indeed, that's exactly how it works for regulated banks. What investors overlooked in last week's panic was that we actually saw the largest bank failure in history – Washington Mutual – with absolutely no losses to customers or the U.S. government, precisely because the good bank was seamlessly cut away and sold to J.P. Morgan, wiping out shareholder equity, preferred equity, and subordinated debt, with partial repayment to the bondholders. Snap – just like that.
razib writes:

great show. lots of the specific details i was aware of just reading blogs and looking up terms, but you did a great job trying to make it semi-coherent. at least, as coherent as you can get in a 60 minute interview.

mk writes:

Great show, I agree.

One question: If CDS's must be substantiated by a trading strategy that maybe can't be executed, does that mean that CDS's are worth much less than people thought?

For a specific example: suppose AIG has a 1/1000 chance of defaulting on some insurance contract in the next year.
Suppose I sell a derivative that pays $1000 if that default happens in the next year.
Ignoring interest rates, this security appears to be worth about $1.
But my ability to substantiate the $1000 payoff depends on my ability to dump AIG stock. Even worse, I'd need to dump this stock at a time when I feel it might really default. Unless I have privileged info, this implies that others who have issued CDS's based on AIG will also be worried and will execute the same stock-dumping strategy.

So what's the real value of the CDS? In order to answer this, don't we need to answer questions like "how many people will try to dump AIG if it looks at risk of default?" These answers will determine how credibly I can claim to be able to execute the trading strategy that substantiates my security.

Of course even if I cannot execute this trading strategy, I can take a haircut and pay off the $1000. But if I sell 999 other CDS's relating to AIG, maybe I can't really take 1000 haircuts at once.

So it seems the value of one CDS security depends on the value of other securities that have similar payoff scenarios.

There are then two limits relevant to valuing the security:
(1) An upper limit of aggregate payout of all CDS's on AIG, because there is an upper limit of money that can be raised in a crisis period by everyone simultaneously liquidating AIG's stock.
(2) An upper limit of aggregate payout of CDS's on AIG that I issue, because there is an upper limit of simultaneous $1000 haircuts that I can take.


My question is: are these limits accounted for in pricing the security? Is someone keeping track of whether these limits are being surpassed?

Thanks very much for even reading this far.

Arnold Kling writes:

mk,
You have captured my view, which may or may not be correct. And in practice it is difficult for investors to know how many of these swaps are outstanding against any one firm. So I don't see how you could factor the number into the price.

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