CDSs

Paper reacting to an article on the $45 trillion Credit Default Swap market.

$45 Trillion

The other day, you asked me to take a look at John Mauldin’s newsletter dated November 26, 2007. I apologize for the delay. However, the first thing that hit me hard when I looked at the article was “how can there be a $45 trillion market that I know nothing about.” More accurately, I should say a market that I know “almost” nothing about. Last summer, while working with our expert witnesses, Tom Murphy, who trades currencies and currency related derivative for the Bank of America, mentioned that there is now a market for “trading risk.” At least in the area of debt, “Credit Default Swaps” (CDS) are a vehicle for trading default risk. In his article, Ted Seides expresses his concern about the stability of this $45 trillion market, which few people even know exists.

My first instinct is to trust in markets. In most cases, I have much greater faith in markets’ ability to produce correct results than I have faith in any other individual or institution to produce correct results. This includes any particular government agency. The basis for my faith in markets is the same basis for my faith in quantum mechanics. I know that based on the Heisenberg Uncertainty Principle that the location of any sub-atomic particle in my body cannot be known. It is simply a probability distribution. At any given point in time there is a very remote possibility that a particle, which is a part of my body could be at the center of Jupiter. But, because such quantum leaps are random, and the quantum leaps of the trillions upon trillions of particles that make up my body tend to offset each other, in the aggregate, I will not find myself at the center of Jupiter any time soon. The concept that explains the stability of macro bodies in physics and the stability of markets is called the “Law or Large Numbers.”

Under most market situations, individual participants can be significantly mistaken and make unwise decisions. However, most of these mistakes will not tend to be made in the same direction. Thus, these individual mistakes will tend to cancel out, but the accurate information contained in participants decisions tends to come through and determine the direction of a market as a whole. This phenomenon is explained very well by James Surowiecki in his book “The Wisdom of Crowds.” (Surowiecki, 2004) Thus, my initial inclination is to believe that the market for CDSs, like other markets, will tend to function well and that there is no need for panic.

However, there are many examples from the past in which markets have failed. From the Tulip Bulb bubble in the Netherlands during the 17^th Century, to Japan of the late 1980s and the Dot.com bubble in the U.S. in the late 1990s, we have seen failures in the Law of Large Numbers, when it comes to markets. Bubbles tend to be the result of two things: 1) Large amounts of liquidity, and, 2) a good story.

Good stories are always at the heart of bubbles. Unlike sub-atomic particles, market participants have minds and can be swayed en mass by a good story. In the late 1980s the story that was told was that “the Japanese sun is a rising sun, while the U.S. is destined to continuously decline.” The common wisdom was that the 21^st Century would be the Japanese Century. Thus, taking the future into account, it made complete sense that Japanese stock valuations should climb and climb, and that the few square blocks of real estate under the Imperial Palace in downtown Tokyo should exceed the value of the entire state of California. However, once the Bank of Japan began to remove liquidity from the market, the entire façade crumbled driving stock and real estate values down by more than 80 percent.

The Dot.com bubble was similar, although fortunately not as pervasive. A lot of liquidity provided by the Federal Reserve combined with a story about “how the Internet was changing everything.” People believed in this new world and threw out their old valuation tools, until it all began to crumble in 2000 and 2001.

In both cases, notice how the story undermined the Law of Large Numbers. Instead of errors offsetting one another, the story caused people’s mistaken beliefs to align. Thus, most errors tended to be made in the same direction. Such an alignment of errors can overwhelm the accurate information in the system and cause the market to go terribly wrong. While I do not know enough about the CDS market to make a good judgment one way or another, let me make a few observation that give me both comfort and concern.

First, on the negative side, the market is an over-the-counter market. It appears to be comprised primarily of investment banks, large players in the lending industry, and hedge funds. In other words, the total number of significant players may actually be quite small, despite the nominal $45 trillion size of the market. The relatively small number of participants, when compared to the stock or bond markets my make my Law of Large Numbers analysis above less relevant. The number or participants may not be all that large.

Second, on the positive side, the largest holders of CDSs are investment banks, which play the role of “market makers.” In my work with currency options, I have learned that banks functioning are market makers make their money through fees or buying and selling based on a spread. Banks are not in the business of speculating or accepting the actual risk in the transactions. Thus, the banks take great care is taken to ensure that the positions in their portfolio are offset (hedged). They do not want to hold a portfolio, which will expose them to risk in either direction. If the market makers in the CDS market are following the same rules they follow in the currency and currency option markets, then this would significantly reduce the possibility of serious problems developing in this market.

Third, we should consider the role played by speculation in a market. Speculators tend to keep prices in line by looking for opportunities to make money. CDSs can be used for speculation purposes, because the value changes as the perception of credit risk changes. The second largest category of CDS holders is hedge funds. Like with any financial product, the speculation by hedge funds should have the positive effect of helping to set the proper price, which accurately reflects the risk associated with CDSs.

However, as we saw with the collapse of Long-Term Capital Management in 1998, speculation by large hedge funds can also have a dark side. Once again there was a good story at the heart of the problem. In 1997, Myron Scholes and Robert Merten received the Nobel Prize in Economics for their work on the Black-Scholes option pricing model during the 70s. They joined with others to form LTCM. The good story was that these mathematical geniuses had developed powerful models that would enable them to make large amounts of money with relatively low amounts of risk. Who could question such geniuses? The irony of this story is that the geniuses forgot about the power of a good story. Believing that people behave just like sub-atomic particles, their statistical formula’s dismissed the possibility of a “fat tale” (actually I mean a fat tail, as in the tail on a normal distribution curve). The fat tail caused by the Asian Contagion and the Russian credit default brought LTCM to its knees and came very close to taking down the U.S. economy, as well. (Lowenstein, 2000)

Five years from now, will we be talking about the CDS debacle, which devastated the world economy? I certainly hope not, and I see plenty of room for optimism. But in my ignorance, I also know that sometimes, with a good story, markets can be irrational.

References

Credit default swap. (2007). In Wikipedia [Web]. Retrieved

December 4, 2007, from

http://en.wikipedia.org/wiki/Credit_default_swap

Lowenstein, Roger (200). When Genius Failed: The Rise and

Fall of Long-Term Capital Management. New York,

NY: Random House.

Seides, Ted (2007, November, 26). The Next Dominos:

Junk Bond and Counterparty Risk.

John Mauldin's Outside the Box, Volume 4- Issue 7.

Surowiecki, James (2004). The Wisdom of Crowds. New York,

NY: Doubleday.

Yergin, Daniel (2002). The Commanding Heights : The Battle

for the World Economy. New York, NY: Touchstone.

		December 4, 2007 *Credit Default Swaps - The $45 Trillion Market*
	Paper reacting to an article on the $45 trillion Credit Default Swap market. The other day, you asked me to take a look at John Mauldin’s newsletter dated November 26, 2007. I apologize for the delay. However, the first thing that hit me hard when I looked at the article was “how can there be a $45 trillion market that I know nothing about.” More accurately, I should say a market that I know “almost” nothing about. Last summer, while working with our expert witnesses, Tom Murphy, who trades currencies and currency related derivative for the Bank of America, mentioned that there is now a market for “trading risk.” At least in the area of debt, “Credit Default Swaps” (CDS) are a vehicle for trading default risk. In his article, Ted Seides expresses his concern about the stability of this $45 trillion market, which few people even know exists. My first instinct is to trust in markets. In most cases, I have much greater faith in markets’ ability to produce correct results than I have faith in any other individual or institution to produce correct results. This includes any particular government agency. The basis for my faith in markets is the same basis for my faith in quantum mechanics. I know that based on the Heisenberg Uncertainty Principle that the location of any sub-atomic particle in my body cannot be known. It is simply a probability distribution. At any given point in time there is a very remote possibility that a particle, which is a part of my body could be at the center of Jupiter. But, because such quantum leaps are random, and the quantum leaps of the trillions upon trillions of particles that make up my body tend to offset each other, in the aggregate, I will not find myself at the center of Jupiter any time soon. The concept that explains the stability of macro bodies in physics and the stability of markets is called the “Law or Large Numbers.” Under most market situations, individual participants can be significantly mistaken and make unwise decisions. However, most of these mistakes will not tend to be made in the same direction. Thus, these individual mistakes will tend to cancel out, but the accurate information contained in participants decisions tends to come through and determine the direction of a market as a whole. This phenomenon is explained very well by James Surowiecki in his book “The Wisdom of Crowds.” (Surowiecki, 2004) Thus, my initial inclination is to believe that the market for CDSs, like other markets, will tend to function well and that there is no need for panic. However, there are many examples from the past in which markets have failed. From the Tulip Bulb bubble in the Netherlands during the 17^th Century, to Japan of the late 1980s and the Dot.com bubble in the U.S. in the late 1990s, we have seen failures in the Law of Large Numbers, when it comes to markets. Bubbles tend to be the result of two things: 1) Large amounts of liquidity, and, 2) a good story. Good stories are always at the heart of bubbles. Unlike sub-atomic particles, market participants have minds and can be swayed en mass by a good story. In the late 1980s the story that was told was that “the Japanese sun is a rising sun, while the U.S. is destined to continuously decline.” The common wisdom was that the 21^st Century would be the Japanese Century. Thus, taking the future into account, it made complete sense that Japanese stock valuations should climb and climb, and that the few square blocks of real estate under the Imperial Palace in downtown Tokyo should exceed the value of the entire state of California. However, once the Bank of Japan began to remove liquidity from the market, the entire façade crumbled driving stock and real estate values down by more than 80 percent. The Dot.com bubble was similar, although fortunately not as pervasive. A lot of liquidity provided by the Federal Reserve combined with a story about “how the Internet was changing everything.” People believed in this new world and threw out their old valuation tools, until it all began to crumble in 2000 and 2001. In both cases, notice how the story undermined the Law of Large Numbers. Instead of errors offsetting one another, the story caused people’s mistaken beliefs to align. Thus, most errors tended to be made in the same direction. Such an alignment of errors can overwhelm the accurate information in the system and cause the market to go terribly wrong. While I do not know enough about the CDS market to make a good judgment one way or another, let me make a few observation that give me both comfort and concern. First, on the negative side, the market is an over-the-counter market. It appears to be comprised primarily of investment banks, large players in the lending industry, and hedge funds. In other words, the total number of significant players may actually be quite small, despite the nominal $45 trillion size of the market. The relatively small number of participants, when compared to the stock or bond markets my make my Law of Large Numbers analysis above less relevant. The number or participants may not be all that large. Second, on the positive side, the largest holders of CDSs are investment banks, which play the role of “market makers.” In my work with currency options, I have learned that banks functioning are market makers make their money through fees or buying and selling based on a spread. Banks are not in the business of speculating or accepting the actual risk in the transactions. Thus, the banks take great care is taken to ensure that the positions in their portfolio are offset (hedged). They do not want to hold a portfolio, which will expose them to risk in either direction. If the market makers in the CDS market are following the same rules they follow in the currency and currency option markets, then this would significantly reduce the possibility of serious problems developing in this market. Third, we should consider the role played by speculation in a market. Speculators tend to keep prices in line by looking for opportunities to make money. CDSs can be used for speculation purposes, because the value changes as the perception of credit risk changes. The second largest category of CDS holders is hedge funds. Like with any financial product, the speculation by hedge funds should have the positive effect of helping to set the proper price, which accurately reflects the risk associated with CDSs. However, as we saw with the collapse of Long-Term Capital Management in 1998, speculation by large hedge funds can also have a dark side. Once again there was a good story at the heart of the problem. In 1997, Myron Scholes and Robert Merten received the Nobel Prize in Economics for their work on the Black-Scholes option pricing model during the 70s. They joined with others to form LTCM. The good story was that these mathematical geniuses had developed powerful models that would enable them to make large amounts of money with relatively low amounts of risk. Who could question such geniuses? The irony of this story is that the geniuses forgot about the power of a good story. Believing that people behave just like sub-atomic particles, their statistical formula’s dismissed the possibility of a “fat tale” (actually I mean a fat tail, as in the tail on a normal distribution curve). The fat tail caused by the Asian Contagion and the Russian credit default brought LTCM to its knees and came very close to taking down the U.S. economy, as well. (Lowenstein, 2000) Five years from now, will we be talking about the CDS debacle, which devastated the world economy? I certainly hope not, and I see plenty of room for optimism. But in my ignorance, I also know that sometimes, with a good story, markets can be irrational. References Credit default swap. (2007). In Wikipedia [Web]. Retrieved December 4, 2007, from http://en.wikipedia.org/wiki/Credit_default_swap Lowenstein, Roger (200). When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York, NY: Random House. Seides, Ted (2007, November, 26). The Next Dominos: Junk Bond and Counterparty Risk. John Mauldin's Outside the Box, Volume 4- Issue 7. Surowiecki, James (2004). The Wisdom of Crowds. New York, NY: Doubleday. Yergin, Daniel (2002). The Commanding Heights : The Battle for the World Economy. New York, NY: Touchstone.