CDS: Where Is The Truth?

Whether they're "Financial weapons of mass destruction" per Warren Buffett or simply an intelligently designed instrument for managing risk as many claim, there is a marked difference of opinion on credit default swaps. The opinions flow back and forth in the media, even "60 Minutes" jumped into the fray, and among the blogs there is little agreement.

I won't profess to be anywhere near an expert but I did take some time this morning pulling up some recent posts from two pretty good bloggers who appear to be on opposite sides of the argument (if I misrepresent their opinion I apologize in advance). Both Yves Smith at Naked Capitalism and Felix Salmon at Portfolio.com state their positions well and provide lots of ancillary sources to support their position. I'll put some links to their posts at the end of this but let's do a quick overview of their takes on credit default swaps.

First, Felix Salmon is an unapologetic supporter of CDS's. Beginning with the orderly unwinding of the Lehman's default swaps he has supported a position that argues that the market is fully capable of handling defaults. Through netting and various other hedging strategies he feels that the net exposure in the CDS market is minimal. He does support his arguments with some good facts.

Salmon, however, goes further and seems to take the position that absent the CDS market the losses suffered by the banks in the credit crisis might have been much worse. He points out, correctly I think, that the banks were not writers but rather purchasers of protection. As such they have been able to reduce loss as a result of the protection they purchased. The argument has been advanced that the mere existence of CDS's induced banks to over leverage. A sort of the devil made me do it argument. Salmon's position is that if it wasn't CDS's then it would have been some other financial innovation that led to the banks taking on too much leverage.

On another side of the table is Yves Smith. While she may have other positions, I took away from her posts three main issues.

First, recent reports from DTCC and some news outlets suggest that the CDS market is not as large as previously reported. DTCC announced in early November that the market was no larger than about $34 billion. Shortly thereafter, individuals familiar with the market pointed out that only a portion of the contracts that had been written were actually accounted for by DTCC. Smith notes that there is a need to know the dimensions of this market and that the current pronouncements are doing little to get to the bottom of the dimensions of the market.

Second, she points out that the supposedly orderly settlement of the Lehman CDS's may not have been all that orderly. Again DTCC creeps in as they were not shy about trumpeting the non-event the settlement is painted to have been. Smith quotes a column from Institutional Risk Analytics that contends not all of the Lehman CDS contracts were settled through DTCC and that in fact those that weren't were responsible for some of the disruption in the Libor market. It's a very interesting discussion and again one which beautifully illustrates the opaqueness of the CDS market.

Finally, she notes that even though a settlement goes well that does not mean that the system hasn't suffered dislocations due to the default. Essentially, Smith is arguing that the process of providing additional collateral as credit events occur can be serious as well. The argument rings true especially when credit events are occurring at a rapid pace in a time of overall system stress. Precisely the state of current markets.

Just to throw one more opinion in here, I will refer you to Derivative Dribble. They are on Salmon's side. I mention the blog simply because it's the best I've found for learning the basics of derivatives. They explain it in an easy for the layman to understand manner. They won't make you an expert but they will give you a good basic understanding. You're on your own after that.

Anyway back to Smith and Salmon. As I said, Salmon is pretty much in the CDS's are good and not that big a problem corner. At least that's the way I see it. I don't think Smith is anti-CDS but she clearly is skeptical about our understanding of the size and ramifications of the market.

As for me, I come down on the fence. Not a comfortable place to be. I'm willing to give Salmon the benefit of the doubt and agree that they may be useful tools. I agree a lot with Smith if she is saying that we need to get our hands around this puppy and we aren't anywhere near doing so. The pity is that this argument has been going on since the demise of Long Term Capital ten years ago. Now we're in a monumental battle to save the financial system and we still have no understanding or control of CDS's.

Now is probably a good time to quit talking and force these things onto some existing or new clearinghouse. If they lose a little of their vaunted flexibility in the process then so be it. Once we can confidently say they are under control and the risks understood and manageable we can move from the "G" version to "PG" or "R" iterations. Not before.

Tom Lindmark

Yves Smith 1 and 2 and 3
Felix Salmon 1 and 2
Derivative Dribble 1 (Go back and read prior posts)