in which I ponder further a physicist's amateur perspective on the stupidities my ex-colleagues perpetrated
I have ranted before on the current aspects of the fiscal crisis, including the credit default swaps (CDS)
now, I don't pretent to be an expert, but I am somewhat numerate and the basic theory of CDS makes for interesting reading.
There are two root problems: one is the basic toy model assumes default probabilities are independent events (exponential in time, really? come on lads you can do better than that...) and uncorrelated; but, the other problem is that the amplitude of the risk is way underpriced.
Browsing some iTraxx data, it looks like back in 2005, for example, CDS contracts on 5 year debt were at 20-50 basis points for commercial debt (senior finanical, through consumer credit). One basis point is 0.01% or 1/10,000 - so at 20 basis points for a 5 year contract (I am assuming the price is the upfront price not the annual payment) the formal risk is estimated at 1 in 2,500. Since the essence of a credit default is bankruptcy or near equivalent, this means the CDS salesmen were estimating mean lifetimes for finanical firms of 500 years, roughly.
And 200 years for consumer companies - the US is only 226 years old, any commercial companies around from the foundation of the US? Canada maybe, but not in the US.
This is stupid, and made CDS good buys for people with deep pockets looking for long term wealth (and gave them incentive to want the markets to crash, along as they thought they could survive the turmoil). Take stupid odds from people with no intention of ever paying up, and wait for thing to go wobbly. Oh, and then make sure the government actually steps in to cover your bankrupt counterparty. Clever, eh?
Didn't even have to have insurable risk to play, wait for some other sucker to make a big bad loan, and take a sidebet on it going bad.
The CDS market will have to be regulated, and loopholes iteratively covered as they are found by clever bastards.
A simple regulation scheme would be to:
a) No naked CDS. Require CDS purchasers to have insurable interest to get a contract, and have anyone found to have naked contract be voided.
b) No 100% cover - cap the CDS contracts at 90% or 95% of value.
No free rides on loans, force banks to do due diligence and not just take out lazy reinsurance.
- Log in to post comments
I have no quarrel with your thesis, but when evaluating the 500 year mean lifetime, you have to remember this is between credit defaults per company, not the lifetime of the company as such.
Given that when a business goes into decline it usually gets taken over and gradually assimilated, the fact that 200-year old companies aren't around by name doesn't mean they defaulted.
Still an' all...
Yeah, but the fact that companies can undergo multiple defaults in a lifetime means the characteristic CDS timescale is shorter than the mean company lifetime. So the risk is more severely underestimated.
Now, as you note some businesses are assimilated, and I also didn't account for businesses just winding up - paying off debt, and shutting down without default - but to estimate the fraction assimilated and wound down requires data, as does the actual mean number of defaults ( > 1) per company that does default.
However, the characteristic lifetime in the rate equation is the mean company lifetime, and they've underestimated that by an order of magnitude.
Overestimated the company lifetime right?
What was the book where the 10%-90% rule (with lifetimes being on a normal curve, looking at anything at all, the odds are you are between 10 and 90% of life) was invoked to get expected lifetimes and for a lot of things like skyscrapers or large corporations. The calculated lifetimes were a lot shorter than many expected? It's predictions were better than most.
yes, sorry - underestimated the risk, overestimated the mean lifetime
Manchester Bus paradox works well - proving the universe is Bayesian
Agree with the optimistic risk assessment but not so sure about the last step due to being confident of the government stepping in. I suspect there's a strong element of everyone else is doing it, it helps the EPS this quarter, and it's much safer to be wrong with everyone else than sticking your neck out and having it lopped off due to crying wolf too early.
e.g. it almost always turns out that many of the stock analysts who hyped companies during a bubble had their own serious doubts. If everyone is wrong the personal price to pay within the field is limited, the general brouhaha notwithstanding. Astronomy works that way too ... :-)