Timmy elsewhere

At the ASI.

Given that the Greek CDS market is about to pay out and banks aren\’t about to fall over, what\’s the problem with these \”toxic derivatives\”?

6 thoughts on “Timmy elsewhere”

  1. They may not be evil but they are surely completely pointless. So you lend some money to someone and buy insurance from someone else against that someone turning out to be a bad debtor. The premium you pay them being basically the interest you charge on the loan. And then if say your crashed debtor is a big one the insurance can’t pay out anyway.

    Why not just stick your cash under the mattress?

  2. JamesV: Let me try rephrasing what you wrote to discuss a slightly different topic.

    “Fire insurance may not be evil, but it is surely completely pointless. So you build a house and buy fire insurance from someone else against your house burning down. The premium you pay them end up being basically the cost of your house burning down. And then if say your house burns down in a large fire the insurance can’t pay out anyway. Why not just stick your cash under the mattress?”

    With fire insurance the holes in this argument are fairly clear. (Broadly: 1) There is a value to shifting risk around. 2) The expected value of your premiums is always going to be significantly less than the cost of rebuilding the house.) If you think for a minute, you’ll see that the same holes apply to the argument regarding CDOs.

  3. Cody: up to a point. The assumption behind fire insurance is that fires occur at random and so risk diversifies – there are going to be only so many fires each year. But in some circumstances defaults triggering CDS payouts will be highly correlated.

    The CDS market survived the financial crash only because the US government put nearly $200bn into AIG.

  4. @Cody,

    You make a return on owning a property – at least the “not paying rent on a rented place”. You insure it because it represents 90% of your net wealth, and insuring it costs, what, 0.1% of the value per year?

    You’ll note that really big property conglomerates often do not insure their buildings. They just accept that 0.1%, 0.01%, whatever, of them will burn down every year. Losing 1 or 2 buildings just isn’t a problem when you own 1000 or 2000.

    Likewise, those stupid enough to buy Greek debt wish to make a return from it, but then choose to hand over most of that return in “insurance”. This despite mostly being in the “self insurers” category. I can understand a small retail investor wanting insurance, not a huge bank or trading house that never has more than a few % of its eggs in any one basket.

    Especially as the insurance by its very nature is likely to fall over the minute anyone makes a claim, because everyone will be making a claim. That’s why it’s difficult to get buildings insurance against an earthquake or a nuclear weapon being dropped on or in the vicinity of your house yet somehow there are people out there claiming to offer insurance against financial armageddon. I call bullshit.

    I think CDS only exist so that the institutions that buy it can claim their positions are lower risk than they really are. Looks good for your balance sheet if you can ignore the obvious counterparty risk in your insurer falling over if country X does actually default and suddenly 10 or 11-figure sums of money are missing.

    So CDS are a product that are useful to the customer except when the customer actually needs them.

  5. JamesV: I think you may be slightly overestimating the cost of CDS contracts on Greek debt, and you’re certainly overestimating the risk of those contracts not paying out.

    Also, while it may seem like a minor quibble, you don’t have to be stupid to buy Greek debt. It – obviously – depends on the price you pay. The market price represents a consensus view of the default risk. It’s quite likely to be wrong at any given point, and if it errs on the side of overestimating the risk, then it’s potentially smart to buy Greek debt, same as any other underpriced asset. There’s always the risk that the market is right and you’re wrong, but if you also manage to pick up CDS protection then any difference – however small – is profit. If, of course, the CDS protection can be relied on.

    Yes, obviously there’s a risk that the CDS contracts can’t be relied on…but in the case of Greece, the risk is minimal. It’s fine to go on about “financial armageddon” and “11-figure sums”, but at the end of the day we’re talking about a couple billion dollars for which collateral has already been provided. (This is not the AIG collapse, nor are we likely to see the like of that again…thankfully.) A Greek default is simply not worth getting excited about.

  6. I’m not thinking of Greece defaulting but the potential of a biggie doing so – say Germany in 20 years. Can’t be ruled out.

    Ironically, Greece could have bought CDS on its own bonds and made a killing on its own default.

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