Sunday, May 04, 2008

CDSs vs. CDOs: Why the party isn't over quite yet

The Economist has an interesting article on the Credit Default Swap marketplace ("Swap Shop"). I've written about this market before, but it is one that is even more important today than it was just a 18 months ago. Credit Default Swaps are essentially bets that anyone (well, any financial institution) can place on another credit instrument (e.g. a corporate bond). You can buy or issue a CDS without being a party to the underlying credit instrument, though often the participants in the CDS market use these vehicles to hedge their risks as parties to credit issuance. CDSs are different from the current black sheep of the finance family, the Collateralized Debt Obligation (CDOs: basically a pool of mortgages or other debt that is bundled, chopped up ("securitized"), and then re-sold). While the current "Credit Crunch" is largely a result of a meltdown in the CDO market due to mispricing of risk and other negligent/reckless lending practices in home loans, the CDS market is prospering. It grew from $34.4 Trillion in 2006 to $62.2 Trillion in 2007 and continues to grow rapidly (yes, you read those numbers correctly--the CDS market is many times larger than the entire US economy, even if most people have never heard of it). Here's the rub: this vibrant CDS marketplace will actually rescue us from the "Credit Crunch," unless of course it manages to cause the entire global economy to implode in the meantime. Fortunately, that unless isn't very likely. Yet. The CDS marketplace is like a safety net. As it grows more dense, more complex, more perfectly optimized as a risk-management tool, it also becomes more rigid--losing the very flexibility that it needs to perform its function. Currently, firms use the CDS marketplace as a network of insurance policies. When something goes wrong, as long as those firms that are obligated to pay under the CDS system have the spare change to do so, the safety net functions admirably. Of course, as a largely unregulated world shrouded in the fog of murky and non-transparent accounting practices (or worse, overly rigid ones like the new Basel-II standards), it isn't really possible to tell when a firm has over-committed themselves in this CDS shadow-world. Because CDS providers make money by issuing these swaps, and because at the right price there is a virtually unlimited market to purchase said swaps, the ratio of committed reserves to actual reserves of the financial industry in aggregate is rapidly accelerating. This makes the CDS marketplace increasingly "rigid"--where rather than absorb a shock, it spreads through the network without dissipating.

At any given point--such as now--it is much more likely that the system absorbs whatever shock it receives. But, as every moment passes, the CDS system becomes more optimized, and therefore less flexible and more brittle (there are historical precedents for this). Over time it will become increasingly likely that the any given shock shatters an increasing inflexible CDS system, but, in my opinion, we're not there yet. There is still lots of room for optimization in the system--for example, this CDS-style risk-management notion really hasn't spread to the retail level. When that happens--when I can buy a CDS on my neighbors mortgage to protect myself from the decline their bankruptcy and resultant foreclosure will cause in my home value, then I'll think we've crossed the Rubicon. Coincidentally, that's a really good business idea... (note: only partial sarcasm... I've long thought that there is a huge and untapped market for retail hedging of risk exposure far beyond life, car, and home insurance: why don't more individuals hedge exposure to volatile energy costs, food costs, housing values, job markets, etc.??)

So am I just saying that, most likely, we'll recover from our current economic mess? Not quite. What I am saying is that the current economic problems are caused by a very curable problem--poor credit practices. They are, admittedly, being exacerbated by the onset of the next source of economic problems, Peak Oil, but that is not yet the underlying cause of what's happening. I must admit, the media does seem fixated on telling us how there really is a depression, right now, in America--in my opinion because they have to talk about something, and because you don't get ratings for saying "nothing particularly striking to report today, Bob." Parts of the broader media complex--blogs and websites mainly--do nothing but cherrypick news that supports their view that we're one wake-up away from a "Mad Max" apocalyptic future. All this motivates me, at times, to defend my prediction that we aren't in a recession, and that we won't see a real recession this year at all. Of course, this conflicts starkly with my other prediction that we are currently experiencing a "slow crash." Am I schizophrenic? I don't think so (who does?)--rather, I suggest that these two views are compatible provided that the differing time periods are kept in mind.

I maintain my prediction that we won't enter a recession this year. Of course, I take that narrow-minded position that a recession should actually have to conform to the definition of recession before it counts--if people are allowed to go about willy-nilly and define what a recession is and then tell me that I'm wrong when I say the current data doesn't meet the definition, more power to them. Just for completeness, US Q1 2008 GDP growth = 0.6%, and a recession is officially defined as two consecutive quarters of zero or negative GDP growth. Contrast this with the incessant ranting of the media that "7 out of 10 Americans think we're already in recession" (and the unspoken data point: 9.9 out of 10 Americans can't actually define the threshold for recession, but the media still reports their opinion... kind of like "7 out of 10 Americans think the Surge in Iraq is working" while "9.9+ out of 10 Americans don't have the data to reach an informed opinion on the topic"), the current economic figures suggest that we are NOT in a recession.

So there's nothing but smooth sailing on the horizon and I'm transitioning my oil call options into suburban homebuilders? No. There are some grey swans that could create a true recession or depression: actual and sharp decline in oil production is one of them. I don't care how high oil prices go ($300/barrel, $500/barrel), as long as it's just a bidding war for plateauing, but not yet declining supplies, this won't cause a true recession in my opinion. Our very ability to bid prices to such heights will be reflective our our economic strength. But once actual energy supplies begin to decline substantially (say, 5% from peak), then this will cause economic damage.

Net oil exports are one key data point to watch--and they may already be showing substantial declines (in the 5% range). However, to the extent that oil exporting countries are increasing domestic demand by stepping up purchases of consumables and durables from the West, this may temporarily postpone the impact of net oil export declines. No telling, yet, whether net oil export declines or actual net production declines will be the first to start to impact the global economy, but I think we'll have time for one more bout of partying before either one puts the permanent kaybash on the festivities...


Anonymous said...

I'm all for sticking to the - reasonable - definition of recession. But what if the measure of the terms is being yanked all over the board? Are all these financial instruments part of the GDP? Are they as accurate as the current version of the CPI:

...the government reported last week a net drop in the measure of inflation most closely watched by the Federal Reserve, leaving people to wonder how that number can be falling when everything from a tank of gas to hamburger meat is sky-high. [more]

And it could be true that a handful of people are making so much more money now while the overwhelming bulk of the population is losing hand-over-fist. That would not technically be a recession but I'm not sure it qualifies as a party.

Theo_musher said...

Seems like to me if there are all these financial instruments that I can barely understand keeping the economy afloat, then it would be a good bet that peak oil will be solved in a way I don't yet understand.

It may not sound rational...but obviously there is a great motivation on the part of humanity to avoid disaster. I think oil companies will only be able to price gouge for so long until hyper cars, electric cars etc. become a factor, followd by Green skyscrapers with wind turbines and so forth that generate all their own power and pump extra into the grid. I would be willing to bet it would happen first in these middle east "oasis" economies, like Dubai. They know more than anyone oil won't last forever.

Theo_musher said...

I think a crash of civilization has the makings of a "reverse black swan" A crash of civilization would be a black swan for most people, but for people that have been anticipating a crash, even looking forward to it in a way, the black swan of "no crash" emerges "out of nowhere" when it doesn't come.

You have even pointed out the confirmation bias of people looking for a depression or a recession in the media. I think there are probably some bizarre species of ludic falacies at work also. This whole idea of a crash is after all a model.

Jeff Vail said...

Theo: good point--I think that we need to be cautious of "faith-based" views of the future. I think a slow-crash is currently happening, and I think that we will fail to "solve" the oil problem (if, by solve, one means figure out a way to keep on growing forever). However, I think it's possible that I'm dead wrong. And even more importantly--I have more respect for any thinker who recognizes the possibility that they're wrong than I do for a thinker, no matter how amazing in other ways, who is convinced by their own logic...

Theo_musher said...

Well its interesting. I read a post you made where you referenced "black swans" and I had no idea what you meant so I did a google search and found out it was a book which I then went out and bought. I am about 3/4 of the way through it. Good stuff in there. I like the idea of being a "skeptical empiricist" or "empirical skeptic" or whatever it is.

As far growth lasting forever- I think in terms of material exploitation, it can't, but that is only a small portion of GDP. In terms of continued consillience or coherence on the part of humanity, I think it could go on indefinately. I think economic growth is a bi-product of this type of progress. The two are not equal or equivalet but closely related.

BTW, I just posted a post on my blog that is related to your last weeks post. Not sure how to make a ping back or whatever. But anyway its about how I have changed my mind about hierarchical solutions to slowing growth.

Beware of the Shogun

Theo_musher said...

To put it the best way I can think of this is the type of growth I can see continuing more or less indefinately and this from Popper's wikkipedia entry:

Karl Popper :

"In All Life is Problem Solving, Popper sought to explain the apparent progress of scientific knowledge—how it is that our understanding of the universe seems to improve over time. This problem arises from his position that the truth content of our theories, even the best of them, cannot be verified by scientific testing, but can only be falsified. If so, then how is it that the growth of science appears to result in a growth in knowledge? In Popper's view, the advance of scientific knowledge is an evolutionary process characterised by his formula:

In response to a given problem situation (PS1), a number of competing conjectures, or tentative theories (TT), are systematically subjected to the most rigorous attempts at falsification possible. This process, error elimination (EE), performs a similar function for science that natural selection performs for biological evolution. Theories that better survive the process of refutation are not more true, but rather, more "fit"—in other words, more applicable to the problem situation at hand (PS1). Consequently, just as a species' "biological fit" does not predict continued survival, neither does rigorous testing protect a scientific theory from refutation in the future. Yet, as it appears that the engine of biological evolution has produced, over time, adaptive traits equipped to deal with more and more complex problems of survival, likewise, the evolution of theories through the scientific method may, in Popper's view, reflect a certain type of progress: toward more and more interesting problems (PS2). For Popper, it is in the interplay between the tentative theories (conjectures) and error elimination (refutation) that scientific knowledge advances toward greater and greater problems; in a process very much akin to the interplay between genetic variation and natural selection."

Like I said, I think the type of "progress" related to economic growth
is not completely equivalent to this type of progress but fairly closely related. I think the economic world tests hypotheses in a real life type of fasification. Things either work or they don't.

At some point maybe the problems will getr too complex to be solved. As to whren that will be who knows? Long term we all die anyway.

Theo_musher said...

The formula didn't get coppied for some reason but you can see it by following the link.

Theo_musher said...

But anyway, at the risk of writing too many commnts, I want to finally say, I respect your respect for the truth and your willingness to admit to the possibility of beig wrong.

I have recently decided that I have been wrong about "the crash"

Interestingly, I find your two main ideas of "Rhizome" and the "problem" of growth to be in contradiction. I think I sensed that contradiction all along. I think that is what drew me to hierarchical solutions to the "problem" of growth.

I truly think that, speaking of Popper, there are a lot of elements in the "peak oil community" that are drawn to peak oil and the idea of a crash, because basically for whatever reason, they are enemies of the Open society. I think growth and progress is part and parcel of open societies. Open societies produce positive feedback loops of the third semantic time binding circuit. Open societies produce upward spirals not hierarchies.

I predict that in the future will reverse on one or the other of your two main ideas.

Theo_musher said...


I mean to type "I predict that in the future YOU will reverse on one or the other of your two main ideas."

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