Thursday, October 23, 2008

Greenspan - the rest

11:04 a.m. Greenspan obliquely supports the divorce of CDS trading from physical settlement, suggesting that settlement issues relating to the "discretionary" request for the exchange for physical collateral "be resolved". [update/note: I mention this only because I have yet to hear any official say anything with this degree of particularity, indicating that they are thinking at all about the risk-characteristics of newer instruments. In other words, this is not a view on whether the development of a cash-settled market, as has happened, is good or bad.]

Using the Arrow framework, we went through a period in which risk was hidden, more than spread, via silly model assumptions and an issuance gravy train with scant capital backing.


We also went through a period in which derivatives and structured-products magnified so-called spread risks, those related to credit quality and to different maturities on the yield curve; and, somewhat counterintuitively, the spreading around of risk that occurred enabled that multiplication, without reducing the systemic risk, either by isolating loss or putting risk(s) in the hands of those most capable of pricing it or bearing it without systemic implications (e.g. the hands of seasoned experts, "natural hedgers", or well-capitalized speculators or investors).

To analogize, the first is like a bad loan that gets syndicated, but to affiliates.

The second, to summarize at even a higher level of abstraction, was like writing financial insurance to protect people from ... the business cycle, basically.

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