CDSs Crash Land On Planet Gamma

In the preface to a previous post I mentioned the concept of correlation, denoted by the Greek letter γ (gamma). There is an excellent Wired magazine article by Felix Salmon that goes into significant detail on how a simplistic and short-sighted approach to correlation "sunk" Wall Street's CDO industry and precipitated today's crisis - or at least was its proximate cause. I highly recommend reading it.

Today, a bit more on my current view that correlation madness has ran its course and will fizzle back into obscurity.

First, a bit of background: I have in the past posited that CDSs are responsible for the lightning speed with which the crisis has spread from real estate to money, credit, equity and commodity markets. In chemistry terms, credit default swaps catalyzed a financial critical reaction, making it run faster and more destructively. They turned what could have been a severe - but otherwise normal - crisis into a runaway market meltdown.

[Note: Some think that all financial derivatives are bad - this is simply not so. According to the Bank for International Settlements as of June 2008 there were $683 trillion in nominal value of over the counter derivatives outstanding (OTC: not traded on regulated exchanges). Seventy five percent were interest rate swaps, forward rate agreements and foreign exchange swaps, i.e. run-of-the-mill instruments used in the daily operation of bank treasury departments. But the $57 trillion in CDSs are another species altogether.]

It was the newly created CDS market that provided the "toxic" structured product manufacturers (CDO, CDO squared and cubed, CPDOs, etc) with the ability to use and abuse low correlation values, and thus vastly expand the amounts of highly rated (AAA and AA) marketable tranches they could create. For example, a low gamma of +0.2 for a pool of mortgages would allow 70% of the pool to go into the AAA tranche, while a gamma of +0.5 would allow only 50% (all numbers hypothetical).

Once it was shown that actual correlation was higher when the real estate bubble burst, all hell broke loose. Every trader in the money and credit markets started plugging higher assumed correlation values into their spreadsheets, resulting in higher presumed risk and thus lower prices for everything from CDOs and equities to government bond spreads. The loop fed back into itself via - what else? - the CDS market, which now produced even higher gamma values. In other words, after a point the crisis was not only self-made but self-sustaining, too.

Understanding this "technical" cause of the current financial crisis leads us to conclude that part of the damage done to some credit and equity markets is pretty much artificial, i.e. not due to underlying economic fundamentals. That's why I have been saying recently that things are overdone on the downside.

The way out of this hole is pretty obvious, to me at least: use a modicum of common sense in evaluating risk and not exclusively arcane mathematical formulas that end up in the GIGO dustbin. In gamma terms, just as +0.2 was way too low for reality then, a gamma of +0.8 may be way too high now.

There are other necessary steps, too:

1. Reduce the nominal amount of CDS outstanding. Demand that every major counterparty comes to a "netting conference", where they will be required to drill down to the final customer level.
2. List all remaining positions on regulated exchanges that provide central clearing, position and margin limits, tight regulation and better transparency. This is harder than it sounds for the single name business (i.e. CDSs written on individual companies or entities) but should be very doable for the index business which constitutes a large portion of CDSs in existence.
3. Have all new business conform to standard futures exchanges policies that already exist regarding customer risk and disclosure, margin, position limits, etc.

I am pretty sure that all of the above are getting some attention from market participants, regulators and even some market-savvy politicians. And this is - partly, at least - why we are currently experiencing a rally in equity and credit markets. Let's call it a "relief rally" for now and leave it at that...

PS: In view of the above, I agree with FASB's recent ruling on mark to market.