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Credit Default Swaps November 21, 2008

Posted by A Texan In Grad School in Economic Theories.

I won’t pretend to completely understand CDS.  In a general sense they are like any other swap where two parties try to swap risk types.  This post by Megan McArdle hits the nail on the head for what my gut has been telling me about CDS: their activity is symptomatic to the credit crunch, but not the cause.

I imagine the economy as a cruise ship.  The boat is humming along quite quickly when all of a sudden somebody notices we’re taking on water because there’s a hole in the side of the ship.  Now somebody looks at the hole’s location and notices it was next to a big luggage room.  He points out that nobody noticed we were taking on water because the luggage room is so wide that it takes a lot water to fill it to a level somebody will notice.  He recommends that as a safety precaution the luggage rooms should be smaller, thus prompting faster notification of leaks.

The luggage room is the CDS market.  It postponed our awareness of the leverage situation of the economy, but it is not the root cause.  The hole is the problem.  We need to identify what made the hole and treat that problem.



1. Winston Chang - November 21, 2008

No. CDSes are more like rigging a huge number of very large ships together, where each ship can only see the ships to which they’re immediately connected, and there’s no limit to the number of ships they can latch themselves onto. In theory this makes everyone more safe (hedging/transferring risk), but if a lot of ships start going down at the same time, or a very large ship connected to a lot of smaller ships, which in turn are connected to a lot of other smaller ships sinks, it triggers a chain reaction that will eventually bring everything down.

So no, the leak wasn’t caused by the rigging, but the rigging’s set up a domino effect that turned what would have been just a simple recession into a potential 3-decade depression, requiring massive government intervention to avoid catastrophe.

2. A Texan In Grad School - November 21, 2008

The rigging metaphor does seem to be more applicable. I don’t know if I’d accept the “3-decade depression” conclusion though.

While regulating the CDS may diminish their multiplier effect in the future (that assumes the regulation is done correctly), it won’t do anything do discourage such reckless behavior in the future when some other complex financial contract comes along. Perhaps by not bailing anyone out it would send a signal to be more timid in the future because no matter your size, the government will let you fail.

Also one has to consider why these ships were tied together in the first place. Part of the reason so many firms wanted to hand off their risks was that they knew they were making risky loans but at the same time knew the government would back them up. As Larry Summers described it, the system was composed of privatized gains and socialized losses.

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