CDS = MIRV
So I was reading up on the Commodity Futures Modernization Act ...
Anyhow, I saw that one of the things it did was to deregulate Credit Default Swaps, which have gotten less-than-great press recently. Warren Buffet, who can see the future, called them "financial weapons of mass destruction."
Perhaps I'm late to the party here, but surely Sen Richard Lugar (R-IN) understood what he was sponsoring, right? The salient point is that any institutional investor could take out an insurance policy on anyone else's debt. As long as everyone pays their debts, this means that a company could make money off the fact that most companies in America are solvent. Hooray! Except:
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion.
This reminds me of a shortcut that we took during the Cold War. As rocket and warhead technology improved, missiles got much more capable... but not that much smaller. Warheads got much much smaller. Your two options were to put a single warhead on a teeny-tiny missile so you can drive it around and keep it hidden, or to put many warheads on a single big missile (called MIRVing). The policy-makers in the US grabbed onto the latter option, and Senator Richard Lugar spent a good part of the 1980s and 1990s working with Sam Nunn and Joe Biden trying to write treaties with the USSR (later Russia) to change this. The problem with MIRVs is the same problem - they're destabilizing.
It only takes one nuclear explosion (or mayyybe two) to wipe out a missile silo. If that silo is holding 10 or more of your warheads, then as soon as you detect that an adversary has launched a missile -- any missile -- you have an immediate incentive to get your warheads somewhere safe, like "in mid-air, sailing towards Russia." This requires nerves of steel and very very very good quality control procedures. On the contrary, if your warheads are each deployed separately on a single missile, and that missile is road-mobile, then the enemy's nukes can't find you. You can wait out the nuclear strike, assess the damage, and launch a counter-attack without having to waste any warheads on his (now-empty) silos.
So, two things: first of all, Senator Lugar should have seen this coming.
Second, CDS risk should be limited to the size of the debt they're insuring; it might even make sense to shuffle them together so that a CDS covers the risk of several debts with different payouts based on AND/OR conditions.
Anyhow, I saw that one of the things it did was to deregulate Credit Default Swaps, which have gotten less-than-great press recently. Warren Buffet, who can see the future, called them "financial weapons of mass destruction."
Perhaps I'm late to the party here, but surely Sen Richard Lugar (R-IN) understood what he was sponsoring, right? The salient point is that any institutional investor could take out an insurance policy on anyone else's debt. As long as everyone pays their debts, this means that a company could make money off the fact that most companies in America are solvent. Hooray! Except:
The market for credit derivatives is now so large, in many instances the amount of credit derivatives outstanding for an individual name is vastly greater than the bonds outstanding. For instance, company X may have $1 billion of outstanding debt and there may be $10 billion of CDS contracts outstanding. If such a company were to default, and recovery is 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. However the loss to credit default swap sellers would be $6 billion.
This reminds me of a shortcut that we took during the Cold War. As rocket and warhead technology improved, missiles got much more capable... but not that much smaller. Warheads got much much smaller. Your two options were to put a single warhead on a teeny-tiny missile so you can drive it around and keep it hidden, or to put many warheads on a single big missile (called MIRVing). The policy-makers in the US grabbed onto the latter option, and Senator Richard Lugar spent a good part of the 1980s and 1990s working with Sam Nunn and Joe Biden trying to write treaties with the USSR (later Russia) to change this. The problem with MIRVs is the same problem - they're destabilizing.
It only takes one nuclear explosion (or mayyybe two) to wipe out a missile silo. If that silo is holding 10 or more of your warheads, then as soon as you detect that an adversary has launched a missile -- any missile -- you have an immediate incentive to get your warheads somewhere safe, like "in mid-air, sailing towards Russia." This requires nerves of steel and very very very good quality control procedures. On the contrary, if your warheads are each deployed separately on a single missile, and that missile is road-mobile, then the enemy's nukes can't find you. You can wait out the nuclear strike, assess the damage, and launch a counter-attack without having to waste any warheads on his (now-empty) silos.
So, two things: first of all, Senator Lugar should have seen this coming.
Second, CDS risk should be limited to the size of the debt they're insuring; it might even make sense to shuffle them together so that a CDS covers the risk of several debts with different payouts based on AND/OR conditions.