5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 1 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchMay 11, 2010

Should We Ban Naked CDSs?

I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banning nakedCDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can't get proper clearing,transparency, and capital adequacy requirements in place then we should ban them.

Let's go back to first principles. The direct benefits of having more developed, liquid, and sophisticated financial markets arethreefold:

They allow people to buy insurance: people facing or holding too much of one particular risk can trade piece of it away toothers, and so make a win-win deal: the buyer of insurance makes a negative expected value bet but one that, given themagnitude of the distress that would be caused if the risk became reality, they are happy to make; the sellers of insurancemake a positive expected value bet.

Saving and investment: people with wealth who went to spend later can make win-win deals with people with ideas whoneed financing to turn those ideas into productive and profitable enterprises.

People who have done research and learned information about the structure and likely evolution of the market can bet ontheir knowledge: they win because they make their positive expected-value bets, and everyone else wins because after theyhave bet financial market asset prices better reflect fundamental social values and scarcities, and so are better guides toprivate and public economic planning.

The disadvantages of having more developed, liquid, and sophisticated financial markets are fourfold:

People who are excessively and irrationally averse to risks can trade those risks away at a price, and so lose wealth becausethey are shrinking at shadows.

People are are excessively and irrationally unconcerned about risks can trade to accept those risks, and so lose wealthbecause they are excited by the thrill of tossing the dice.

A more developed financial market is one in which it is easier to make money by unfairly appropriating somebody else'sinformation through insider trading.

A more developed financial market is a more fragile market: when prices move suddenly and bankruptcies and failures todeliver emerge, it destroys the web of trust in asset values that the smooth intermediation of the circular flow of economicactivity requires, and the result is depression.

In general, you want to set up your financial markets so that they do as good a job as possible at (i) rewarding those who workhard doing research into fundamental values, (ii) matching individuals with wealth to save with entrepreneurs with ideas to tryout, and (iii) enabling those who want to shed diversifiable risk to do so. And you want to set up your financial markets tominimize (i) the irrationally risk-averse's ability to throw away their money, (ii) the irrationally risk-loving's ability to throwaway their money, (iii) the unfair appropriation of other people's information through insider trading, and (iv) the chance that achain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity and quality, and create adepression in the real economy.

There is an eighth consideration, however, and which way it cuts---whether it is a benefit or a disadvantage--is unclear:

A more developed financial market increases the chance that somebody who thinks market prices are too low and wants tobuy will find a counterparty who thinks that market prices are too high and wants to sell.

This eighth consideration is definitely not win-win. One of the two parties is definitely wrong--prices right now are, if they arenot exactly right, either too high or too low. Both think that they are getting a good deal, but both cannot be correct. As far asthe two parties are concerned, these trades are at best zero-sum and probably less than zero sum: risk is, after all, increased.

However, when all the people making too-high and too-low bets meet in the marketplace prices move until the number whothink prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low(and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market asset

Dashboard Blog Stats Edit Post

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 2 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

(and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market assetprices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and publiceconomic planning.

On the other side of the argument, somebody is holding a portfolio that is based on false beliefs about the way the world works.Such people are especially likely to fail when reality comes calling--and so encouraging these directional-bet transactionsincreases the chance that, when reality comes calling and when prices move suddenly, they go bankrupt or fail to deliver--andthat destroys the web of trust in asset values that the smooth intermediation of the circular flow of economic activity requires,and the result is depression.

George Soros believes that this last consideration should lead us to limit the extent to which our financial markets are friendly todirectional bets. Thus he calls for the banning of "naked" credit default swaps:

George Soros Says Credit Default Swaps Need Much Stricter Regulation: AIG failed because it sold large amounts ofcredit default swaps (CDS) without properly offsetting or covering their positions. What we must take away from thisis that CDS are toxic instruments whose use ought to be strictly regulated: Only those who own the underlying bondsought to be allowed to buy them. Instituting this rule would tame a destructive force and cut the price of the swaps....

CDS came into existence as a way of providing insurance on bonds against default. Since they are tradable instruments,they became bear-market warrants for speculating on deteriorating conditions in a company or country. What makes themtoxic is that such speculation can be self-validating. Up until the crash of 2008, the prevailing view -- called the efficientmarket hypothesis -- was that the prices of financial instruments accurately reflect all the available information (i.e. theunderlying reality). But this is not true. Financial markets don't deal with the current reality, but with the future -- a matterof anticipation, not knowledge....

[B]eing long and selling short in the stock market has an asymmetric risk/reward profile. Losing on a long position reducesone's risk exposure, while losing on a short position increases it. As a result, one can be more patient being long and wrongthan being short and wrong. This asymmetry discourages short-selling. The second step is to recognize that the CDS marketoffers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short onbonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offerslimited profits but practically unlimited risks. This asymmetry... exerts a downward pressure on the underlying bonds....The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect thefundamentals that market prices are supposed to reflect... bear raids on financial institutions can be self-validating.... AIG,Bear Stearns, Lehman Brothers and others were destroyed by bear raids in which the shorting of stocks and buying CDSmutually amplified and reinforced each other. The unlimited shorting of stocks was made possible by the abolition of theuptick rule.... The unlimited shorting of bonds was facilitated by the CDS market.... Many argue now that CDS ought to betraded on regulated exchanges. I believe that they are toxic and should only be allowed to be used by those who own thebonds, not by others who want to speculate against countries or companies...

Tim Geithner disagrees:

Seeking Alpha: My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally inthis case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what peoplemight just feel is a speculative bet on some future outcome.... [T]he absolutely essential thing is that there is more capitalheld against these positions so we never again face the situation where those types of judgments could imperil the system...

I call this one, narrowly, for Geithner: The key elements are clearing, transparency, and capital adequacy requirements thatmaximize the flow of information into market prices from the fact that people with money are willing to put it on the line toback their predictions and that minimize the chances of disruption of the web of trust.

Brad DeLong on May 11, 2010 at 08:44 AM in Economics, Economics: Finance, Obama Administration | Permalink

Reblog (0) |

Favorite

| Digg This | Save to del.icio.us | Tweet This!

TrackBack

TrackBack URL for this entry:http://www.typepad.com/services/trackback/6a00e551f080038834013480ad0e34970cListed below are links to weblogs that reference Should We Ban Naked CDSs?:

Comments

Mark Field said...I worry much less about the ability of the "irrationally risk loving" to throw away their own money than I do about their abilityto throw away other people's money.

Also, you say "when all the people making too-high and too-low bets meet in the marketplace prices move until the number whothink prices are too high (and are willing to put their money behind that belief) equals the number who think prices are too low(and are willing to put their money behind that belief). This reveals the balance of opinion, and so moves financial market assetprices to a place where they better reflect fundamental social values and scarcities, and so are better guides to private and public

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 3 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

economic planning."

But isn't it more precise to say that the balance of opinion is not between equal numbers of *people*, but between equalnumbers of *dollars*? And if so, is it really true that the result "better reflect[s] fundamental social values ... and so [is a] betterguide[] to private and public economic planning."?

Reply May 11, 2010 at 09:13 AMSimon van Norden said...Does anyone know whether there is empirical evidence to back the claims made in the last paragraph of the Soros quotation?

Reply May 11, 2010 at 09:42 AMcsissoko said...Haven't you completely missed Soros' point (which is actually basic Keynes): "speculation can be self-validating"?

Because speculation can be self-validating, liquidity (which facilitates speculation by making it easy to buy and sell over shorttime horizons) is inherently dangerous. The real question here is how much liquidity do we want to have in our markets --where do we draw the line between good liquidity and bad liquidity.

By making an efficient markets assumption ("... reveals the balance of opinion, and so moves financial market asset prices to aplace where they better reflect fundamental social values and scarcities, and so are better guides to private and public economicplanning"), you are essentially claiming by assumption that all liquidity is good liquidity.

Keynes (and Soros) have a much more nuanced understanding of financial markets as is nicely discussed in this piece by TED:http://epicureandealmaker.blogspot.com/2010/01/conventional-wisdom.html

The justification for banning naked CDS is precisely the concern that they result in too much liquidity and a tendency to themispricing of credit.

Also you need to keep in mind that the investment banks are all aggressively looking for people with bad information and/orinflated egos with whom to trade customized, unclearable swaps since these are almost always the most profitable deals. Thiswouldn't be such a problem if the easy marks were actually managing their own money instead of pension funds, municipalbudgets, etc.

That said, I actually think that any ban on naked CDS should actually be fairly narrow and include an exchange tradedexemption.

Reply May 11, 2010 at 09:49 AMDaniel Greenwood said...The major alleged benefit of swaps in general is "insurance."

But insurance works by converting undiversified risk into diversified risk, in effect removing variance and allowing the insured,like the insurer, to pay only the expected, or average, cost. Fire insurance allows a homeowner to experience the fire losses of anaverage homeowner without having to own enough homes for the law of large numbers to apply.

Similarly, the advantage of a CDO over the underlying loans is that the CDO represents a slice of a bundle of loans, thus givingeven a small investor instant diversification. The law of large numbers means that the CDO will suffer a more predictableaverage default and prepayment rate, rather than the largely unpredictable all-or-nothing loss profile of an individual loan.

By the time we get to derivatives based on CDOs, further benefits to diversification are conceptually impossible. A fullydiversified investor, holding securities that represent diversified institutional investors or banks, which themselves holddiversified portfolios CDOs representing diversified bundles of loans, does not need and cannot benefit from furtherdiversification. They don't need insurance, because they are already living at the average. An insurer can't sell them anythingthey don't already have.

There is no insurance here. No rational actor is going to pay money to buy diversification that they already have. So, either thebuyers are irrational, or they are buying something else, and the candidates are are all social negatives: complexity intended todeceive customers, supervisors, investors or regulators; risk shifting to irrational or incompetent investors that consistentlymisprice it (or, more likely, price on the expectation that they will be able to shift losses to the taxpayers); evasion of rulesmeant to limit risk; evasion of (internal) supervisors or (external) regulators or gaming of their systems for assessing risk basedreturn; gaming of accounting rules or monitors; or speculation for speculation's sake, with attendant increase in instability andrisk.

This is not insurance. It is an instrument that offers new opportunities for destabilizing speculation. Increased trading is almostalways destabilizing, since traders often trade not on fundamentals but on their impressions of how other traders perceive othertraders intentions to trade. Thus, the CDS market's main social "contribution" is increased potential for herd-like suddenmovements that can have dramatic, nearly always negative, on the real economy, which depends heavily on a reasonablypredictable financial market.

And it is an instrument for expropriation of the public fisc. Actors like AIG can assume risk without charging for it because theyknow that the risk they are assuming is systemic: the only way they have to pay off is if everything goes bad at once, and if thathappens, they can simply declare insolvency and walk away with the premiums charged, leaving the obligations to be covered bythe Geitner Put.

Allowing this is akin to allowing companies to sell earthquake insurance without reserves and with an (implicit) governmentguarantee that policies will be paid by the taxpayers if necessary: we might as well just hand over the keys to Fort Knox with anote saying "help yourself." At least that would have less likelihood of creating a global recession as a side effect.

Reply May 11, 2010 at 09:52 AMscathew said...

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 4 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

Did pretty well without `em, so I say "burn `em all"...

Reply May 11, 2010 at 10:15 AMDave Lewis said...Mr. Delong,

Here's a perspective on the issue you might not have considered (at least I haven't read about your consideration thereof).

All CDS purchases create hedging potential, like stored energy, ignited by price action in the chosen arbitrage hedge. NakedCDS purchases can create more hedging potential than actual securities to sell.

I used to trade at a Hedge Fund and we sometimes joked (in the way only over-paid, money focused, dim wits can) how easy itwould be to force a crisis on a nation. Just buy large volumes of low delta puts on the currency, equity index and debt and thenstart to sell the underlying. The guys from whom you bought the puts will be forced to hedge and it will be their selling thatcreates the crisis.

I've written some about this on my blog, if you have an interest.

Reply May 11, 2010 at 10:29 AMV.V. said...In view of the last few years, and the "benefits" of other financial innovations on world economy and well-being, the conclusionreached by Prof DeLong appears completely uninformed by experience. The conditions in your conclusions are either met or notmet, and concluding "yes, if" when the "if" clearly hasn't been true in the last X years, and it's not in the process of turning truenow is at least misleading and possibly self-deluded.

Reply May 11, 2010 at 10:30 AMV.V. said...Also, what Daniel Greenwood said.

Reply May 11, 2010 at 10:34 AMBarbara said...How about: banning anyone who really matters from owning them? Like insurers, pension funds, etc. That way only people whohave lots of their own money to play with are potentially affected. I bet not many of them will ever buy such an instrument forthe same reason most of us don't get into a poker game where our house is the stakes. A naked CDS is too much like a bet andthe notion of "diversity" is much more easily achieved with "real" assets.

Reply May 11, 2010 at 10:37 AMNeal said...It's OK to have casinos. It's OK to gamble at casinos. However, the problem comes when the casino or casino patrons want to bebailed out by the people who just happen to live near the casino. Either a fire-proof barrier is provided or the activities arebanned.

Reply May 11, 2010 at 10:38 AMtinbox said...Is this some kind of joke? On the one hand, we have Soros who has been discussing (and exploiting) with great insight feedbackloops in finance for many, many years, and on the other hand we have Tim "100% payout" Geithner. So Tim thinks that when AIG writes CDS on Paulson's hand-picked bag-o-crap CDO, all they need to do is set aside a bit morecapital? Like what, maybe $100 billion? Ok, we all know Tim's got to home from the dance with them that brung 'im, but how can anyone site Tim Geithner as somesort of expert opinion on anything besides subsidizing financial giants?

Reply May 11, 2010 at 10:49 AMSora said...I actually disagree vehemently with Neal. Investing is inherently different from gambling, but if investors are treating theirfinancial decisions like it's gambling, then we should restrict the market from their participation.

The reasoning behind the desire for regulation is questioning the concept of "winning" or "losing" in the market. But asophisticated marketplace is not a giant casino. You don't "lose" if you buy a Prius but it turns out the Leaf is better value.Nobody would call Craigslist a casino, although people often get unequal value from their purchases. If you contradict thisreasoning, we should be even angrier at GM than we are with Goldman Sachs.

I feel that what you're really trying to say isn't that trades should be restricted but suckers should be.

Reply May 11, 2010 at 10:57 AMchris said..."This reveals the balance of opinion, and so moves financial market asset prices to a place where they better reflect fundamentalsocial values and scarcities, and so are better guides to private and public economic planning."

Whoa -- there's a whopper of a hidden assumption in that sentence. The balance of opinion isn't necessarily a better guide toanything. If the individual opinions that go into the balance are ill informed, or misinformed, or influenced by sentiment, thenGIGO applies to the averaging process.

Consider the balance of opinion during the Dutch tulip craze, for example (one of the classic historical examples of marketsbehaving irrationally, which so many modern theories confidently predict could never have happened). It would be ridiculous toanalyze this as "the fundamental social value of tulips temporarily massively increased for no explainable reason".

"(iv) the chance that a chain of bankruptcies and failures-to-deliver will disrupt the web of trust, cause a flight to liquidity andquality, and create a depression in the real economy."

It seems like there ought to be some way to firewall A from the risks of B's insolvency in general, not just when A is a depositorand B a traditional bank. That would cut the chain reaction at the first step and possibly make the concept of a flight to quality

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 5 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

and B a traditional bank. That would cut the chain reaction at the first step and possibly make the concept of a flight to quality(for non equity holdings) meaningless.

Reply May 11, 2010 at 11:32 AMNeal said...The issue is CDS instruments, not "investing". And picture the CDS casino as one where the dealer is dealing marked cards andthe players are "counting" cards. There are sharks on both sides of the table. So yes, it is clear that a number of parties that wereblindly enticed to enter the casino should not have been allowed to enter the casino and we are just beginning to see the falloutfrom their stripping.

You can gamble with your own money. You can bet billions on the shape of the next cloud for all I care. But when the bet goesbust, I object to paying for the fallout when there was no benefit to me.

The entire US corporate tax revenue for 2010 is projected to be $158 billion. What portion of that was from the financial sectorthat have benefited so mightily from these instruments? $10 billion, $20 billion, $40 billion?

How many multiples of that pitiful tax revenue have been spent and will be spent in repairing the fallout from their operations?Until there is excess revenue when compared to losses they cause they deserve to be stopped. They are a polluter that refuses topay the cost of clean-up.

Reply May 11, 2010 at 11:38 AMEbenezer Scrooge said...What kind of debt holder has a legitimate desire to hedge?

- Certainly not the issuer of borrowed-money debt. Any hedge weakens their monitoring incentives. The risk-buyer itself has nomeans of monitoring. The debt thus becomes more risky.- Generally not the trade creditor. There is already a plethora of instruments for offloading this risk. Letters of credit have beenaround, in some form or another, since the Lombards.- A writer of CDS? Well, yes, if the end-users were legitimate. Otherwise . . .

Reply May 11, 2010 at 12:00 PMBarry said...Brad, Geithner was (a) chosen by Wall St to be the NYC Fed Chair, and (b) demonstrated during the crisis that he was 100%corrupt, and (c) demonstrated 0% ability to anticipate any problems.

Why do you listen to him?

Reply May 11, 2010 at 01:04 PMsave_the_rustbelt said...Am I the only one who thinks we are creating securities primarily to have more raw trading materials, and the professionaltraders are moving useless paper in circles, generating commissions and bonuses until the merry-go-round stops?

Am I too cynical?

Reply May 11, 2010 at 01:32 PMwillid3 said...not sure that naked CDS ok if the reason the CDS with an interest aren't. i can see the reasoning for the latter (bond holder buya CDS doesn't care if the company fails or not). but selling a naked CDS is akin to selling insurance on your neighbors house.you know have a vested interest in them having a fire.

Reply May 11, 2010 at 02:31 PMRon said...Trying to get back to the question of “should we ban naked CDS”. I think it is important to recognize that market participanthave always had the ability to take a short position on the credit of a company. They shorted bonds (like some short equities). Infact, the CDS as insurance analogy is really misleading. Because it implies that the CDS position is buy-and-hold. When inpractice it is used more as a trading instrument. In that regard, it is more useful to think of CDS as a short bond positionpackaged with a term bond borrow. That last bit is where the power is. Shorting bonds in the past was difficult because bondborrowing was difficult. CDS made that much easier. And that is the problem too.

So CDS decreased the friction cost of going short credit. Banning “naked” CDS would be a way of increasing friction cost.

Soros’ point about “reflexivity” is that downward shifts in market prices have a way of turning fear into reality. Wider CDSspreads increase borrowing costs (or, even how much you can borrow), which in turn can weaken the company. For financials,this is the “new finance” version of a run on the bank.

The tinder on the forest floor is the “hedging potential” which Dave Lewis wrote about. Not just deep-out-of the-money options,but credit buried in counterparty risks or liquidity facilities or other contingent credit liabilities. Pre-CDS holders of these risksjust crossed their fingers and prayed. Post-CDS holders of these risks could buy CDS protection and hedge. And this is the kindof transactional pressure which is largely price indifferent – i.e. the person buying CDS isn’t expressing a valuation judgment,they are reducing risk.

Now add on the current fascination with momentum trading and the fear that “somebody must know something”, and it’s easyto imagine the kind of explosive downside we saw.

So should we ban “naked” CDS? I don’t think so. It wasn’t the problem, and we would lose significant benefits. Here is analternative world to consider:

Get rid of the dry tinder• Centrally cleared swaps to remove counterparty risks• Improved risk management so that contingent credit risks are known, accounted for, and hedged early. Mark to marketaccounting and requiring all non-cleared derivatives to post collateral would be a good start too.

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 6 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

accounting and requiring all non-cleared derivatives to post collateral would be a good start too.• Have regulatory liquidity requirements, not just capital requirements. Less reliance on short term liabilities funding long termassets (especially illiquid long term assets).

Punish momentum trading and reward fundamental investing.• Regulators should exercise their privileged position of intimate knowledge of the fundamental health of the banks theyregulate by lending to those firms which are financially solvent, but experiencing a reflexivity driven run on the bank.• The threat would shift the risk / return of the momentum shorts, the action would crush them.

We could then preserve the real benefits of derivatives.• Derivatives spur investment, growth and create more jobs. And I’m not talking about the financial sector here. Companies needto manage their financial risks (interest rate, fx, commodity and credit). When these risks are unmanaged, project uncertainty ishigh and companies don’t invest, they don’t grow, and they don’t hire.• Derivatives aid price discovery, and confidence in price is important for companies to raise money cheaply and efficiently.Price discovery is hard, particularly in credit markets. The pooling of liquidity, benchmark status, and lower transaction costs ofderivatives make them ideal battlegrounds for the bulls and bears to settle on the best guess on price. Yes, somebody is going tomake money and somebody is going to lose money. But having positions that lose money or do less well than others is part ofinvesting. Positions just have to be sized correctly so they don’t endanger your firm (or your retirement).• Derivatives aid liquidity. A liquid secondary market reduces borrowing costs for borrowers, without it investors would charge apremium to hold positions “for life”. All that trading serves a social purpose (whether we need as much trading as we have to getthis benefit is another question…..).

OK, this is longer than the original post, apologies �

Reply May 11, 2010 at 04:54 PMRobert Waldmann said...Contra the renegade DeLong

Oh my oh my, Brad DeLong prof Noise Trader Risk ... himself seems to have left noise traders completely out of the story. Point3 (used to be point 4 and I'm still throwing the same cow)

"People who have done research and learned information about the structure and likely evolution of the market can bet on theirknowledge: they win because they make their positive expected-value bets"

In the real world half of them win and the other half lose. The assertion as quoted assumes that all people have rationalexpectations so bets by people who have done research must be positive expected-value bets. So why did the average pensionfund underperform the S&P 500 even though the average pension fund beta was 1 ? (I'm citing our co-author Andrei).

If you abandon your new found faith in rational expectations (which you absolutely assume in the quoted passage) you mustagree that it is an empirical question whether super smart people who try to beat the market reduce or increase the meansquared (or mean absolute) deviation of prices from fundamentals. The answer seems to be totally obvious to me. There hasbeen a huge increase in research and active trading and employment of braniacs in finance and asset price volatility hasincreased. Asset prices are much much too volatile to reflect rational updating. I look at the rough correlation and guess thatthe hard working smart people trying to beat the market are driving prices further from fundamentals.

OK so you will bring up Luskin and say that they just can't overcome the effects of the idiots. However, you can't explain howmore developed etc financial markets can make it easier for a rational investor (if one exists) to affect prices without making itmore easy for Luskin to affect prices. Oh and if you type "market selection" then I will rethink my atheism, since demonicpossession would be the only possible explanation.

Reply May 11, 2010 at 07:43 PMRobert Waldmann said...still reading. Now throwing and additional Heiffer. You find a problem with some people taking positive expected value betswith the less informed only if this is due to insider trading. Why ? Your assessment of the effect on welfare depends on how thesmart money got smart. Why ? Can you give a utilitarian explanation ?

Above in point 3, the fact that other people are taking negative expected value bets is not counted as a cost. Why not ? If wecare about money metric utility, in this case one's gain is euqal to the other's loss so the only terms that don't cancel are the costof the research and the (assumed) improvement in pricing. You assume that the socially optimal amount of research into assetvalues is infinite. Do you really believe that ? One problem with sophisticated etc markets is a very large fraction of the verysmartest people in the world are doing research on asset values and not on, say, physics. I count that as a cost. It appearsnowhere on your list.

The alleged improvement in pricing (which I really think is much less than non-existent) is justifying a lot. Why is research intothe "structure and likely evolution of the market" more valuable than any other research ? Why is it good for the smart to takethe money of the foolish ? Both are only good to the extent that they make prices closer to fundamentals. A utilitarian (no moremoney metric utility) thinks it is socially costly when the very smart become very rich at the expense of large numbers of fools.

The improvement in pricing (which the data scream does not exist) must be very valuable to justify the time skills and effortdevoted to trading and the huge increase in income inequality which definitely resulted.

Reply May 11, 2010 at 07:54 PMMark Field said...Ron: "Mark to market accounting and requiring all non-cleared derivatives to post collateral would be a good start too."

The problem I have is that these requirements are both pro-cyclical; they add fuel to the fire in both directions.

Reply May 11, 2010 at 08:08 PM

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 7 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

Matthew G. Saroff said...If a CDS is an insurance policy, than a naked CDS is insurance policy which pays off when someone else's property loses value.

It's like purchasing fire insurance on your neighbor's home: It gives you an incentive to torch it, See Magnetar.

As to the argument that the presence of the Naked CDS helps with "Price Discovery," I think that we should be willing to pay afew more basis points on bond insurance in order to avoid situations where people create failure and bet against it.

This fact has been known for 364 years, as this article shows:In 1746, Parliament passed the Marine Insurance Act, requiringanyone seeking to collect on an insurance contract to have an interest in the continued existence of the insured property. Thuswas born the insured-interest doctrine. The indemnity doctrine, which precludes a buyer from insuring property for more thanit’s worth, soon followed. The point of these rules is to limit insurance contracts to trading existing risks and not to create newrisks by giving buyers of insurance incentive to destroy property. The doctrines have been part of insurance law in both Englandand the United States (which in 1746 were colonies under English common law) ever since.

Reply May 11, 2010 at 08:53 PMMatthew G. Saroff said...sorry left off the url of the articlehttp://www.projo.com/opinion/contributors/content/CT_arthur7_04-07-08_GM9JLMS_v22.39d108d.html

Reply May 11, 2010 at 08:55 PMJim Bales said...Brad asks:"Should We Ban Naked CDSs?"

And answers:"I say, narrowly, no--that if we can get proper clearing, transparency, and capital adequacy requirements in place banningnaked CDOs would not do any good and would do a little bit of harm. But it is a close call. And if we can't get proper clearing,transparency, and capital adequacy requirements in place then we should ban them."

It seems to me that your response is better characterized as:"I say yes, ban them -- unless we can get proper clearing, transparency, and capital adequacy requirements in place". For surelythe difficulty will be getting those requirements enacted, will it not?

Why, instead, do you treat the default answer to banning as "no"?

Best,Jim Bales

Reply May 11, 2010 at 09:04 PMRobert Waldmann said...OK now a calf. To put it as gently as possible Geithner is lying. He didn't make any of your arguments. He claimed that we can'tban naked CDSs. He knows this is nonsense. If we say that cash settlement CDS contracts can't be enforced we will haveeffectively banned naked CDS. Bears will still be allowed to speculate, but they will not make money if they are right.

Once upon a time long long ago, CDSs were physical settlement CDSs. If one had an instrument in default and a CDS written onit, one could give the instrument to the CDS writer in exchange for the face value of the instrument. If one has a naked physicalsettlement CDS one can get nothing. The result is that bear raids are totally unprofitable. Some firm went bankrupt (I forgetwhich one). Its bonds sold for 100 cents on the dollar. There were naked physical settlement CDSs outstanding. The holders ofthose CDSs were eager to buy the bonds at any price below 100 cents on the dollar. Speculators who correctly guessed that thefirm would go bankrupt made nothing.

We can't have that. So the cash settlement CDS was invented. It was invented exactly to make bear speculation profitable. Nowyou may argue that this is a good thing as, when the bears are right, we benefit from their ability to profit from their insight(your argument 3). Geithner, however, did not make that argument. He said there was no way to separate genuine insurancefrom speculation. He knows perfectly well that this is a long solved trivial problem and that financial innovation was used toeliminate the problem that old style CDSs were useful only for insurance and not for speculation.

Reply May 11, 2010 at 09:26 PMNahtanoj said...Brad -- you start the piece by listing three benefits from more developed, liquid, and sophisticated financial markets, so it isstriking that naked CDS do not provide any of those benefits. In particular:

* Insurance: the holder of a naked CDS is NOT insuring against a risk he has - that is what makes it naked. Instead, he is"insuring" against a risk that he does NOT have -- that is what makes it speculation. Naked CDS violate the principle ofinsurance regulation and law that people aren't permitted to buy insurance unless they have an "insurable interest" -- i.e., thatthey actually are exposed to the risk against which they are buying the insurance.

Another way to say this is that naked CDS create perverse incentives for creditors. The late crisis exposed examples ofbondholders driving companies into bankruptcy in order to profit from CDS positions. Bankruptcy is a hugely costly anddisruptive event for the companies involved and the economy generally, and creditors normally have strong incentives to avoidit through negotiation with the debtors. Naked CDS create incentives for creditors to push for destructive outcomes for theirdebtors, in order to make their naked CDS positions pay off. THIS IS WHY PEOPLE ARE NOT NORMALLY ALLOWED TOBUY "INSURANCE" ON ASSETS ON WHICH THEY DO NOT HAVE AN INSURABLE INTEREST.

* Saving and investment. Investing in naked CDS does not provide financing to people who need financing to turn ideas intoproductive and profitable enterprises. It's a zero sum game that does not transfer capital to the real economy for investment.

* Better prices in markets. Since the amount of outstanding naked CDS on any particular reference credit can be orders ofmagnitude greater than the outstanding amount of the underlying reference credit, pricing factors related to the dynamics of the

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 8 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

magnitude greater than the outstanding amount of the underlying reference credit, pricing factors related to the dynamics of thespeculative CDS market can overwhelm the effect of pricing factors related to the characteristics of the underlying referencecredit. Naked CDS create a mechanism for speculative activity to disrupt the real economy.

Reply May 12, 2010 at 03:36 AMBarbara said...I just want to add a comment on the insurance aspect of this question. It's not that people who have insurance on theirneighbor's house are actually going to burn it down, though I think you can see that the likelihood of that equivalent in theworld of high financie is actually much higher. Nonetheless, there are two items that, I think, count as costs:

As with insurance, you can only win with a naked CDS if there is a loss to someone else. At best, it's a zero sum game. Whatproportion of people's investable money do you want parked in vehicles that depend on losses to others? Just forget negativeincentives -- money in that naked CDS isn't doing anything other than waiting for the loss that will be their gain.

This isn't like normal investing, where "gains" are typically or at least historically associated with some kind of economic gain.Comparison to the dot com bubble seems apt: sure, there were many overpriced assets, but does anyone think the innovationsand products were totally phantom?

Reply May 12, 2010 at 05:35 AMRon said...Mark Field: Agree that pro-cyclical elements added to the fire in the fall of 08. And to the extent that market prices getdisconnected from fundamentals (all fear, all greed) then the cost here can be pretty big. But on balance I think the signalingvalue of MTM for risk management, and the subjectivity and transparency problems of alternative methods (subjective reserves)outweigh the pro-cyclical costs. A lot of what fuels fear in a crisis is the uncertainty around book value – seems like MTM couldactually be an improvement over subjective reserves in a time of market stress. But more important, and what seems to havegotten lost in this accounting discussion, is the impact that MTM makes on a company’s risk culture. I think if more firms weredaily marking to market their positions, then management would have focused more quickly on position size. Even in the goodtimes there are down days, and big PNL swings have a way of attracting attention. Many focus on risk stats like VAR or stresstests, but daily PNL swings is an old school risk tool that is highly underrated.

Regarding the requirement of collateral on non-cleared derivatives, I think this is only upside for the system (the firms whopreviously didn’t have to post lose a distinct advantage). Not that I’m recommending the restatement of existing contracts – thathas complications for market confidence. But if AIG had to post collateral against all of their “super-senior” trades you wouldhave had two early signals which probably would have shut down the business before it got as big as it did. The first is thatdisputes between dealers and AIG over marks would have highlighted the illiquidity of this position. Big liquid positions can betolerated; big illiquid positions are a huge red flag. Second, the weakening of credit markets in 01-02 would have created asmaller version of the liquidity crisis for AIG and put the business model in question earlier (i.e. they would have survived thatone, learned from their mistakes, and never let the book get as big as it did).

Reply May 12, 2010 at 08:46 AMRon said...Mark Field: One more thing, there are limitations here. The downside of mark to market is “mark to model”. In which profitsand losses are created out of thin air. This was at the root of the Enron problem. But there has been a fair bit of work done toclean out the worst of that behavior, but it is definitely something to guard against.

Reply May 12, 2010 at 08:54 AMMark Field said...Ron: I agree with you on the problems of other valuations, particularly subjectivity and transparency. A clearinghouse probablywould help; an exchange would be even better. In either case, MTM might actually mean something.

Reply May 12, 2010 at 10:15 AMKen Houghton said...SvN: No. The claims that it was "speculators" and "bear raids" that took down BSC, AIG, etc. and not Jamie Dimon and hiscohorts has not be documented.

It's difficult to document a convenient falsehood, except anecdotally with Interested Parties.

(The payoff diagram of options is another question, and you know that at least as well as I, so I assume you're not worryingabout the first few sentences.)

Reply May 12, 2010 at 10:36 AMTim Worstall said..."AIG failed because it sold large amounts of credit default swaps (CDS) without properly offsetting or covering their positions.What we must take away from this is that CDS are toxic instruments whose use ought to be strictly regulated: Only those whoown the underlying bonds ought to be allowed to buy them. "

This makes no sense at all. That someone *sold* CDS and went bust has no implications whatsoever for whoever might buy aCDS, whether they own the underlying bond or not.

AIG lost, what, $150 billion? There were enough actual holders of RMBS etc to cover that amount easily....so whether peoplewere going nakedly short or simply going short makes no difference at all.

It might be possible to say that AIG went bust *and also* that there should be no naked shorting. But *therefore* does notfollow.

"The key elements are clearing, transparency, and capital adequacy requirements that maximize the flow of information intomarket prices from the fact that people with money are willing to put it on the line to back their predictions and that minimizethe chances of disruption of the web of trust."

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 9 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

Me: Economists:

Paul KrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox Mafia:

Ezra KleinMatthew YglesiasSpencer AckermanDana GoldsteinDan Froomkin

Moral

Philosophers:

Hilzoy and FriendsCrooked Timber ofHumanityMark Kleiman andFriendsEric Rauchwayand FriendsJohn Holbo andFriends

We're already doing that. Can we just cast our minds back and recall what actually happened? Those who had AAA creditratings did not have to post collateral. Thus the implicit cash flow drain on AIG was not made explicit. This almost certainlyskewed their view of what was happening.

The contracts have changed. Everyone, even AAA risks, now post collateral each and every day. We've already increased thetransparency....the transparency that the risk managers of those writing CDSs require.

Reply May 20, 2010 at 03:41 AMTomkwood said...Professor, when you are on, you are ON! What a great set of first principles. Total keeper.

Reply May 24, 2010 at 09:14 PMComment below or sign in with TypePad Facebook Twitter and more...

Post Preview

Will Democrats Steal Your 401(k)?The Atlantic - May 12, 2010She may or may not have been the first major economics blogger, depending onwhether we are allowed to throw outlying variables such as Brad Delong out of ...Related Articles » « Previous Next »

economics DeLong

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 10 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html

5/25/10 11:32 AMShould We Ban Naked CDSs? - Grasping Reality with Both Hands

Page 11 of 11http://delong.typepad.com/sdj/2010/05/should-we-ban-naked-cdss.html