Michael Lewis: Why Exactly Do CDSs Exist?

Michael Lewis conducted an interview with Atlantic magazine, centered mainly on the financial crisis. Though Lewis spent the last few years looking at tech and sports, he’s now “back in the [finance] game.” And we’re all the better for it. The interview is well worth a full read, but here’s one our favourite excerpts:

(The Atlantic) Michael Lewis: …What really happened was that traders on Wall Street have the risk on their books measured by their bosses, by an abstruse formula called Value at Risk. And if you’re a trader on Wall Street you will be paid more if your VaR is lower — if you are supposedly taking less risk for any given level of profit that you generate. The firm will reward you for that.

Well, one way to lower your Value at Risk as a trader is to sell a lot of credit default insurance because the VaR formula doesn’t count it as risk. Because it’s so unlikely to happen, the formula doesn’t grab it. The formula thinks you’re doing business that is essentially riskless. And the formula is screwed up. So this encouraged traders to sell lots and lots of default insurance because, while they get a small premium for it, it doesn’t matter to them because the firm is essentially saying, “Do it, because we’re not going to regard this risk you’re taking as actual risk.”

It’s insane. That market is huge as a result. But if people actually had to have the capital, like a real insurer, to back up the contracts they’re riding, the market would shrink by — who knows? Who knows what would be left of it?

So yes, if you just made the rules better, a lot of the problems would just take care of themselves. If you’re sitting in the SEC or if you’re sitting in Washington, I don’t know if it’s easier to make the rules better or if it’s easier to ban the things themselves.

The Atlantic: In the book Franklin Edwards has this analogy between the kind of situation you’re describing and the choice between building better roads and scrapping new cars. And I suppose if the credit default swap is the new car, it sounds like one solution here might be build a better road — change the in-house rules by which risk is evaluated and so on.

But to follow the analogy through, the better road would cause most of the new cars to leave the road. You know, I have yet to have a financial person persuade me that there’s a really useful reason for a credit default swap. I know why they exist and I know why they’re used. They’re mostly used as speculative instruments. And the people who are selling the insurance are mostly selling it because they don’t pay a price for it until everything goes bad. They weren’t judged as taking any particular risk. But I have yet to have anybody explain to me why these things are terribly useful. They might have some good use and I just haven’t heard it yet, but I’m dubious. Continue Reading–>

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