Jeez, what a week … not being a financial expert, I am loathe to opine on what’s been going on in financial markets this week. I do find some things striking, particularly from a historical perspective.
The first thing that strikes me is that what’s driven this is the development and use of two new financial instruments over the past decade or so: collateralized debt obligations (CDOs) and credit default swaps (CDSs). A CDO is a slice (tranche) of a portfolio of fixed-income assets; a CDS is a contract that transfers the credit obligation for a fixed-income asset from one party to another. Investopedia has a pretty clear definition and illustration of a CDS:
The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.
For example, the buyer of a credit swap will be entitled to the par value of the bond by the seller of the swap, should the bond default in its coupon payments.
New financial instruments like these are valuable because they allow for more, and more varied, transactions for the transfer of risk from one party to another, as well as across time. They are useful tools for hedging, and for allowing parties to be more flexible and adaptive to changes in their business environment.
Derivatives and credit instruments have existed in some form since the 12th century or so, but the size and integratedness of global markets changes the impacts when unanticipated outcomes happen. With such large and integrated global markets, the third-party rating agencies play an important role in creating healthy markets here; their evaluations are what parties use, and have used for over a century, to price risk in a transparent way. But it’s difficult to price risk, and it gets harder as the instrument gets more intricate. It’s also hard to price risk with new instruments, because pricing risk is easier when you have data on the behavior and performance of the instruments in different situations. This is why the credit rating agencies have been criticized a lot over the past year about their failure (in hindsight) to price CDO risks accurately. In terms of regulatory institutions, it doesn’t look to me like there’s much of a role for new regulation, because what’s necessary is the learning about how CDOs perform in different circumstances. But, as I said, I’m not an expert in financial ratings, so I’m interested in hearing more discussion.
Another thing I find striking is the way that the instrument transactions are consummated, particularly the CDS transactions. They are largely over-the-counter (OTC) transactions, which means that they are done bilaterally, or directly between two parties, instead of being exchange-traded. There’s a big difference in transparency, and in regulatory environment, between OTC transactions and exchange transactions, but OTC offers a lot of opportunity to create and consummate heterogeneous transactions, while exchanges focus on products that are more standardized. OTC trading clearly plays a role in enabling parties to prosper, but my question is this: does my “learning curve” argument apply here, to OTC-traded CDS instruments? I’m really not sure, and I think it’s important, because my “learning curve” argument has implications for the type of regulatory institutions we devise for these markets. Can we retain the benefits of OTC trades while simultaneously making the environment more transparent?
UPDATE: My call for help has been answered in the comments by Craig Pirrong, an excellent financial economist. In his comment he links to his post on clearing, and how a central clearing counterparty for OTC transactions could have mitigated some of these effects. It’s a superb, clear, thorough explanation, and I recommend it strongly.