Thursday, November 20, 2008

"there are people who trade CDS and do not understand crucial details of contract terms and bond seniority"

Megan McArdle is correct about CDS's:

"It's absolutely clear to me that we bailed out AIG because of its counterparty CDS risk, and that they're escalating other problems more generally. But it's less clear to me that they're the main source of contagion in the financial markets. And at this point, many, many, many things are escalating other problems.

I don't mean to downplay the role of CDSs. I'm just not sure how they came to be the main villain of the piece, that's all."

That's correct. Here's my comment, dealing with a comment by a reader:

"because CDS are so poorly understood. As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority, and I've often seen trading by major banks that takes place in ignorance of recent, public and relevant corporate news. "Which is precisely what you'd expect from shops that use CDS for speculative and not hedging purposes, but still dismaying.

The big point, though, is that if CDS insiders have occasional gaps in their understanding, then it's frightening to think of bank management and government regulators acting with even less understanding. Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don't understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean."

I'm having a hard time understanding how selling and trading investments that you don't understand isn't either fraud, negligence, or fiduciary mismanagement.

Personally, I find CDS's very clear,and CDO's as well. What's a little strange is how they were used in various hedging strategies, which a careful investor never would have been talked into.

Also, AIG and CDS's, Lehman, etc., all have slightly different problems, so you have to look at each case individually.

To the extent that CDS's are a problem for AIG, you'd have to figure that the main problem is the defaults. Otherwise, AIG would be collecting the premiums and rolling merrily along. Surely the default has to precede the claim. The downgrade which led to the increase in capital requirements must have been based on something.Namely, actual defaults, or fear that AIG wouldn't be able to cover forthcoming defaults.

That was a revealing comment, if true.

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