Decent article on credit derivatives.

Strikes me the author highlighted the key problems via the highlights in the article. I know a lot of my collegues are positively frightened by the poorly understood amount leveraging that is going on through these mechanisms. Trillions of dollars of highly leveraged bets on a model whose underlying function is not well understood, by big money center banks as well.

I would pay particular attention to the story re the Ford and GM story recounted. If that does not worry....
 

Thank you Col-

This part troubled me in particular:

"Much of that money is riding on Mr. Li's idea, which he freely concedes has important flaws. For one, it merely relies on a snapshot of current credit curves, rather than taking into account the way they move. The result: Actual prices in the market often differ from what the model indicates they should be."

A lack of dynamic modelling coupled with the temptation to feed in overly optimistic data is going to cause some major problems.

Secondly, and I'm just throwing this out on a guess not knowing much about derivatives, it would seem to me that while there are prodigious sums involved the number of decision-makers for those sums is dangerously small.

Small enough that you don't really have a natural " market" action in a technical sense because the action of any decision-maker is too influential. Kind of like the distortion of price competition in an oligopolistic setting. These risks are not being assessed correctly because prior errors are not being efficiently corrected in a way that would lead decision-makers to make better future choices.
 

Mark:

You hit the nail on the head. Unless the Fund or Bank involved has a proper risk control function to reign in the modeller/sales/marketing people, there are strong incentives to do data to do deals. That's no news of course, but here it is dangerous for the non-obviousness of the model/market.

As for your guess, it is spot on. the number of people who understand this stuff in a really thorough way and are in control is probably globally in the low triple digits. That is globally. The real decision makers perhaps less. The number of actors really making the market, perhaps 5-10.

And all this is highly leveraged.

Remember Long Term Capital?

We're an order of magnitude bigger now.

I think I posted some comment on my old journal some months back regarding a conversation with colleagues who are convinced that the credit derivative market is a time bomb. I am not sure they're right, but both are old hands who've gone through explosions.
 

Well, this is no genuine solution in terms of getting derivatives to function with the feedback loop of a genuine free market but is some kind of disinterested third party rating group possible ? Sort of like Moody's to at least put a damper/check on the more egregious cowboy behavior?

Something is needed - these instruments in the current scenario would seem to have the potential to derail a regional developing economy or trigger a recession in the EU or the US in the event of a catastrophic miscalculation.
 

Indeed, credit derivatives do indeed have the potential for provoking a serious systematic crisis.

However, it is not obvious that there is a way to easily regulate for a vareity of structural reasons.
 

Do you have any other articles or info on credit derivatives pricing or trading? Been looking to find out more info on the player in the market... I've some interesting information on the following sites:
http://www.cdscawley.com
http://cdsaxiom.com

Know where I can find any additional info on the other players?