Thursday, July 2, 2009

Buiter on credit and naked CDS

Excellent article by Willem Buiter, professor of econ at LSE, in the FT. I want to quote a few passages

Despite inadequate supervision and regulation, the financial innovation process that started in the final quarter of the 20th century probably improves overall economic performance during normal times. It does, however, increase the likelihood of abnormal times—panics, manias and crashes—occurring, and exacerbates the scope and severity of financial crises.

Those that have been following the for-dummies series will be able to dissect this sentence easily :) It is the monetarist argument in Buiter-speak. He writes well and fluidly but is a bit opaque imo. Financial innovation of MBS and associated CDS did result in a rapid increase of the total monetary volume. Buiter says

When risk is mispriced and misallocated, financial crises and collapses can occur. Financial crashes and associated defaults and bankruptcies are socially costly because they involve a waste of real resources as well as a reshuffling of property rights. When that happens, the aggregate non-diversifiable risk in the economy is not just distributed inefficiently, but its total quantum is increased. Risk that should be diversifiable under orderly market conditions ceases to be so.

In other words liquidity dissapears from these markets. The secondary implodes, you can't sell the stuff, just like you can't resell your house.

Not to toot my own horn, but as Buiter says himself in the article "if you don't toot your own horn, who will?". He lashes out against naked CDS.

One of the reasons for my ignorance (widely shared, I may say in my defence) was the pace of financial innovation in instruments and institutions. Most of the new instruments and institutions were motivated purely by regulatory and tax arbitrage, domestic and crossborder. But some it it was genuine. Even those that were genuine and potentially socially useful (interest rate swaps, securitisation, CDS). Even the genuine innovations were, however, often abused and became socially damaging. CDS provide an example. Just as short selling equity is potentially efficiency enhancing but naked short selling is just gambling, so insuring credit default risk is potentially efficiency enhancing when the buyer has an insurable interest and the writer of the CDS is sufficiently capitalised. Current arrangements permit ‘naked’ CDS buying (buying CDS on a security in excess of the face value of your holdings of that security).

No comments: