exercises in compound storytelling

Tuesday, October 7, 2008

This American Life, episode 365

Cashflows for a Credit Default Swap.Image via WikipediaThis American Life does a good job of explaining how the current financial problems spread in episode 365: Another Frightening Show About the Economy.

They explain that a credit default swap involves two parties engaging in a transaction and a third being engaged to insure one side's payments. There are a couple of problems:
  • This isn't insurance in the usual sense of the word
  • It's possible to buy this insurance without being a party to the original deal
The first problem is what caused AIG to fail: they weren't able to distribute their risk sufficiently to guard against widespread defaults. The second is what caused financial problems to spread:
  • It caused multiple parties to be exposed to the defaults of otherwise independent companies, because these parties are selling credit default swaps
  • Many companies both bought and sold credit default swaps in the same issues, but at different prices, and pocketed the difference, ignoring the fact that they were still exposed to a different kind of risk: the risk that their counterparty would default on the credit default swap they were owed.
As best I can tell the underlying problem is that it wasn't ultimately possible to hedge CDS risk; I'm not sure what the right solution is. This American Life suggests that one solution is to make everyone's book transparent. That's just silly; investment banks don't make money by telling everyone what they own. They also suggest that the problem is that credit default swaps are unregulated. I'd agree insofar as there should have been requirements that whoever was originating these things either have substantial reserve requirements or that they mark them to market in a sensible way. I'm not sure how to do the latter; the former would in theory either cut the market or distribute the CDS origination trade.

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1 comment:

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Do you have a Private mortgage insurance (PMI) policy? If you do your PMI insurer has passed along their risk by buying a credit default swaps (CDS) to protect them in the event you have your home that your home is taken away from you. CDS and PMI are the same thing. Make people wanting to buy a home put at least 20% down if you don't like them. nomedals.blogspot.com