How central are CDSs

By Megan McArdle

Reader Seth writes:

Without going into details (my employer would not be happy), let me say that I work at a firm deeply involved in the CDS wing of the credit crisis.  And while I partly agree that CDS are a sign rather than a source of the current market ills, I think you would also agree that that's perhaps downplaying their role.  They've had an immense exacerbating effect, by prompting a lot of government action (like the AIG acquisition), and, most importantly, by hypercharging confusion, chiefly because CDS are so poorly understood.  As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority, and I've often seen trading by major banks that takes place in ignorance of recent, public and relevant corporate news.  Which is precisely what you'd expect from shops that use CDS for speculative and not hedging purposes, but still dismaying. 

The big point, though, is that if CDS insiders have occasional gaps in their understanding, then it's frightening to think of bank management and government regulators acting with even less understanding.  Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don't understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean.  THAT is why Buffett called them "financial weapons of mass destruction" - not because they START a war, but because they have immense capacity to radically ESCALATE it.  They didn't start the credit crisis - all of us, collectively and naively overextending ourselves, did - but they have absolutely played a subsequent role in accelerating this from a crisis to a major crisis. 

And they did it quickly too: CDS turned this from crisis to major crisis in only 17 hours - from roughly noon on Sep 14 (when it became clear that Lehman would fail and I got a call to report for duty on a Sunday) to Sep 15 when it was widely reported that S&P had downgraded AIG due to its CDS obligations.  At that point everyone started worrying about collateral, and then discovered that they were not able to properly worry about collateral, since they did not fully understand derivative collateral requirements.  All they knew is that they were facing something big and scary, and so - once again collectively and naively - we all stopped lending just to be safe....which is sort of like movie victims who close their eyes when the monster is right in front of them: it's both the most intuitive and the least productive thing to do.

It's absolutely clear to me that we bailed out AIG because of its counterparty CDS risk, and that they're escalating other problems more generally.  But it's less clear to me that they're the main source of contagion in the financial markets.  And at this point, many, many, many things are escalating other problems.

I don't mean to downplay the role of CDSs.  I'm just not sure how they came to be the main villain of the piece, that's all.

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