What if credit default swaps weren’t the big problem?

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The calm and and less-painful-than-expected conclusion of the big auction of Lehman Brothers’ credit default swaps has led to some talk that maybe the role of CDSes (CDSs? CDS?) in bringing on our current financial near-debacle has been wildly overblown.

Making the case perhaps even more strongly is Ben Stein’s Yahoo column from last Friday, in which he argues that “these deadly derivatives” (CDSes, that is) are the No. 1 cause of our current troubles. If you believe that Ben Stein is invariably wrong (and this is not an unreasonable belief), then CDSes cannot be the No. 1 cause of the financial crisis. Q.E.D.

But are they a major cause? The yes argument seems to have two parts:

1) Credit default swaps encouraged banks and other financial institutions to take more risks than they would have otherwise, because they figured they could insure against those risks using credit default swaps.

2) The credit default swap market is so poorly organized and so fragile that the government had to step in and bail out (or backstop, if you prefer) Bear Stearns and AIG to prevent its collapse, which they feared might bring the entire financial system down with it.

As for #1, taking more risks isn’t in and of itself a bad thing. The problem is if the CDS market did a really poor job of pricing those risks. It didn’t do a great job, that’s for sure–and maybe the diffuse nature of CDS-enabled risk sharing, in which the people who made the loans were several layers removed from those who bore the risks, made things worse. But CDS market participants do seem to be learning from their mistakes, and it’s not as if banks have a great record on evaluating risk internally. As Merton Miller said back in 1997:

For all the horror stories about derivatives, it’s still worth emphasizing that the world’s banks have blown away vastly more in bad real estate deals than they’ll ever lose on their derivatives portfolios.

Now that we’ve gotten to a world in which derivatives and real estate deals are inextricably entwined, I’m not sure one can still say that with confidence. But it’s worth pondering as we move on to argument #2, which is that the CDS market is a giant house of cards whose collapse could bury us all. The results of the Lehman auction would seem to indicate that it’s a sturdier structure than many had thought. But it’s possible that the bankruptcy of AIG would have been much, much worse since it was a big seller of CDSes–that is, a big writer of insurance policies.

The simple truth is that we just don’t know. That ought to be reason enough for us to move toward an organized, transparent CDS exchange that would presumably make such questions easier to answer. But it also makes it impossible to say with much confidence whether credit default swaps are financial weapons of mass destruction or not. Collateralized debt obligations–now those are definitely financial weapons of mass destruction. CDSes, not so sure.

Oh, and one other thing about that Lehman auction. Lots of people throw around the $54.6 trillion notional value of CDSes outstanding as an indication of the money at risk, but it really is not, as lots of the contracts cancel each other out. The notional value of the Lehman swaps was $400 billion. The money that actually changed hands in settling them was estimated at $6 billion. Apply that same ratio to the $54.6 trillion and you get $818 billion. Which is a lot, but–to go back to Merton Miller–probably less than banks have lost on real estate.

There is a complication, though: If lots of swap counterparties fail, as Steve Hsu explains, the losses can climb toward the notional value.

So are credit default swaps the No. 1 cause of our current financial crisis? Really, I don’t know. I do know that my head now hurts.

Update: Nokia has agreed a deal with its banks in which the interest it pays on loans varies with the spread on its credit default swaps (via Alea). So maybe the CDS market isn’t so horrible at pricing risk.