Posted on 03/16/2009 10:01:11 AM PDT by TigerLikesRooster
Satyajit Das's Blog - Fear & Loathing in Financial Products
Credit Default Swaps – Exercises in Surrealism
Posted At : March 16, 2009 5:35 AM | Posted By : Satyajit Das
Related Categories: Derivatives
At the quantum level, the laws of classical physics alter in intriguing ways. In financial markets, at the derivative level, the rules of finance also operate differently.
The derivative industry’s indefatigable advocacy of credit default swaps (“CDS”) centers on the fact that contracts related to recent defaults settled and the overall net settlement amounts were small. Closer scrutiny suggests causes for caution.
The CDS contract is triggered by a “credit event”; broadly, default by the reference entity. CDS contracts on Freddie and Fannie were ‘technically’ triggered as a result of the conservatorship necessitating settlement of around $500 billion in CDS contracts with losses totaling $25 to $40 billion. Government actions were specifically designed to allow the firms to continue fully honouring their obligations. Triggering of these contracts poses questions on the effectiveness of CDS contracts in transferring risk of default.
Practical restrictions on settling CDS contracts has forced the use of “protocols” – where counterparties may substitute cash settlement for physical delivery. In cash settlement, the seller makes a payment to the buyer of protection to cover the loss suffered by the protection buyer based on the market price of defaulted bonds established through an “auction” system.
(Excerpt) Read more at wilmott.com ...
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Ludwig von Mises, the Austrian economist from the early part of the twentieth century, once noted: “It may be expedient for a man to heat the stove with his furniture; but he should not delude himself by believing that he has discovered a wonderful new method of heating his premises”.
Ludwig von Moses...brilliant economist from the Austrian school.
You gotta love Ludwig Von!
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