Reuters Magazine: Felix Salmon: The devil in the CDS

Fri Jan 27, 2012 11:12am EST
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By Felix Salmon

(Reuters) - The world of international finance is largely incomprehensible, even to its practitioners. Consequently, a whole industry, of which I am personally part, has sprung up to "explain finance" to the public. This makes the public think that understanding finance is something that is possible.

On top of that, finance is particularly susceptible to the kind of hubris that one finds in people who think that if they've made millions of dollars, they must be the "smart money," with an edge not only over the public but even over their fellow bankers and financiers. That, in turn, sets up some very easy morality plays. When the inevitable nemesis arrives, the weaknesses of the erstwhile Masters of the Universe are exposed for all to see, and those of us whose job it is to Explain Finance take every opportunity to spell out exactly what these prideful men got wrong. They weren't smart, they were stupid!

If very intelligent, successful, and aggressive men like Robert Rubin, John Thain, or Jon Corzine could be so stupid, then, realistically speaking, everybody was stupid. And if everybody was stupid, then, in reality, nobody was quite as stupid as we now think they were.

In the immediate aftermath of the financial crisis, a lot of books came out pointing fingers and assigning blame. We wanted to know why the crisis happened, how it happened, and whose fault it was. Inevitably, these books took on a political tinge - none more so than the final report of the Financial Crisis Inquiry Commission, which was disowned by all the Republicans on the commission for reasons that were intellectually dishonest but politically expedient. As the FCIC concluded, the crisis was avoidable. But the problem with assigning blame is that everybody tends to exonerate themselves and their friends: it's much easier to just blame others. As a result, no one ever learns any lessons. What we really need, in the wake of the Great Recession, is less fingerpointing and more insight. Happily, there is a surplus of insight in two recent books on subjects that have left the smartest people in the room looking dumb.

Nicholas Dunbar, author of "The Devil's Derivatives," is that rarest of animals: A genuine expert on the structured products at the heart of the crisis who is not afraid to tell the truth about just how harmful they were. Dunbar has spent his career in the structured-finance trade journals, which sets him apart from all the authors who had to try to work out what on earth was going on only after the world started falling apart. More importantly, Dunbar was one of the best-sourced journalists in the field long before the financial crisis hit.

Lots of big-name journalists tried to understand structured finance after the fact and many of them had long acquaintances with very important executives at big Wall Street banks. But getting people to talk to you honestly after the world has blown up is pretty much impossible. To know what people were thinking in the years when the sector was booming, when the seeds of disaster were being planted, you needed to be talking to them at the time. And that's exactly what Dunbar was doing.

Dunbar's also special in that he wasn't just talking to the senior Wall Street executives who tend to get wheeled out in front of the press on a regular basis. That's lucky, because those executives, as we now know, didn't really have a clue about what was going on. Instead, Dunbar was talking to midlevel traders and brokers and investors and regulators - the full apparatus of market participants who collectively managed to get everything so spectacularly wrong.

Dunbar's great at taking the long view of things, and you won't find a better explanation, anywhere, of why banks shouldn't mark their assets to market. This isn't an easy book to read, but it's a necessary book to read, because it reveals the deep structure of the crisis as no one else has managed to do, using real-world examples to explain, for instance, how ultra-safe credit ratings and massive yet unpredictable market volatility were two sides of the same coin. And if you want to understand credit default swaps (CDS), this is the first and last book you should read. Dunbar explains with ease how the CDS became the perfect instrument for banks looking to engage in regulatory arbitrage: they essentially allowed banks to turn credit risk, which required lots of capital, into counterparty risk, which didn't.   Continued...