Methinks someone listened to This American Life this week.
This stuff confuses and frightens me. I think there's even more dangers though than simply "big", "leveraged", and interconnected.
We have a court system designed to resolve bankruptcy. It's extremely complicated and courts have to make judgement calls about fairness and intent.
Now you've got third parties with bets riding on the resolution of negotiations in which they have no standing.
If you're trying to insure me you'd better be sure that you have exactly the same requirements and procedures as the person you think you've sold the problem to.
Yeah, that's a problem.
This market needs to be regulated NOW, not just to control the trade but to make it transparent, see who's holding what.
Oo, I listened to it too. I loved the wrapup bit about CDS where the nice expert fella pointed out that thanks to zero regulation and zero reporting requirements, nobody has more than a vague idea how much may be tied up in that unraveling market. So $60 billion is more of an algebraic inference, really.
oops - for "billion" substitute "kajillion." dang liquid lunch again.
In principal it's not a problem. In fact it's not that crazy. A hedge is a hedge, gambling is gambling, and CDS's can serve as useful hedges.
To use your analogy it WOULD make sense for me to insure your car IF your getting in a wreck infecte my income. Say you were an employee of mine and I could get the insurance really cheap. Of course that wouldn't help you, but if you were to get in a wreck and my income suffered, then I'd have the insurance payment as a hedge against that eventuality.
It's not the instrument itself, but a lack of regulation in how it was used that was and continues to be the problem.
Do we allow life insurance policies on random people?
The biggest problem with CDS is that they aren't backed by anything other than the credit confidence of the counter party risk.
@6: I don't remember the specifics atm, but didn't Wal*Mart get in trouble for taking out life insurance policies on their employees?
Also, anyone remember that Beavis and Butthead episode where they have to sell candy bars? They are each given a box of candy bars to sell for fundraising. They each sell one for a dollar to the first house they go to. Then, Beavis "borrows" a dollar from Butthead, so he has two dollars. He buys a candy bar from Butthead with that two dollars. Then Butthead buys a candy bar from Beavis with that two dollars. Back and forth until all the candy bars are gone. Then when they go to turn in the money, Butthead asks for the dollar back that he lent Beavis. The fundraiser guy was PISSED! Then when they realized that since Beavis and Butthead fucked up and there was not enough money for the class trip, everyone got their parents to pitch in to bail out the class trip fund.
This is like the reinsurance spiral that happened in england back in the 80s. The companies kept poor track of their retrocessional reinsurance and were in effect passing a hot potato around all the way around a circle back themselves.
A @ 9: Thank you! I was trying to remember this reference. Updated the post.
Bet you're sorry now you didn't buy my credit default swap default swaps - insuring against exactly this kind of train wreck - when they were cheap (because everybody thought the trains would run on time forever) ... but you can still buy in for just a few trillion dollars.
Seriously, it's not a $60T problem - because most of the unsettled obligations offset each other.
If the buy sides and sell sides of this insurance game were neatly chained together, we could settle one chain at a time (by spreading the uncovered liability over the chain, from end risk-dumper to end risk-taker). All of the players would get hurt in the process, and some of them ruined, touching off additional defaults.
Unfortunately it's not that simple, since ultimate risk-bearing responsibility wasn't simply passed down the line on a 1-to-1-to-1-to-1 basis ... all this was done in something closer to the most complex conceivable fashion ... but it's still nothing that requires $60T or a million monkeys at a million keyboards for a million years to unwind.
Anybody who listened to This American Life on Saturday had a very bad weekend. As I said before, WELCOME TO GD2. The problem, which NO ONE CAN FIX is linked-leverage. All of this crap has been bought and sold on credit. So it only takes one default to set off a chain reaction. It's endemic and the only way to clean it up is to let someone give us 60 Trillion (and counting) or default on the debt. That's right, Mass Default. Sort of like Mass Extinction, except this time it's your retirement accounts, your job and maybe the country that's being wiped out. Sound scary? Good.
#9 - reading about the credit crunch I've been thinking about that episode as well. It's one of my favorites just behind "Best Day Ever".
@ 6 -- Hedges can be problematic, even if they all clear.
Take the case of tournament sports - golf, tennis, what have you. It's common practice for players to bet a little against themselves going into the money round, so they cash in enough of their results to cover travel expenses whether or not they pass the next hurdle. No problem there.
The very same hedge bet, multiplied by a small constant, can be used to give the player an undisclosed motive to dump the game and lose at the critical juncture (which is apparently suspected in the case of some Masters of the Universe today).
The more serious practical vice is the use of derivatives (stock options being a simple case, and the Wall Street annual bonus compensation system being even simpler) to give executives positive exposure to corporate gains from their risk-taking decisions but zero exposure to corporate losses ... biasing their behavior toward the idiotic.
@15: Yeah, but it's unrealistic. In real life they would be FORCED to pay back the money, or face consequences since they did eat the candy bars. Oh...
I forgot how much I love that show.
"Blah blah credit blah blah markets blah blah. . ."
Bill Clinton must have forgotten to veto that bill. Cause Democrats don't favor deregulation, do they?...
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