Not at all. From the market’s perspective, Buffett’s plan is probably the best proposed so far, but from the monoline’s perspective it’s one of the worst. A split allows them to keep their existing book and keep doing new business. Buffett’s plan would have deprived them of their existing book at an expensive price, given their dangerous new competitor huge market share instantaneously, and left them with less hope of doing new business in municipal finance. If they’d accepted it their shareholders would probably have sued.

And I agree that the proposed split between muni and other businesses is exceptionally problematic, since it leaves the buyers of non-muni insurance in a single toxic pool, when they thought they were joining a much larger and safer pool. In fact, I would say it marks a step towards the kind of abrogation of existing contracts that will be required in the event of a larger breakdown.

He’s talking about the CDS market, which is a necessarily win/lose bet. I.E. he doesn’t understand the basics of what he’s talking about.

Seriously, don’t worry. Even banks with huge exposures like Citigroup aren’t in any real danger of going bust. And the big Australian banks weren’t even dependent on the securitisation market for funding, so the impact on them is much more limited than on non-bank lenders. They did a fair bit of securitisation for capital and funding diversification purposes pre-Basle II, but there’s much less incentive for that now. I suspect that by far the main impact of the crisis on the big four was having to provide liquidity support to ABCP conduits, and even that’s something that affected smaller institutions more.

And Burritoboy, you find Mish close to idiotic? I thought his overall analysis is shrewd, but I could be wrong. I’m no financial genius—I couldn’t follow the half of what you said—but I was astute enough to sell out of the U.S., move my money to a friendly European country known for its chocolate and emigrate to Australia. (Years before I ever heard of Mish.)

If you have a moment, could you elaborate on why you think Mish (not that CDS Trader commenter) is on the nose? Here I’ve been feeling smug because his doom-laden scenario mirrors mine. You think perhaps the future is NOT black? Mate, I’m bummed!

Technically, delivery happens after one of a number of defined “credit events”, including but not limited to default. You’re right that simple financial stress isn’t enough, but depending on the nature of the underlying (eg investment grade corporate bond, high yield corporate bond, corporate loan, asset backed security), non-default events include restructuring and bankruptcy.

But I don’t think any of that amounts to “No need to worry”.

I agree that a breakdown in the credit default swap market would require both a spike in actual defaults and a big increase in counterparty risk, say because of actual or threatened insolvency of one or more money-center banks.

As you say, some increase in defaults is virtually certain at this point, and the volume of outstanding securities is far larger than last time this happened back in 2001. I don’t think anyone knows how big an increase in defaults would be needed to generate substantial stress in the market as a whole.

As regards failure of a money-center bank, I agree that still looks unlikely, but I think its far from impossible. Suppose that two or three of the shocks we’ve seen recently (“rogue” traders (or maybe scapegoats for failed internal controls, unexpected writedowns, failure of a subsidiary) hit one of them at once, and the governments involved mucked up the regulatory response.

1. The large notional value of credit derivatives, for instance, is misleading. Since it’s a derivative, the longer the derivative exists (generally) the lower it’s real value – because the underlying bond or occurance hasn’t yet happened and now simply has less time to happen. (Of course, on a specific company or event level, the circumstances might be that that particular company or event has weakened, bringing that particular bond or other closer to happening. But that’s not systemic – older derivatives will, as a group, be less valuable). Some of notional value of derivatives are actually more or less defunct stuff from years back that have little real value now.

2. You only have to physically deliver on CDS when the underlying bond actually, really defaults. Not when the bond is stressed, not when the company has a bad earnings report, not when the company has financial problems, not when the rating is lowered. It won’t (much) matter that, say, a muni bond’s rating is lower because the insurer of that muni goes bankrupt – the muni itself is closer to default (now that it lacks insurance) but the default rate of the muni is still probably quite low.

Will the default rate go up? Probably. But the physical settlement will actually only occur comparatively rarely (unless we’re asserting the economy will simply collapse, in which case we have plenty of more pressing problems).

And, of course, the occurance of companies or entities defaulting on their debt that underlies the CDS is somewhat idiosyncratic – GM may default, but Ford doesn’t. Or they both do, but in different years. Etc.

3. There are many flavors of credit derivatives. CDS are not really much like CDO’s, for instance. Interest-rate derivatives are not much like CDS or CDO’s.

4. The only real concern is if bad directional bets exist in a concentrated form somewhere within the system. I.E., that the banks are all very net long credits when the underlying credits are defaulting and the hedge funds are all net short. Or the insurers are all particularly net long, etc. This WAS the case with mortgage derivatives since the banks were the issuers / suppliers / servicers of those mortgage derivatives and made guarantees to clients about some of those mortgage derivatives – guarantees that are usually not common with other derivatives. That particular cause is not necessarily the case with other classes of derivatives.

5. The only real question is counterparty risk IF bad directional bets are highly concentrated somewhere within the system but especially so within the largest American money-center banks. While it’s certainly possible that bad directional bets are concentrated there within the system, it has to be this scenario to really be a major worry. Generally, the bank’s philosophies on CDS is (or, at least, was) to use them as hedges against their long exposure (their long exposure from the actual outstanding loans). Thus, those books should be relatively well-hedged. Other entities (hedge funds, but others as well) traded all sorts of strategies, but the collapse of a hedge fund (even an entire class of hedge funds) isn’t the problem that a collapsing bank system is. (And if the hedge funds bet wrong, that may actually rebound to the benefit of the banks, if the banks are on the other – the right- side of the hedgies’ wrong bets. Of course, that also hinges on who exactly supplied what leverage for those collapsed hedge funds.)

6. Now, if the banks used their CDS trading book as a seperate profit-making center, then that book could decline in value – but largely from bad bets (not probably outright defaults, since they’re fairly rare and idiosyncratic) that any trader could make, whether they’re working at a bank, hedge fund or any other trading desk. Again, the only huge worry here is if the banks’ trading books were all effectively betting the same wrong way. But that has little to do with the derivative markets’ size(s) or that they are derivatives, but just a critical part of the financial system making concentrated bad bets (just like making bad outright loans to South American countries in the Seventies, for instance).