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Derivatives Don't Cause Losses People Do

Derivatives Don't Cause Losses...

Derivatives Don't Cause Losses People Do


Such was the thrust of testimony before a Senate committee this week by Robert Pickel, head of the International Swaps and Derivatives Association (ISDA), and Richard Lindsey, former president of Bear Stearns' brokerage unit, regarding the role of credit default swaps (CDSs) in the current economic crisis. Said Lindsey,

"[R]isks [are] not created by derivatives. They [are] created by
individuals or corporations making bad choices when using derivatives."

Given recent events, perhaps it would be churlish to point out that derivatives, particularly when combined with massive leverage, can magnify and concentrate the effect of those bad choices (as the travails of AIG have amply demonstrated). Regarding CDSs, "Black Swan" author Nassim Taleb noted this week,
"We refused to touch credit default swaps. It would be like buying
insurance on the Titanic from someone on the Titanic."
Even as TARP has morphed from an asset purchase program to a recapitalization plan, financial market turmoil and volatility remain unabated. Many observers blame the fear that continues to grip the financial world on the dawning realization of the threat posed by the $62 trillion (by some accounts) CDS market. The exponential growth of the CDS market over the past few years, its opacity and lack of regulatory control, and the fear of counterparty risk in the wake of Lehman's failure have made CDSs the latest instrument to raise the spectre of further massive losses at financial institutions and hedge funds. As investors, politicians and regulators cast about for root causes of the current crisis and steps that need to be taken going forward, a harsh light is being shone on CDSs.

CDS proponents are pushing back. Messrs. Pickel and Lindsey, while conceding the need for some changes in the market (such as a central clearing house for trades), reject the notion that direct government oversight of the market is necessary or appropriate. Similarly, The Depository Trust and Clearing Corporation issued a statement last week that strongly disputed the size and opacity of the CDS market, claiming that the $62 trillion notional value amount represents double counting (i.e., adding in both sides of a single trade), and that the real number is approximately $35 trillion. The DTCC also takes issue with the potential losses that will result from Lehman's bankruptcy. While some analysts have that predicted total losses arising from protection sold against a Lehman default could be as high as $400 billion, the DTCC contends that virtually all of the Lehman trades will net out, and that required payouts will not exceed $6 billion.

We will find out very shortly who is correct. The financial markets are now directly confronting the concerns raised months ago in this space (and many others). An auction conducted last week by ISDA produced a settlement price for Lehman debt of less than ten cents on the dollar, which means that Lehman protection sellers must pay their counterparties over 90% of the par value on the underlying bonds. Did protection sellers properly hedge their risks by buying protection coextensive with their potential exposure? If they did, will their counterparties be able to make good?

Settlements are required to be made next week, on October 21st. After that, the financial markets can begin to focus on the potential impact of the WaMu CDSs. That settlement auction is scheduled for October 23rd.

by Ben Feder

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Link to This Resource: Derivatives Don't Cause Losses People Do

http://richard-wilson.blogspot.com/2008/10/derivatives-dont-cause-losses-people-do.html

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