Tuesday, March 10, 2009

The blunderer who is Ben

Curiouser and curiouser. In Sunday's New York Times, 'economics' columnist Ben Stein comes out against speculative portion of the CDS market.

This kind of stance is one of those bonehead simplifications of a complicated subject that appeal to people who want to think they are sophisticated without having to do a lot of wonkish reading. You know. People like ... Ben Stein.

Here's a link to his column for those of you with a subscription to the NYT.

And here is the bit that has provoked my ire:

ADD A RULE Don’t allow speculators with no insurable interest to buy credit-default swaps on bonds.

When used properly, these instruments can function as a legitimate kind of insurance. Yes, if you are a real buyer of the bonds of a given company, you should be able to buy insurance. But you shouldn’t if you are just a shark circling prey, bringing blood into the water.

Allowing speculators to buy C.D.S.’s merely to bet against a firm in difficulty just blasts the prices of bonds, kills the balance sheets of banks, insurers and hedge funds, and throws fear into the system

First, it is absurd to try to draw a sharp distinction between the "legitimate insurance" use of a CDS and the illegitimate speculative use. Those speculators provide precious liquidity for the market. If you have GM bonds in your portfolio, and you want to buy default protection, you'll be glad that there are counterparties in the market willing to sell protection to you. And part of the reason there will be such counterparties in the market is that there are speculators to whom they can sell. The speculators, in other words, increase the size of the overall pool, making life easier for the hedgers who need to wade into it.

Second, on any CDS contract, whether hedging or speculative, there is a winner as well as a loser. If a hedge fund makes a speculative bet that GM will fail, it is because and to the extent that somnebody else -- typically, a bank or insurance company -- has made a speculative bet that it will survive for the life of the contract. Stein doesn't even explain: which side of that bet is the public policy problem? Which side is the "shark," which side is the "prey"? If the protection is sold too cheaply, the bank has taken a foolish position. But on that same presumption, the hedge fund has made a wise decision. The outcome isn't going to "killl the balance sheet" of them both.

Third, in more general terms, why shouldn't we expect that a liquid market in CDS will cause prices, i.e. spreads, to move to an equilibrium that won't represent a foolish decision on either side?

There are some necessary changes in the CDS marketplace. Central clearing and settlement would be a good idea, and some standardization of product is probably necessary to make that happen. Such developments are underway. But Stein blunders right through all of that, cognizant of none of the real issues because he just wants somebody -- the SEC? the CFTC/ Treasury? Congress? it doesn't really matter -- he just wants somebody to "add a rule".

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