Good News: Credit Markets worked as designed!

Now the bad news: the global credit markets worked as designed. :frowning:

I am posting my very non-expert understanding of what I think is one of the more interesting parts of the Credit Default Swap failure-which apparently has a large role in the present economic crisis. I am hoping people who understand these things will critique my comments and fight my ignorance on the subject.
First I owe my present level of understanding to US National Public Radio and Mr. Gregg Berman-that nuclear physics major who went to work in Wall Street. He was interviewed and explained the process quite well. And what he pointed out is that the credit market, far from failing, has worked exactly as it is designed to. Of course no one wanted it to seize up, but the system worked exactly as designed.

What he basically said was that the swaps are a form of insurance. People bought these things to protect themselves if their investment failed. Just as you buy home insurance to protect yourself if your house burns down. However the system has what turned out to be a fatal flaw-you didn’t have to have an interest in the property to buy insurance in it. This flaw had been excluded from classical insurance for a very long time, but since CDOs were unregulated, anyone could buy insurance on a property they didn’t own. Why would they do that? Because if the property failed, they would collect. And that was how the system worked as designed. Mr. Berman and his coworkers designed very successful models that sought out and found the riskiest investments possible. Of course they didn’t think of it that way, they thought of it as finding the highest return possible. But ultimately it is the same thing. Their companies then bought CDOs on those investments and sat back and waited. So instead of minimizing or spreading risk, as insurance is supposed to do, this market ended up concentrating risk. It was spectacularly successful. Except of course the unthinkable happened-the compaines backing these CDOs couldn’t pay. When trust left the market and reality became apparent, the whole system collapsed overnight.

And the problem was magnified by the fact that anyone could buy a CDO on a given property. If a property (say a bond) failed, many people would expect to be paid the face value. So that 1 billion in bonds could cost the insurers 10 billion. Or 20 billion.

It all comes down to this insurance market neglected to include the fundamental concept that real insurance has had for a very long time-you have to have an insurable interest in a property before you can purchase insurance.

So, to the experts, how did I do?

That’s actually a pretty good summary.

Anyone else notice that NPR seems to be the only news source (in the US anyway) that takes the time to explain complex subjects? Every time I listen it’s like I get an injection of “smart”.

thanks!
kind makes one nervous about other large systems designed in the last 20 years. Are any of them (no examples come to mind-but any large system designed without prior experience being part of it) as vulnerable?

One thing missing - no one doing these things thought about counter-party risk (eg, ability of the other party to pay).

That was certainly missing from Wall Street. All those rating agencies said things were fine, neglectiong as you pointed out to consider the counter-party risk. In my post I did say Except of course the unthinkable happened-the compaines backing these CDOs couldn’t pay".

As others have pointed out, a significant factor was that the majority of these trades were hedged-the insurance was bought and sold by the same people. I don’t understand the concept, but apparently that increases the damage and risk of failure by at least a factor of two.