2 Responses to “December 15, 2008”

1. prefhound says:

   December 16, 2008 at 1:10 pm

   “…wants the heart of the financial world to move to Dubai”

   There is an interesting summary of the history and mechanics of CDS on wikipedia (http://en.wikipedia.org/wiki/Credit_default_swap). Apparently they snuck in as unregulated in the Clinton years.

   Given the huge size of the market — often bigger than the outstanding supply of corporate bonds — and the systemic risks from “domino” effects, where the bankruptcy of one counterparty triggers more payment obligations that might bankrupt other counterparties in a chain reaction, and given the opaqueness of CDS and derivative contracts on bank balance sheets, it seems prudent to have more visibility for sure.

   I worry that small percentage losses on big positions might translate into mighty big dollar losses (e.g. 2% of $50T is still $1T; and these amounts are over and above sub-prime). The credit crunch has gone way beyond sub-prime and I wonder what role CDS are having.

   As the wikipedia article shows, however, the CDS’s are somehow marked to market with counterparties on a daily (probably net) basis, so there does seem to be some underlying capital commitment — which is a good thing. Also, at least in the Lehman bankruptcy, there was an orderly position squaring with only about 1.5% of notional value having to change hands as cash, despite a recovery of only 8 cents on the dollar. So, it could be argued that banks have been behaving responsibly (so far) with these products and they have worked as advertised.

   Unfortunately, banks and other financial firms are prone to screwing up from time to time and their still-increasing leverage has to be a worry for all investors and regulators. One benefit of a CDS exchange will be more transparency, and another may be higher capital requirements. If the Americans move CDS to an exchange, then other major developed economies will too.

   All Dubai has to do is have one major glitch and the big banks will stay away.

   I for one, am glad that not all regulatory action is in the direction of further “forebearance” like avoiding mark to market, loosening insurance and bank capital requirements, and fudging pension accounting — which can all add systemic risk. At least moving CDS to an exchange (a lot of which had already been committed to by major players) goes in a different direction.

2. jiHymas says:

   December 16, 2008 at 5:50 pm

   exchange

   It’s not an exchange that’s being talked about, it’s a clearinghouse. I’ve made the distinction before, in response to a post by Accrued Interest.

   marked to market with counterparties on a daily (probably net) basis, so there does seem to be some underlying capital commitment — which is a good thing.

   Not just marking, but collateralization. As I noted in a response to a piece by Econbrowser, the Bear Stearns

   financial statements for 2007 show $15.6-billion “Securities Received as Collateral” and $15.7-billion “Securities Owned and Pledged as Collateral”.

   The major pro-cyclical problem with the usual collateralization agreements are also highlighted in the report:

   Additionally, a reduction in our credit ratings could also trigger incremental collateral requirements, predominantly in the OTC derivatives market.

   I consider the snowballing of collaterallization to be the big problem – essentially, that’s what killed AIG and the monolines. But I suggest that a more direct method of addressing the problem is to tighten up the capital requirements rather than using the big stick of enforced central clearing.

   All Dubai has to do is have one major glitch and the big banks will stay away.

   It will just be regulatory arbitrage. As long as somewhere exists that you can book a trade without too many rules, but with enough rules to enforce the contract … that’s where the business will get done.