The Empire Strikes Back

As nightmarish memories of September 2008 fade, the financial industry is gearing up to fight new regulations. The battle lines are being drawn and became more visible this week.

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Credit Default Swap Update

In a blog entry almost six months ago, I suggested that prices for credit default swaps (CDS) would tell us when the financial crisis was winding down. Unfortunately, the data this week tell us that the end is not in sight. This is probably obvious to you given the news headlines of the last few days, but looking at credit default swaps can help us understand how bad things are.

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Understanding the Underlying: Where do Credit Ratings Come From?

“We’re structure experts, we’re not underlying-asset experts.”

—Moody’s employee

How exactly did the credit rating agencies assign ratings on collateralized debt obligations backed by mortgages? In “Triple-A Failure” in the April 27 issue of the New York Times Magazine, Roger Lowenstein explains in detail how Moodys rated one such issue, which Lowenstein calls “Subprime XYZ”. Lowenstein’s article is notable for the insight it provides into Moody’s ratings process. The ratings agencies were not the only culprit in this crisis, but they played an important role, and the Lowenstein article helps to elucidate that role.

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When Will We Know?

Reporter: But now I’m asking you: When will we know?
Henry Hurt: Blackout lasts for 3 minutes. If they’re not back in 4, we’ll know.
—Apollo 13

When will we know that the credit crisis is over? One way to tell will be by looking at the market for credit derivatives. Credit default swaps (CDSs) permit investors to buy or sell insurance against the event that a specific company defaults (or more generally, experiences a “credit event”). The buyer of insurance pays a quarterly or semiannual premiums to the seller. In return, the seller promises in the event of default to pay the buyer the loss in bond value due to default. When CDS premiums are high, it is a sign that investors are worried about a default.

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Guns Don’t Kill People

Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
— John Maynard Keynes

Is the Black-Scholes option pricing model responsible for the current credit crisis? The writer Michael Lewis (whose writing I generally admire) answers “yes” in “Inside Wall Street’s Black Hole” in the March 2008 issue of Portfolio magazine. He pins the blame on papers written 35 years ago by “academic scribblers.” He doesn’t blame Alan Greenspan, borrowers, lenders, ratings agencies; or investment banks. He blames professors. I don’t think this is one of Lewis’s finer efforts, but since he is highly regarded and widely read, it seems worthwhile to consider what he has to say.

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