One casino too manyBy Martin Hutchinson
Wall Street over the last generation has been a prolific generator of casinos, in which the dealing community can make a very nice living indeed by providing investment and "hedging" services to outside investors. Of all these casinos, the credit default swaps (CDS) market has been among the most lucrative. As the credit crisis has unfolded, however, it has become increasingly apparent that the CDS market's damage to the global economy is sufficiently severe to justify closing down or at least sharply restricting Wall Street's favorite sandbox.
During the surge in size of the derivatives market in the early 1980s, in which I was an active albeit minor participant, we looked extensively at the possibility of designing credit derivatives. The need, after all, was obvious: there were banks excessively exposed to particular borrowers and equally other banks and insurance companies with appetite for credit and no exposure to those borrowers. Credit derivatives could allow participants to buy and sell credit risks, aligning their exposures with their beliefs about the market.
There were always two problems. First, there was no obvious way for credit derivatives to settle; the process of bankruptcy was sufficiently fuzzy and differed sufficiently from case to case that there was no watertight way of calculating when credit derivative buyers should be paid and how much. Second, the credit exposure taken on through trading credit derivatives was huge; the cash flows were hugely asymmetrical, with a certainty of modest annual payments going in one direction and a low probability of a massive cash settlement in the other. In that sense, they were like life insurance policies, but life insurance policies where the sum assured was not hundreds of thousands or a few million, but hundreds of millions or even billions.
Those problems were never solved. Instead, from the middle 1990s, a market grown crazy through never-ending expansion and excessively cheap money simply started trading credit derivatives without solving the problems underlying them. No watertight settlement procedure was ever designed; the current standardized settlement procedure involves a mock auction of a few million dollars of credit exposures, with the prices reached determining the settlement of exposures involving billions, or even hundreds of billions, of dollars. ......(more)
The complete piece is at:
http://www.atimes.com/atimes/Global_Economy/KC04Dj02.html