Guest Post: Economic consequences of speculative side bets – The case of naked CDS

By Yeon-Koo Che, Professor of Economic Theory at Columbia University, and Rajiv Sethi, Professor of Economics, Barnard College, Columbia University, cross posted from VoxEU

The role of naked credit default swaps in the global crisis is an ongoing source of controversy. This column seeks to add some formal analysis to the debate. Its model finds that speculative side bets can have significant effects on economic fundamentals, including the terms of financing, the likelihood of default, and the scale and composition of investment expenditures.

There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang Münchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes (2010) who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance. In sharp contrast, John Carney believes that any attempt to prohibit such contracts would crush credit markets, Felix Salmon thinks that they benefit distressed debtors, and Sam Jones argues that they smooth out the cost of borrowing over time, thus reducing interest rate volatility.

One reason for the continuing controversy is that arguments for and against such contracts have been expressed informally, without the benefit of a common analytical framework within which the economic consequences of their use can be carefully examined. Since naked credit default swaps necessarily have a long and a short side and the aggregate payoff nets to zero, it is not immediately apparent why their existence should have any effect at all on the availability and terms of financing or the likelihood of default. And even if such effects do exist, it is not clear what form and direction they take, or the implications they have for the allocation of a society’s productive resources.

In a recent paper (Che and Sethi 2010), we have attempted to develop a framework within which such questions can be addressed and to provide some preliminary answers. We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice.

Heterogeneous beliefs and side bets

A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information. Individuals receiving the same information can come to different judgments about the meaning of the data. They can therefore agree to disagree about the likelihood of default, interpreting such disagreement as arising from different models rather than different information. As in prior work by John Geanakoplos (2010) on the leverage cycle, this allows us to speak of a range of optimism among investors, where the most optimistic do not interpret the pessimism of others as being particularly informative. We believe that this kind of disagreement is a fundamental driver of speculation in the real world.

When credit default swaps are unavailable, the investors with the most optimistic beliefs about the future revenues of a borrower are natural lenders: they are the ones who will part with their funds on terms most favourable to the borrower. The interest rate then depends on the beliefs of the threshold investor, who in turn is determined by the size of the borrowing requirement. The larger the borrowing requirement, the more pessimistic this threshold investor will be (since the size of the group of lenders has to be larger in order for the borrowing requirement to be met). Those more optimistic than this investor will lend, while the rest find other uses for their cash.

Now consider the effects of allowing for naked credit default swaps. Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it. However, pessimists also need to worry about counterparty risk – if the optimists write too many contracts, they may be unable to meet their obligations in the event that a default does occur, an event that the pessimists consider to be likely. Hence the optimists have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives. The borrowing requirement must then be met by appealing to a different class of investors, who are neither so optimistic that they wish to sell protection, nor so pessimistic that they wish to buy it. The threshold investor is now clearly more pessimistic than in the absence of derivatives, and the terms of financing are accordingly shifted against the borrower. As a result, for any given borrowing requirement, the bond issue is larger and the price of bonds accordingly lower when investors are permitted to purchase naked credit default swaps.

This effect does not arise if credit default swaps can only be purchased by holders of the underlying security. In fact, it can be shown that allowing for only “covered” credit default swaps has much the same consequences as allowing optimists to buy debt on margin: it leads to higher bond prices, a smaller issue size for any given borrowing requirement, and a lower likelihood of eventual default. While optimists take a long position in the debt by selling such contracts, they facilitate the purchase of bonds by more pessimistic investors by absorbing much of the credit risk. In contrast with the case of naked credit default swaps, therefore, the terms of lending are shifted in favour of the borrower. The difference arises because pessimists can enter directional positions on default in one case but not the other.

Naked credit default swaps and self-fulfilling pessimism

While this simple model sheds some light on the manner in which the terms of financing can be affected by the availability of credit derivatives, it does not deal with one of the major objections to such contracts: the possibility of self-fulfilling bear raids. To address this issue it is necessary to allow for a mismatch between the maturity of debt and the life of the borrower. This raises the possibility that a borrower who is unable to meet contractual obligations because of a revenue shortfall can roll over the residual debt, thereby deferring payment into the future.

As many economists have previously observed, multiple self-fulfilling paths arise naturally in this setting (see, for instance, Calvo 1988, Cole and Kehoe 2000, and Cohen and Portes 2006). If investors are confident that debt can be rolled over in the future, they will accept lower rates of interest on current lending, which in turn implies reduced future obligations and allows the debt to be rolled over with greater ease. But if investors suspect that refinancing may not be available in certain states, they demand greater interest rates on current debt, resulting in larger future obligations and an inability to refinance if the revenue shortfall is large.

A key question then is the following: how does the availability of naked credit default swaps affect the range of borrowing requirements for which pessimistic paths (with significant rollover risk) exist? And, conditional on the selection of such a path, how are the terms of borrowing affected by the presence of these credit derivatives?

For reasons that are already clear from the baseline model, we find that pessimistic paths involve more punitive terms for the borrower when naked credit default swaps are present than when they are not. Moreover, we find that there is a range of borrowing requirements for which a pessimistic path exists if and only if such contracts are allowed. That is, there exist conditions under which fears about the ability of the borrower to repay debt can be self-fulfilling only in the presence of credit derivatives. It is in this precise sense that the possibility of self-fulfilling bear raids can be said to arise when the use of such derivatives is unrestricted.

The finding that borrowers can more easily raise funds and obtain better terms when the use of credit derivatives is restricted does not necessarily imply that such restrictions are desirable from a policy perspective. A shift in terms against borrowers will generally reduce the number of projects that are funded, but some of these ought not to have been funded in the first place. Hence the efficiency effects of a ban are ambiguous. However, such a shift in terms against borrowers can also have a more subtle effect with respect to project choice: it can tilt managerial incentives towards the selection of riskier projects with lower expected returns. This happens because a larger debt obligation makes projects with greater upside potential more attractive to the firm, as more of the downside risk is absorbed by creditors.

The impact of speculative side bets

The central message of our work is that the existence of zero-sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic about the future revenues of borrowers, and would therefore be natural purchasers of debt, to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic about the borrower’s prospects, and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns.

James Tobin (1984) once observed that the advantages of greater “liquidity and negotiability of financial instruments” come at the cost of facilitating speculation, and that greater market completeness under such conditions could reduce the functional efficiency of the financial system, namely its ability to facilitate “the mobilisation of saving for investments in physical and human capital… and the allocation of saving to their more socially productive uses.” Based on our analysis, one could make the case that naked credit default swaps are a case in point.

This conclusion, however, is subject to the caveat that there exist conditions under which the presence of such contracts can prevent the funding of inefficient projects. Furthermore, an outright ban may be infeasible in practice due to the emergence of close substitutes through financial engineering. Even so, it is important to recognise that the proliferation of speculative side bets can have significant effects on economic fundamentals such as the terms of financing, the patterns of project selection, and the incidence of corporate and sovereign default.

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  1. craazyman

    You really don’t know which projects are “efficient” or “inefficient” until after the fact. The financing cost is only a market signal, but one that (like all market signals) can be wrong, in hindsight.

    So there’s no way to judge — a priori — whether inefficient projects are being funded or not. The notion that CDS can restrain funding of inefficient projects is inherently immeasurable and therefore theoretically nonsensical.

    Then there’s this mind pretzel, although it’s no fault of the authors:

    “A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information.”

    How can this statement be considered unorthodox? [Well I guess in academic finance anything is possible ;) ] — it’s like saying it would unorthodox to believe football betting pools can exist because it doesn’t make sense that folks would have differing expectations on game outcomes, considering all bettors know who the players are and the track records of the teams. Moreover, this same unorthodox belief negates the notion that project efficiency can be objectively measured in advance of results.

    It’s amusing to see academic theory strain itself to explain the real world. It works in physics pretty well, and maybe in medicine to some degree, but in most other human disciplines it’s pretty funny.

    Oh well, far better to sit around and academicize this stuff than to go work for some Government Supported Gang of Looters and write Naked CDSs for a living and bankrupt taxpayers and savers. ha ha ha. That’s for sure.

    1. Yves Smith Post author

      1. You need to read ECONNED. It discussed many of the ahem, peculiarities of mainstream economics, among them the use of a SINGLE “representative agent” to make the math tractable. Many if not most models assume homogeneous tastes. The authors are making more realistic assumptions than you will find in quite a lot of economic work.

      2. You don’t engage the authors’ argument, you merely say you don’t like it. Honestly, that’s not terribly persuasive.

      1. craazyman

        I did read Econned. I thought it was terrific and very necessary. Although I wonder if the folks who really need to read it will.

        I did engaged the authors’ conclusion, which is pasted below:

        “And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns . . . This conclusion, however, is subject to the caveat that there exist conditions under which the presence of such contracts [CDS] can prevent the funding of inefficient projects.”

        In my view, the notion of “efficiency” is foggy and highly imprecise. It stands unquestioned in much of economics and finance as a inherently good thing that advances social utility. Yes, I don’t “like” that, and for reasons that are entirely self-evident to anyone who channels with the right side of their brain (as opposed to left side, not wrong side) so they don’t get lop-sided. Ha ha ha. yeah And as Professor Einstein famously said “Not everything that counts can be counted, and not everything that can be counted counts.” So what is efficiency anyway? It’s a rhetorical question.

  2. Bruce Krasting

    Of course their are consequences of financial innovation. This is like saying that the evolution of options over the last 20 years was a negative. It was not. The proliferation of ETFs is another example. It has changed trading.

    I am not aware of a country that has been tipped over as a result of CDS. There have been a few corporates. Lehman comes to mind. Do you really think that LEH went down because of CDS? If so you live on the moon. They had no equity. That is why they went bust. CDS just hastened the day.

    I think you have to ask yourself what would happen if you actually succeeded in turning back the clock on this. I think you would find that the global supply of credit would fall as a result. CDS in now part of that system, like it or not. Take it away and you will regret it.

    1. Yves Smith Post author

      This is all straw man.

      1. The authors were not talking about innovation generally. They were talking about credit default swaps. The rationale that is widely presented for CDS is that by making the market more efficient, they reduce the price of credit and reduce the volatility of debt pricing. The authors say there is reason to expect that the reverse happens. That’s significant, but you choose to ignore the heard of the argument.

      2. The authors similarly never suggested that more companies were driven into bankruptcy, this is your invention (although funny you mention that, there is a great deal of anecdotal evidenceof hedge funds taking speculative positions via cDS, then taking a comparatively small position in by then much cheaper bonds to block a reorganization, generally a better course of action and use their muscle to assure a BK filing). They did suggest that more stupid/risky ventures might be financed, and we certainly saw that in spades with ABS CDS, as I describe at length in ECONNEDk, CDS drove demand to the very worst mortgages.

      3. There is also ample evidence that a great deal of what passes for financial innovation merely served as a transfer from the productive sector to the financial sector. No one got paid big bonuses for making markets more transparent and efficient; efficient markets produce minimal profits for intermediaries. See this debate for far more detail:

    2. Anonymous Jones

      “You would find that the global supply of credit would fall as a result.” So how is this a bad thing? For whom is this a bad thing? You do realize that every policy has a winner and a loser right? Who is “you” in this scenario?

      “CDS in now part of that system, like it or not. Take it away and you will regret it.” Again, who is “you” in this scenario? If it some amorphous “majority of citizens,” pray tell, how can you be so sure a majority would regret living in a world with less credit? Can there never be too much credit? Or you’ve just decided that we’re not at the point of too much credit?

      Think before speaking. It usually helps.

  3. Diogenes

    “Furthermore, an outright ban [on naked credit default swaps] may be infeasible in practice due to the emergence of close substitutes through financial engineering.”

    Is it just me, or is there anyone else out there who thinks that if this statement is really true, those of us who care deeply about trying to correct the structural problems in the financial system that caused the crisis should just throw up our hands and concede that democratic capitalism is dead?

    1. readerOfTeaLeaves

      Well, I read it a bit differently.
      I read it as, “We’re academics, so we have to phrase things very, very diplomatically, but what we’re really trying to point out to anyone who cares to read our subtext: Mayday! Mayday! You have to deal with this problem, policymakers and legislators, or else your ship is goin’ down, down, down… !”

      In other words, academese for ‘Houston, you got a mess on your hands here…’

  4. Jim the Skeptic

    Credit Default Swaps (CDSs) are insurance. If they had been called insurance then the states could have regulated them. They wanted federal regulation if any at all. In fact when Brooksley Born tried to regulate them they brought out the big guns and sank her efforts.

    Naked CDSs are insurance policies bought against some other persons property. Such as, I buy a policy against your house. Insurance companies do not write such policies because I might decide to burn your house down. But even if we assume that there will be no intentional damage to other’s property, we still are encouraging speculation.

    IF CDSs were tightly regulated and IF naked CDSs were forbidden, and IF the federal financial regulators would refuse to bail out the the sellers or the buyers of CDSs gone bad, THEN CDSs might be more beneficial than risky. But if you believe any of that is going happen then you must be on some heavy duty drugs.

    1. readerOfTeaLeaves

      Oh, and if I correctly understood Michael Greenberger’s testimony before the FCIC on credit derivatives, in addition to allowing anyone to take out an insurance policy on anyone else’s house, the ‘pricing’ of those derivatives did not come from the market: it came from the math models.

      Perhaps someone around here can enlighten me, but it’s seemed to me that there is a deep, ugly paradox between CDO buyers and sellers talking about a CDO ‘market’, which is completely opaque. Suppose that I do down to my local grocery hoping to purchase veggies: all the bins are covered up, I can’t see what I’m buying.
      (1) I don’t know how many other buyers have already been into the shop today; maybe only 10, but maybe 10,000. I have no way to know how many participants are in the veggie market today.
      (2) The bins are covered up, so I reach in — hoping to get a bunch of carrots — but I’m unable to know whether it is carrots that I’m grabbing, or whether it’s the leftover rotting stuff that never got cleared out by the produce guys for over two weeks.
      (3) The ‘price’ of the veggies has **not** been set by the grocer; it’s been ‘assigned’ by an algorithm created by the Big Brains on Wall Street.
      (4) This ‘algorithmic price’ has been developed using data for the ‘value’ of 2 week old rotting carrots, 10 day old rotting mushrooms, a few of last week’s now-starting-to-get-fuzzy peaches, and a nice fresh grapefruit tossed into the ‘algorithmic assumptions’ so that the Big Brains on Wall Street can claim there is some ‘fresh fruit’ and christen it AAA.

      I like to think that an optimist would view this ‘algorithmic pricing system’ as mostly technocratic nonsense, chortle at the absurdity of such an opaque, deliberately ‘secret’ system, and do almost anything else with their money than shop for veggies at this store.

      A pessimist might prefer such a ridiculous system, as their worst views of human depravity and bad outcomes are far more likely to be reinforced by its low chances of any reasonable chance of decent veggies. In this respect, it is a ‘reflexive’ system [in the Soros definition] in that it reinforces pessimism, volatility, and feeds a boom-and-bust mentality. In such a system, I’d anticipate that within two weeks, they’d stop using even a full grapefruit for the AAA, and just toss in one or two slices, in order to ‘increase their margin’ – after all, no use wasting a whole lovely grapefruit if you can manage a AAA rating with only a few slices, eh?

      If I have misunderstood the absurdities of such a ‘pricing system’, then I am certainly open to being corrected.

  5. jake chase

    History has proven time and again that unbridled speculation results in disaster. That banks supported by monopoly franchises and free money from the FED were permitted to gamble on naked credit swaps is exactly the cause of the multitrillion dollar meltdown which apologists attribute to an abandonment of mortgage credit standards. All anyone needs to do is compare the dollar volume of mortgage defaults with the size of the Fed bailout. But why get involved with facts when it is so much easier to spin theories?

  6. Richfam

    Pricing in financial markets has an influence on investors’ expectations about financial health. What a revelation.

    Can someone please kill this whole idea that speculation both long and short is bad. You’ll turn financial markets into some wierd, backroom gentleman’s game where decisions about a company’s future are decided by the all knowing elders.

    Would you prefer all stocks, bonds, loans, whatever were all in one big mutual fund, lets call it “Mother”. Mother will decide what is good for you and no one questions Mother’s great judgement about the health of a company in Mother’s care.

    Bear raids… oh my god…

    1. scraping_by

      Actually, it’s the idea of financial manipulations separate from and unconnected to real productive material economics that’s getting killed, and it’s the supporters who are killing it. The indisputable costs and the vauge intimations of benefits put this one into the category of useless but dangerous. Defending this as “liquidity” brings that concept into grave doubt.

      I’ve once heard the distinction between “capitalism” which everyone agrees with and thinks is a good thing, and “business” which everyone realizes is problematic and needs to be regulated. Similarly, if there can be found a group of perfect traders with absolutely no non-economic motives and absolutely equal means of trading, let’s go with a market-based solution. Otherwise, knowing the game is rigged, we might as well rig it for the benefit of the rest of us.

      Many people have discovered they’re socialists when they’re told the alternative is going along with kleptocracy.

  7. Dave

    Whilst I thank the good profs for their “framework” and “formal analysis” I really don’t see that it adds much to what is in essence a fairly straight-forward issue. (hiding beneath all that financial mumbo-jumbo).

    Should I be allowed to purchase an insurance policy on someone else’s asset, e.g. their car, their house, or even their life? Of course not. This patently fails the common sense test. At the end of the day is naked CDS really any different? Not really …

    I don’t think we will see fairness and trust return to the market until we get back to the almost folksy attitudes of our financial forebears (I’m thinking of Ben Graham i.e. those of Buffet generation and before). They lived through depression and saw the havoc that was wreaked on the market when trust and confidence evaporated.

    Somehow I suspect that things will need to get much worse before we see a wholesale change of the guard and things then hopefully begin to rebuild on a new basis.

    1. readerOfTeaLeaves

      At the risk of leaving too many comments on this thread, I actually disagree with your view that this article is ‘unimportant’ or tells us what we already know.

      I think it is **hugely important**, and the critical reason is that they are bringing social behavior, and social psychology, into explaining economic behavior.

      As Econned points out again, and again, and again: economics was allowed to get a seat at the POLICY table by dressing itself up as a ‘hard science’ because it ‘looked mathish’. (Okay, that’s my quick rephrasing of what she says with a wry, wickedly witty analysis.)

      For instance:
      The central message of our work is that the existence of zero-sum side bets on default has major economic repercussions. These contracts induce investors who are optimistic …to sell credit protection instead. This diverts their capital away from potential borrowers and channels it into collateral to support speculative positions. As a consequence, the marginal bond buyer is less optimistic … and demands a higher interest rate in order to lend. This can result in an increased likelihood of default, and the emergence of self-fulfilling paths in which firms are unable to rollover their debt, even when such trajectories would not arise in the absence of credit derivatives. And it can influence the project choices of firms, leading not only to lower levels of investment overall but also in some cases to the selection of riskier ventures with lower expected returns.
      We have motives in this analysis, and that is quite a different thing from thing from what I understand of Hayek’s views that information is information is information and all actors are basically robotic and pretty much interchangeable.

      As we all recognize, the simplicity and ‘math’ don’t fit the dynamism and creativity of the real world.

      Yves’ chapter on “Blinded By Science” points out quite well that the actual data used in economics is pretty pathetic; that economists ‘look for results to be statistically significant, and the threshold is that the odds are less than 5% that the relationship is random. But that standard is valid only if the statistician runs a single regression analysis.”

      How many bogus economic policies have been built on a ‘single’ regression analysis? (Personally, I nearly fell out of my chair when I read that sentence, which is why I marked it up and could easily locate it to leave this comment.)

      What ‘science’ would base huge policy decisions, academic positions, etc, on simple regression analyses? Good grief (!).

      At least the proposal in this post leads to several very important things:
      1. It recognizes the role of psychology at specific key points in market decisions and activity
      2. It defines economic behavior not simply by ‘role’, but also by psychological characteristics
      3. It shows how dynamics are created, or not — and if created, how they feed upon themselves
      4. It suggests that not all ‘financial instruments’ have socially responsible, or productive, outcomes

      And certainly sets up conditions that could actually lend themselves to experimental studies that could actually be replicated, in addition to being observable in the ‘real world.’

      It’s seemingly simple, but astutely descriptive — AND also potentially highly predictive.

      1. readerOfTeaLeaves

        Sorry, forgot to blockquote the passage from this post, so the comment is a bit confusing.

        Econned citation (for the hardcover) is p. 61.
        And Yves goes on to point out in that section of her book, “What happens if he instead does twenty regression analyses, tweaking the variables? Well, just by chance, he should expect to get one result that passes muster….”

        The lack of real standards in economics, at least as cited and described by Yves in Econned, is shocking. Absolutely shocking.
        But then, if you don’t really have ‘hard data’, it would be tempting to ‘squish’ the data.

        At least with the sequence of processes described in this post, you could set up an experimental procedure and identify participants as ‘optimists’ or ‘pessimists’ and then run them through the decision criteria to get some hard data. And then you could replicate that experiment.

        And then you’d have the basis for data that could provide richer information than a regression analysis. Crikey.

      2. Dave

        I accept your different point of view, but I’m not sure this paper lends much to the “behavioral finance” debate ~ I think we are all too-aware of the social / psychological dimension of markets already (witness all those myriad “how to trade” books every time you walk into a bookstore!)

        My concern is this is just adds another element of mythology to what is already an over-mythologized debate. And this just serves to further obfuscate both the problem and solution. It’s just not that HARD to understand: financial transactions should be transparent and simple to understand, and not contain hidden leverage or hidden exposures. I think it’s time for a return to folksy-finance. If it wasn’t happening in the 60s it probably shouldn’t be happening now! Bye bye hedge funds, HFT, “wild algos”, CDOs/CDS. We can probably keep securitization, but we need to properly regulate it.

        Like Volcker said, the only significant financial innovation of the last three decades has been the ATM. Before the crash, according to Stiglitz finance was responsible for 40% of corporate PROFITS. This, from what is essentially a “utility”; a conduit for capital to productive businesses (and investments) and a (supposed) manager of financial risk. Neither of which was achieved, of course.

        I’m sorry but I just don’t need mythology and “frameworks” and papers and HFT and all the rest when the answers and just staring us in the face: shut this casino down now.

  8. pros

    It’s only gambling and/or a tool for insider trading.

    the problem comes about in the implied govt guarantee of the TBTF

  9. john c. halasz

    Umm, leaving aside any effort at formal economics, given the wide-spread notion that CDSs are not “true” swaps, (i.e. exchanges of contingent payment streams), but really a form of insurance on bonds, it should be pointed out that insurance on financial assets,- regardless of the issue that CDSs are under-regulated and under-reserved compared to ordinary insurance, not least because of the issue of identifying an “insurable interest”-, doesn’t make a lick of sense, really, because of the logical circularity of using financial assets to “insure” financial assets, (which violates the independence conditions of events and resources underlying “true” insurance): when a financial crisis hits and all asset markets/classes tend to correlate to 1, then financial “insurance” will tend to amplify the crisis, since insurers will need to sell off reserved financial assets to meet claims, thereby feeding the downward spiral of asset “values” and triggering further such claims. (Though the full forensics of this crisis have hardly been completed, I think it’s clear that margin calls on CDSs contributed mightily to the sudden liquidity drain in Q3 2008, which occasioned extraordinary liquidity pumping measures by the Fed et alia). It doesn’t require a fully formal theory to grasp that point.

    To the objection that what about other forms of financial insurance long in existence, well, I think if one closely examines, e.g., mortgage insurance, muni bond insurance or trade credit insurance, they resemble functionally much more supplementary pools of credit that “true” insurance. On the other hand, the only real form of “insuring” financial asset investments is adequate portfolio diversification, which is inevitably incomplete, because of “crowded trades”, agent/principal problems exacerbated by portfolio diversification, and inevitably incomplete information between the commitments to financial assets and the realizations of investments in the underlying real productive economy, which are subject to production/business cycles.

    The only real “insurer” of financial assets can be sovereign governments as risk-bearers-of-last-resort. (If 3 hurricanes hit the Gulf coast in a year, insurance companies would be shocked , but could cope; if 12 would hit in a year, an actuarially infintessimal probability, so they would think, then the government would be the sole resort for rescue and recovery efforts). And that’s not because of any governmental surveillance and omniscience, but because of the sovereign powers of law-giving authority and enforcement, regulation and taxation. But that’s not “insurance” in any actuarial or market-based pricing kinda way, since the risks of crises are incalculable fat-tail events. Hence the trade-off for governmental supports must be regulatory powers to contain such risks, though enforcing bankruptcy and recognition of losses, through requiring adequate equity provisions and limiting uninsurable risk-taking, through prior fees and taxes on financial “institutions”, and, ultimately,- as I think this crisis has shown,- through macro-economic policies focused as much on debt-levels as interest rates or fiscal budgets, and through proleptic taxes on financial “asset” wealth, which would force the wealthy investor class to absorb additional losses from speculative activity ex ante.

    But my point here is not to justify ex post the financial bail-out that has occurred, which I think is obviously FUBAR, nor to advocate for a social insurance state in general. It’s rather to point out the limits to market-based “solutions” to market-generated risks. Bruce Wilder, an habitual commenter chez Thoma, likes to compare credit to insurance. It’s true that credit is necessary not only for investment purposes, but to manage cash-flow and all sorts of other operational risks, (especially for SMEs), but that doesn’t render it formally identical to an insurance concept. On the other hand, “hedging” is a useful market-based “solution” to Kaldor “cobweb” type problems, stabilizing planning horizons for end-users of commodities at the expense of a small draw-off of overall “value” by liquidity-providing speculators. (That’s not the only, nor self-sufficient “solution”, as commodity price-subsidies and reserves are also in use). In addition, such hedging markets are said to be useful for price “discovery”. But problems arise when a) the speculative interest in such markets exceed the functional needs of end-users, and b) when the commodity concept becomes extended to financial assets and start to be used to generate “stabilization” strategies in the financial sector entirely in abstraction from what goes on in the real productive economy. The concepts “insurance”, “credit” and “hedging” need to be formally distinguished, but, in the real world, their boundaries are fuzzy, and probably nothing better illustrates their confusion than CDSs.

    Sethi’s paper makes a certain contribution AFAICT simply by breaking standard economists’ assumptions of homogeneity and equilibrium, but it still remains in remote abstraction from actual business practices. (Granted it gives short shrift to the usual excuse that derivatives are merely zero-sum games and thus could have no dis-equilibriating effects, but then similar arguments are deployed throughout neo-classical financial economics). But I think it misses two key practical questions. 1) If one shorts a stock, for example, one both sends a price signal to the market, by increasing the sell-side, and one commits to future liquidity for that market, thereby enhancing “price discovery”. But CDSs, especially when naked and bundled in synthetic CDOs, seem to do the opposite, raising shorted prices and withdrawing future liquidity commitments. 2) CDSs, through various complex and opaque strategies, can increase inter-connectivity between financial asset markets, not just with respect to bond prices or interest rates, but equities as well, which potentially increases financial market fragility, while providing an illusion of increased stability. Sethi’s paper offers only the dimmest hint of those intuitions and it would be good if he could address them more directly.

  10. marc fleury

    nice one, although I am late to it…

    I am a bit disappointed by the “formal” framework. It seems to be a rehashing of

    1/ It provides better pricing of debt assets
    2/ capital gets diverted to non-productive side bets

    which are both valid points. 1/ is a good thing, and always used by defenders of naked CDS. The point is “better pricing but at what cost”. 2/ is true but strikes me as not fully relevant. It is not the full amount of the nominal that has to be put upfront but rather a fraction of it (corresponding to odds of default), so it is incorrect to say that the full capital is immobilized. Unlike the debt, the capital is never put in circulation. Take a naked CDS on subprime, at first the hedge fund pays the equivalent of the rent, then AIG disburses the debt, actually several times the debt.

    So it is at the moment of realization that naked CDS really become nefarious. The contract requires that the nominal be settled in cash, leading to a widespread panic selling in the markets. Also of note is the fact that we are dealing with debt markets and not equity. The sums in debt dwarf those in the markets. The sums in real estate debt dwarf the other debt markets. And the casino gamblers were allowed to multiply these numbers by 7 (the average naked to non-naked bet in subprime) . THAT is chilling, because the liquidity drain it creates is staggering. It is not captured in the model.

    For a more mathish discussion of this, see

    Here I argue that systemic instability is greatly influenced by the volumes coming from naked CDS.

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