Hivemind, what's the matter with the credit derivatives market?
There's a very interesting story in today's New York Times about the credit derivatives market. That may sound like a contradiction in terms to some people, but stay with me... Apparently, there's a $26 trillion credit card derivative market that nobody really understands, not even the world's top financiers:
High on [the head of the Federal Reserve Bank of New York]'s to-do list is understanding and monitoring the $26 trillion credit derivatives market — twice the size of the United States economy — the fastest-growing financial market there is. Its explosive growth has greased the wheels of the global economy, increasing liquidity, spreading risk and minting money for Wall Street along the way. But it has surged at a time when volatility has been low, debt has been historically cheap and defaults have been virtually absent. When this market gets tested, no one knows for certain how it may react.
Even the heads of some of the world’s biggest banks seem overwhelmed by the size and complexity of credit derivatives. “It makes my head swim,” said Kenneth D. Lewis, the chief executive of Bank of America. [NYT]
Maybe some economically savvy readers can help me out here. It sounds like "a market nobody understands" is actually a euphemism that for a looming disaster that nobody knows how to fix.
In 2004, Mr. Geithner’s staff conducted an extensive review of counterparty risk. But rather than dump its conclusions on the industry, he chose to stay behind the scenes while encouraging Mr. Corrigan to reconvene the group. In January 2005, Mr. Corrigan brought together a group that included some of the most senior executives on Wall Street. Six months later, the group produced a report that made 47 recommendations on issues from the very technical to the philosophical.
Central to the report’s findings were shocking weaknesses in the way credit derivatives were being assigned and traded around without any sense of who owned what. The so-called “assignment issue” was simple: credit derivatives were negotiated by two parties, say JPMorgan and Goldman Sachs. But banks were “assigning” the contracts out to others — like hedge funds — without telling each other. It was a little bit like lending money to a friend who is really rich who in turn lends it to her deadbeat brother and fails to mention it. [NYT]
You've got to read the whole article to get a sense of the anxious bafflement of the financial establishment.
Is this portrayal accurate? If so, what's the underlying problem?
[Edit: I initially surmised that the credit card derivative industry had to do, at least in part, with speculation on unsecured consumer debt (credit cards). I misunderstood. However, I'm still baffled why nobody understands the credit derivatives industry and why there's such widespread anxiety about the state of the market.]