The Kling And I On Credit Default Swaps

Arnold Kling and I will probably never agree when it comes to credit default swaps (CDS). Kling and I have had words in the past over CDS, and so have Kling and Felix Salmon. But so long as spirited debate proves interesting to us and our readers, I’m happy to participate in that hallowed, nerd-sport-of-choice: arguing over the internet.Kling seems convinced that because he cannot conceive of a way to hedge credit risk using the long end of a CDS (the protection seller’s end) it follows that CDSs have no “natural seller.” In short, his position is the following:

“[N]o institution was in a position to sell credit default swaps as a natural hedge against its other business.”

Why would both ends of a CDS need to hedge some risk in order for the CDS to be economically beneficial? I fail to see how hedging is the sine qua non of economic utility. If that were the case, who is a natural buyer of bonds? I’m sure Kling is incapable of answering that question because as a matter of pure logic, any answer to that question is an answer to his, since selling protection through a CDS is economically equivalent to buying the underlying bond (ignoring CDS collateral, which complicates the matter).

In any case, it seems futures and forwards are acceptable means of speculation, but CDS are not. In the case of fuel and other energy and commodity derivatives, there are those in the market who have bona fide economic exposure to the underlying risk. For example, an airline might enter into a swap or a forward contract to lock in a price for fuel, so that it can plan around that price and won’t be brutalized by volatility in fuel prices. The other end of the trade could very well be an entity with no bona fide economic exposure to fuel prices. Rather, that entity wishes to speculate on the movement of energy prices. Both benefit through contract in that both get what they want: the airline wants stable fuel prices and the speculator wants the opportunity to profit by expressing a view on the movement of fuel prices.

The same applies to CDS. Certain entities in the market have bona fide economic exposure to credit risk. For example, banks. In order to shed this risk, banks will contract with another party, the protection seller, to absorb this credit risk. The bank wants to unload its credit risk and the other party wants to speculate as to the probability of default on and, more generally, the movement of credit spreads relative to the underlying credit. And so, both parties get what they want and the transaction is, at a minimum, economically useful ex ante.

Also published on the Atlantic Monthly’s Business Channel.


Originally published at Derivative Dribble and reproduced here with the author’s permission.

2 Responses to "The Kling And I On Credit Default Swaps"

  1. Anonymous   April 3, 2009 at 5:52 pm

    Kling is, of course, wrong; it’s classic derivatives 101 that a speculator funds a hedger (it’s called a thy of normal backwardation to explain how a hedger must entice a speculator). Most trades have at least one “non-natural.” What he should have said is, some protection buyers are not natural buyers. But nevermind…And no matter…your refute is equally elementary: selling credit risk is equivalent to long funded bond, if you ignore the aspects that make it different (exposure is not equal to principal; M2M collatera does not equal exposure). Can is equal to cane, if you ignore the e. And there is the rub. There are key differences beyond the “synthetic equivalence”Satyajit Das has articulated the real issues posed by CDS, which are beyond this distraction of fallacy-refutes-fallacy.

  2. George Harter   April 4, 2009 at 12:58 am

    The older “Natural” financial products, forwards, puts, calls etc were/are tied to a known, priceable good/s-a stock or 1,000 bushels of beans.We are being slaughtered by the marvels of “FINANCIAL ENGINEERING”, Synthetic Derivatives! Evidently unpriceable in many cases. CITI has unwound much of their self-produced garbage????? Hell NO!(what arrogance, creating a tool for fraud, then drinking the KoolAid you made for others!)Arguements concerning Synthetics are mostly time wasting. CDS’s, CDO’s etc will wind themselves down. An example is the creation of a large number of legally “title-less” residential properties. Other parts of synthetics will end end in a similar legal morass.Synthetics simply create a class of Artificial Debt/Insurance/Pseudo Assets. Let all these burn down, do not allow more of them to be created. Very simply, our economy functioned very well after WWII until recently. Of course we had bubbles, recessions.Your synthetics(and hyper leverage) have done a lot more damage to the whole economy than anyone thought possible, we are obviously not in a simple recession. Whatever you and Kling are arguing over is meaningless. Any way you slice them, synthetics have been a financial catastrophe.George HarterBaghdadontheHudson, USA