Brad Setser: Follow the Money

Social theory – and credit derivatives

by Brad Setser
April 17, 2006

Last week, I heard a lecture by Hartmut Rosa, a social theorist who teaches, among other places, at the New School in New York.

He thinks the defining feature of modernity – particularly what he calls late modernity (i.e. now) is acceleration. Not only is the world changing, but the pace of change is speeding up. And the fast pace of change creates demand for innovations that help us manage a faster world, which in turn end up only speeding the world up more (Crackberries?). Or something like that.

The explosive growth of credit derivatives (see Table 1 of this chapter in the IMF's Global Financial Stability Report; hat tip, the New Economist) certainly fits with his thesis. I remember a time (and I am not that old) when credit derivatives were rather exotic. Now they seem to be the bread and butter of credit markets. At least in certain parts of the financial world.

CDOs (collateralized debt obligations, packages of bonds) turned into synthetic CDOS (CDOs composed of credit derivatives). Rather than trading credit risk folks started trading the correlation among the different companies (which became "names") in the CDO – since correlation is rather central to the performance of difference tranches of a CDO.

If trading correlation among tranches of a synthetic CDO sounds kind of greek, that's the point.

Though for all I know, trading correlation among the credit derivatives that makes up a synthetic CDO. may be a part of the past, not the future. Maybe a derivative has come along that eliminates the need to actually own (or short) various tranches of a synthetic CDO if you want to bet on the correlation among different names. Or maybe the really sophisticated folks have moved on to something new.

If you want an easy to read introduction to this topic, I recommend Mark Whitehouse's Wall Street Journal article.

And if you wonder whether all this (financial) technology really makes it safe to drive faster (financially speaking), you aren't entirely alone. Far from it. An awful lot has grown up in a period of relatively limited (macroeconomic) volatility.

Posted by Joseph Wang April 17, 2006 at 10:10 am

Brief intro into CDO’s. You take a basket of things like mortgages and divide them into groups. Then you say that the first X people that default come out of group one. The next X people that default come out of group two. The next X people that default come out of group three etc. etc.

What makes valuation tricky is that you can’t just look at the past default rates and value the tranches since it is likely that when you have one default, times will be bad and and you will get a whole bunch of them. The models that basically say “what are the chances that I get ten defaults if I have one” are called “copula models.”

The difference between synthetic and non-synthetic CDO’s is that with non-synthetic CDO’s the paper you issue has actually bonds behind them. When synthetic CDO’s, you just look at a basket of bonds, you don’t actually need to own them. Ironically if you sell a synthetic CDO, you are in a better shape if you have lots of defaults, since that means that you don’t have to pay out as much.

Derivatives are a generally good thing since they transfer risk from people who can’t bear it to people who can. The classic example of this is the fixed rate mortgage (which you can’t get in China in large part because there isn’t a good derivatives market.)

Posted by Guest April 17, 2006 at 10:42 am

CDO market outpaces high-yield bonds

Adult Swim Only

Posted by bsetser April 17, 2006 at 11:28 am

Derivatives certainly transfer risk; I think the open question is whether they transfer risk to counterparties who can bear them. I worry a bit that hedge funds trying to justfify 2 and 20 are taking big risks in a heads i win (and get more money to manage on the back of good performance), tails everyone else loses … writing insurance against unlikely (but devastating) bad outcomes is one way to jack up performance. and well, if you have to pony up, you aren’t warren buffet. You just go out of business …

Posted by kz April 17, 2006 at 11:46 am

Does anybody know about China’s Min Metals commodity derivative fiasco in the mid-90s? I heard China lost a lot of credibility from the credit market since then.

Posted by Guest April 17, 2006 at 11:53 am

China bank said in talks with Bear Stearns: One of China’s biggest state-controlled banks is discussing investing up to $4 billion in a deal that could end up giving it a minority stake in the U.S. investment firm Bear Stearns Cos., a published report said Monday.

AES to spend $1B on alternative energy: The company, which has interests in power generation facilities worldwide, said it will create an alternative energy group to focus on wind power, energy from biomass and the development of liquified natural gas terminals.

Posted by Jesse April 17, 2006 at 11:56 am

Judging from the current risk spreads and proliferation of CDOs at what appear to be misaligned premia, it appears we are now at the point of just shoving risk around the plate, with no one in particular bearing it, except those who, at the end of the day, will be forced to bear it indirectly by holding US dollar based financial assets and instruments.

Posted by bsetser April 17, 2006 at 12:17 pm

CCB buying into bear stearns in ways that skirt CFIUS (convertibles) is quite interesting — no doubt China vastly prefers a two way flow (Chinese buying into Wall street as Wall street buys into China) to a one way flow.

Posted by Guest April 17, 2006 at 12:21 pm

Banks Have No Exposure to Mortgages? Think Again

Mortgage Lenders: Who’s Most At Risk

Posted by jck April 17, 2006 at 1:28 pm

“Derivatives certainly transfer risk; I think the open question is whether they transfer risk to counterparties who can bear them.”
They transfer risk from the banking system to outside the banking system => that reduces systemic risk since a loss for a bank hits capital [ with a multiplying effect on the balance sheet].
the real question is why derivatives like cds or cdo’s exist at all => since the expected return of a portfolio of riskfree bonds is the same than that of a portfolio of junk bonds it can only be because regulatory capital requirements are biaised in favor of riskfree bonds…remember you get a premium on junk only because you are unlikely to get full payment of interest and principal on average

Posted by Joseph Wang April 17, 2006 at 1:29 pm

One thing to keep in mind is that the term “hedge fund” is similar to the term “small business” in that it really tells you nothing about what the fund does. Hedge funds actually do a lot of different things and this sort of diversifation is good.

Posted by bsetser April 17, 2006 at 1:33 pm

J. Wang — agree that hedge funds = very diverse group, sort of like small businesses.

JCK — regulatory arbitrage is no doubt a big reason. And shifting risk from banks (leveraged) to real money (pension funds) no doubt reduces systemic risk. but shifting risk from banks (who gear up borrowing from depositors) to hedge funds (who gear up by borrowing from banks, if not through structures with implicit leverage) doesn’t obviously eliminate systemic risk. The channels are a bit different, but if a hedge fund gets stuck with a big illiquid position that it needs to dump and other funds have similar positions and all the banks are trying to reduce their exposure to funds with those kinds of positions, my sense is that the banks end up with exposure — just through their counterparties. look who ended up owning LTCM.

Posted by Gcs April 17, 2006 at 1:37 pm

brad

“…if you wonder whether all this … really makes it safe to drive faster ….”

this was a wonderful
yellow lite post sir

if you’re as old and curled of toe as i am
its welcomed

thanx

Posted by Gcs April 17, 2006 at 1:44 pm

brad’s
money line

” An awful lot has grown up in a period of relatively limited (macroeconomic) volatility”

trading risk around now
and saying
“hey its childs play ”

is like call tigers
“not so tuff”

after only watching em sleep

Posted by Anonymous April 25, 2006 at 2:31 am

wld appreciate if you could put up more info on the index – indicies on which the cr. derv trade….how they choose the liquid bonds, etc

Posted by ana November 8, 2006 at 7:17 pm

Posted by Anonymous January 1, 2007 at 7:43 pm

Council on Foreign Relations

Social theory – and credit derivatives

Post a Comment16 Comments

Recent Posts

Categories

Archives

Blogroll