Arnold Kling  

No Further Questions, Your Honor

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Felix Salmon testifies in defense of credit default swaps.

I just had a long conversation with Kai Gilkes of CreditSights, who confirmed for me that it's pretty much impossible, in this market, to back out implied default rates from CDS spreads. There are so many technical factors in the market, so many reasons beyond expected default that people are buying protection on certain credits, that it's impossible to isolate expected default probabilities. So I don't know what implied default rates Dizard is using, but I do know that they're unreliable to the point of uselessness, since right now CDS spreads tell us precisely nothing about expected default rates.

The prosecution rests.

During the Q&A at the hearing yesterday, I said that those of us in economics and finance do not yet fully understand credit default swaps. They've only been around a few years. I said that I suspect they are behind some of the anomalies in asset markets, such as the negative yield on short-term U.S. Treasuries. In my written testimony, I expressed my suspicion that CDS are the explanation for the mysterious multiplier in this crisis--the one highlighted by Brad DeLong.

Salmon says that credit default swaps have "other uses" than price discovery. Those other uses seem to me to consist primarily of creating systemic risk and huge swings in liquidity preference in response to revaluation of out-of-the-money put options.

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COMMENTS (6 to date)
fundamentalist writes:

Myron Scholes linked the multiplier in the current crisis to deleveraging in his debate on the Economist web site. Because of Austrian influence, I’m stuck on the deleveraging answer, too. I would appreciate it if someone could educate me as to why Dr. Kling doesn’t consider deleveraging a good explanation. I’m not being sarcastic. I really want to know.

brian writes:

During the Q & A of Arnold's testimony, the professor from Columbia commented (paraphrasing) that CDS's were not a problem because it was a zero sum game that was self-resolving. I don't understand. It's like saying that credit itself has self-mitigating risk because for every borrower there is a lender. But if someone writes 100 naked puts on a single debt security, they have multiplied potential loss by 100 (less the price of the put.) And to Arnold's point, the word naked above is redundant, because there are no natural sellers of these puts.

Put option sellers can manage risk using various strategies, such as shorting the underlying security, or buying offsetting puts that lay off a portion of the risk, or simply by recognizing the contingent liability and setting aside capital to cover it. Apparently Lehman did this well enough to only bankrupt themselves rather than the entire financial system. This hardly justifies the sanguin remarks of Pinto re Lehman in follow up to Columbia's comment above.

MattYoung writes:

We have a model of the credit default swap in aeronautics, the two engine airplane. The purpose of the second engine is to fly you directly to the crash site when the first engine fails.

Bob writes:

I think it is a mistake to dismiss CDS contracts. Brian's analogy to puts is apt - Arnold, do you advocate banning put options?

Sure, some of the ways CDS contracts were used in the past few years look pretty silly with hindsight. Consider synthetic CDOs - you create an entity that buys treasuries and sells CDS contracts, financed by selling bonds that pass-through the cash flows. Seems like a clever way to create made-to-order higher yield, higher risk securities. It turns out that investors way underpriced the risks, but so did the buyers of WAMU/GM/Lehman/etc. debt. Will/should sythetic CDOs be created in the future? That depends on whether they makes sense with rational pricing. But we shouldn't assume that there are no "natural" sellers of CDS contracts. Or that they create systematic risk (a synthetic CDO's treasury holdings should be sufficient to cover CDS losses - if they aren't, then the problem is leverage not CDSs).

Amicus writes:

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LHP writes:

I do not understand why you eschew the idea of an exchange to obviate counterparty risk. What does AIG's AAA credit rating have to do with its unwillingness to come up with collateral? If CDSs were traded on an exchange AIG would have had to meet margin calls. Other AAA rated companies (e.g., Cargill) have been doing this for years on commodity exchanges and apparently value the protection an exchange and margin calls offer. Whether or not there is a natural seller of default swaps, the margin call and an exchange mitigates not only counterparty riak but overleveraging as well.

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