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Munger / Bloomberg - on CDS


Guest JackRiver
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Absolutely. I agree with his 100% elimination opinion. It's like having a life insurance policy on your neighbor's life. I creates a moral hazard that is not acceptable.

 

You should argue that it should be allowed for collateral of corporate bonds (it's like a insurance policy against a company's default in wich you hold bonds), but it wouldn't take long to lobbysts to put pressure on policy makers to deregulate that, so history would sooner or later repeat itself.

 

So 100% elimination is a good idea.

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Munger made that exact observation at last year's Berkshire AGM, right before Buffett made reference to the "small insurance company  in Canada named Fairfax". As usual, Munger is spot on.

 

-Crip

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But banning it completely runs contrary to principles of ownership and liberty.  

 

Ownership.....ownership of what? I basically call this moral hazard tool: "

"Unjustified speculation about someone else credit risk where I shouldn't give a damn" This as nothing do to with real ownership. I own my car, I own my stock certificate, etc. but a CDS is a very speculative tool that has barely a thing to do with capitalism ownership. By the way, I would like to say that I own my wife, but please don't tell her because she'll give me a slap on my head   ;)

 

Regarding your bonds point, I would basicaly say yes, but:

 

- first if you don't trust the credit of a given company, don't buy the bonds, and if you do, but don't think that the yield compensate you for the risk, ask for better terms or keep searching for something better elsewhere.

 

- second, even if you don't think that the first point is something rational, if you allow CDS to exist just on that basis, sooner or later lobbysts will deregulate that, so you'll see very bad behaviors again with some very bad consequences broadly speaking.

 

Liberty...liberty of what? If I sign a contract with terms that say that if my neighbor goes bankrupt within 3 years, you'll give me one million dollar for a 5000$ premium, the Civil Code of Quebec would tells me that it is probably against public order (and rightly so), so my contract will be invalid (I've never seen a foolish contract like that in a court case, but very likely a judge would conclude that). It should be exactly the same with Wall Street. Economy and capitalism don't need these kinds of foolish tools to prosper.

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I was referring to the ownership of the bond.  By banning CDS, you are essentially denying my right to write an insurance policy against my own property (the bond.)  By requiring ownership of the underlying security, you largely mitigate moral hazard. 

 

I agree. But recent history tells me that sooner or later, it will go beyond that and people with bad intentions will come in. I remember a group of obscure people who said on long articles that basicaly Fairfax was bull******* about their tax liabilities and, oh, in the end of their articles, they said something like "we own some CDS against FFH default". What a questionable behavior!

 

If you want more examples of using some tools that are potentialy very moraly questionable, see:

 

deepcapture.com

Fairfax lawsuit posted on 26-07-2006

etc.

 

 

On the liberty point:

(a) Trust and the use of insurance.  Insurance against an event isn't about trust.  It's about recognizing that there are probabilities of huge events that are incalculable.

 

Well, if I would get a big payout if an event that would create a damage about I shouldn't basicaly financialy care, I would get an incentive to directly or indirectly "help" for that damage to happen. I'm not talking about a 5$ bet about the issue of a football game here. I'm talking about billions and billions of dollars bets against the default of companies that have collectively hundred of thousands employees.

 

If you insured your wife's wedding ring, I am sure it wasn't an indication that you don't trust her.

 

Well, if it was the contrary, I would be financialy stupid or simply insane.  ;)

 

It was simply a recognition that sometimes "stuff happens" that you can never see coming.

 

Yes, but again, to further extend my point, if I would be compensated a lot if my neighbor wedding would end up in a divorce, that would create an uncomfortable moral situation that I wouldn't want to get involved in. But, well, Wall Street like these kind of things and some of them actually "help" get some bad things to happen if they get compensated for that.

 

You can say that you can simply ask for better price on the bond to compensate you for that risk but I'd say that CDS-type instruments are designed to protect against some risks that some people can't price accurately.

 

If they can't price it accurately, why buy them in the first place? At least, they should ask to get directly compensated for the "unknown" risks, or otherwise just say "no" to the offer.

 

(b) On the lobbying point, it's a very logical point but lacks enough practicality for public policy in my view.  You can very well argue that we should ban, instead of regulate, CDS to prevent lobbyist manipulation but if you believe lobbyist manipulation is so strong, then how do you propose to pass that ban?

 

I'm no expert on how to pass legislation in the U.S. I just hope that, after more than a trillion of U.S. taxpayers money on the table, the timing is right to pass this kind of things, because if it is not, when will it be?

 

Regarding the practical point, if I do not allow them to have any active grenade in their house (but they can go ahead with G.I Joes plastic grenades filled with water), probably that they'll find another tools to have fun and lobby with. It's not like they haven't anything else to use their clients money to speculate with.

 

Lobbyists for financial firms will allow an outright ban on CDS when Hell freezes over.  They might, however, be able to accept regulation.

 

Well, like I said before, it is not like after a trillion of taxpayers money on the table because of their lack of prudence, they are really well positioned to ask for, allow or accept something before regulators get things done. But if regulators don't act now, what will they need to do to so? Now it's the perfect timing, not in 20 years.

 

Cheers!

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Guest longinvestor

Of course Munger is right. The world (financial and the rest) will function fine without these instruments.

 

The implication is interesting though. We have seen during much of the past 2 decades, the elite, especially the 20-something brightest minds go work on these and create these imaginative(imaginary) financial products. Come on, getting an ivy-league MBA was the ticket, was it not? To create what? This? Munger has often said that the business schools have been teaching the wrong stuff since he was in college. Is this the moment of truth where all the wrong teaching for 60 or so years has come to a-head to haunt the world?

 

If the "governors of the world" did ban folly in the finance world, how many people do we need just to keep accounts? For example how big of an accounting team does the 100+ Billion company Berkshire Hathaway have?

 

This is worth pondering, this is a question for the generation.

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I think one unintended consequence (even with holding the underlying bond) is that bondholders become less likely to compromise before default in terms of working-out the loan with the company as their economic incentive is not their.  In addition, I think there are other legitimate uses beyond just insuring a bond.  For example, re-insurance exposures by primary insurers.  So even if we allow them for legitimate hedging, we still may have the issue of issue outstanding greater than bond face value and subsequent distortions in the market.  Although, theoretically it may be good to have them, in practice I think it can lead to more risk-taking as some players think they are hedged (therefore leading to less due diligence and regulators allowing more unintended risk taking) and may not be and will lead to abuses that no one can control.  In addition, the CDS is the only instrument I know that is in essence is leveraged bet on failure of instruments that have a public good (i.e. bonds of financial services firm that allow the firms to offer lower rates due to the leverage factor).  Another angle I think is we have look at instruments that allow firms to aggregate risk and appear to have little risk but in fact have only aggregated risk and have become too big to fail.  I think CDSs fall into this camp.

 

Packer

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Yeah Packer, I think you touched on the most important part that everyone was missing.  CDS are leveraged.  You'll note that Munger wasn't calling for a ban on short selling which would fit his commentary in the same way (from what I've seen).  Leveraged bets can create a bizarre incentize structure beyond what a normal contract / security can create.  CDS are so dangerous because they are leveraged (IMO).

 

I generally agree with Munger, but there are simpler more 'free market' solutions:  Increase margin requirements for these instruments a lot, limit total outstanding CDS notional to some small fraction of the underlying, or many others.  I"m not a regulatory expert, but indeed something needs to be done.

 

Crazy times.

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Wow, never listened to munger before. he has a very slow voice...

 

I know he's super  smart but I couldn't bring myself to sit through the entire interview.

Has he always been like this?

 

The man is 85 years old.  Respect for your elders is good thing to remember. Do you have any relatives that old that take a active role in their community and are chairman of a successful public corporation?  Any that can still stand straight and talk clearly?

 

Cheers!

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Wow, never listened to munger before. he has a very slow voice...

 

I know he's super  smart but I couldn't bring myself to sit through the entire interview.

Has he always been like this?

 

Dude, Munger says more in one minute than some people say in a day, seriously.

 

I found him to be fascinating when I saw him at the meeting last year...his commentary is raw, unfiltered and definitely spot on. The  man has a self-awarded black belt in chutzpah. Granted that we all have varying tastes in just about everything but for my money, I'll gladly listen to him any time he is willing to talk.

 

-Crip

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BTW, I didn't see this posted anywhere, but Buffett solved the mystery of the price spike in Berkshire's CDS earlier this year.

 

He said that the companies they sold puts to were required by their "risk management" people to buy CDS to hedge against a Berkshire default.  This was made worse by the drop in the global markets -- the more that the markets dropped, the more the CDS cost them.  He also stated that they already modified one of the contracts so that the duration was shortened from 18 years to 8 or 10 and the strike price was reduced to 900-something, and he thought that was a direct result of having to buy CDS as ever more expensive prices.

 

He said if anyone else wanted to modify their puts, he'd be happy to do so.

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Mandeep, I think Munger speaks a little slowly partly because his words are very, very carefully measured.  Listen to anything he has to say...he's actually been more accurate than Buffett since I've listened to both over the years.  If he had gone out on his own instead of hiding away at Berkshire, I think more people would have recognized him as one of the greatest intellects of the 20th, and now 21st century.  Cheers!   

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