What Me Worry about Credit Derivatives?

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
June 11, 2007

Originally, this was going to be about credit derivatives, but I'd be lucky to find 300 words worth of something to say about them. Then I started writing credit deriviatives and it was longer than 300 words, so it's back to being about credit derivatives after all. Or is it? Read on.

In case you are wondering what a credit derivative is, it's a financial instrument that pays off when a company goes broke. Ain't modern finance grand? Of course, now they come in all sorts of flavors that pay off in various ways when various combinations of companies go broke.

I was around when credit derivatives as I know them were invented at JP Morgan. I even got a green-and-white JP Morgan umbrella for attending their first mass sales pitch in some Wall Street auditorium that was not in their main building. The umbrella has vanished and that's sad because it's the only piece of Morgan swag I ever received.

(In the late 1990s, Morgan was approaching the end of their decades-long white button-down shirt and tie phase. When Morgan finally went business casual, I figured that I would never have to wear a tie again except at funerals. I was almost right. Fed conferences are another tie-worthy occasion.)

The most notable thing about JP Morgan's credit derivatives sales pitch was the public speaking style of the pitcher, Blythe Masters. She talked for what seemed like an eternity, but it was probably just a bit over half an hour. On a purely theatrical level, it was the most impressive talk that I've ever attended (and that's saying a lot). Ms. Masters managed to speak for the entire time as if she were reading from directly a script, but she wasn't. There was no sign of a teleprompter or other aid. Either she had memorized the entire talk or she had the most amazing impromptu speaking style. (I guess another alternative is that, like Buffybot, she's an android.)

In the dawning days of credit derivatives, they were not ready for prime time. The very limited contracts that were available made JPMorgan's other OTC derivatives look like a bargain.

Getting back to the present, everyone seems to agree that credit derivatives exert a strong stabilizing influence on financial markets, but only if at most a few companies go belly up at one time. All bets are off in the case of mass defaults and things will then be worse than if credit derivatives never existed. Since this belief is universal, it almost certainly must be wrong.

My personal insight into credit derivatives is that they have to potential to replace traditional equity. With Sarbanes-Oxley out there, old-fashioned equity is leaving the financial markets in bushel baskets. The riskiest pieces of credit derivatives have been known as "equity" from the beginning, so it's not much of a leap to substitute them for the real thing on the stock exchanges. Conceivable, "real" equity will become obsolete. Credit derivatives themselves arose because bank loans stopped making economic sense because of reserve requirements, making credit derivatives a more efficient way to either get exposure to credit risk (for a price, of course) or get rid of it.

Credit derivatives can also replace lottery tickets. Why pick balls with numbers on them when the whole point of the market mechanism is to select loser companies? (This is the point of it, isn't it?)

Okay, now that only serious or insane readers are remaining, I can discuss an interesting thing that happened to me that I'd rather write about instead of credit derivatives. Today (which is actually May 31), I finally added an uninterruptible power supply (UPS) to my main computer set-up. It is like a boat anchor, packing over 28 pounds into a small package, and includes surge protection and voltage regulation. I unplugged my computer and related equipment and then plugged everything back in. Among those items was my office stereo system, which is an essential item because music (mostly classical since at last the beginning of the year) is the main input into all my productive output. After I plugged everything back in, I turned the music back on and WOW!!!! It sounded much better. As audio propeller-heads say, the sound really "opened up." I would say that it made the music "yummy," but then that's why I don't write for audio magazines and may be a closet synesthete. (Damn you, Bill Gates, when are you going to give your spellchecker a vocabulary.) I could even hear the second violinist's fingernails growing and the tympanist engaged in frottage with the percussionist. If only the performers could learn a trick from Blythe Masters and memorize the score so that they wouldn't have to turn those noisy pages.

Now bear in mind that this is no placebo effect going on here. I acquired the UPS because I have suffered through four momentary power outages in the past week and while I had not lost much work, just getting everything running again is a pain. (Note on June 7: A few days about deploying the UPS, another power outage hit.) I did not purchase the UPS expecting it to do anything to my stereo. Indeed, I considered people who pay hundreds of dollars and up for "power conditioners" for their audio systems to be lunatics. My equipment is okay and would sound much better if I favored speaker placement being able to see my center monitor. (My "stereo" actually has five speakers and a subwoofer, but I'm getting old so it's still called a stereo.) I must say, however that the UPS appears to have improved the sound of my stereo.

The importance of the UPS is not that my music sound (or appear to sound) better, but that the world is full of things that could easily be made to work better and no one realizes it or does anything about it. I suspect that my stereo, which is slated for replacement really soon now, slowly degraded and could no longer handle the "bad power" generated by the power company formerly known as Niagara Mohawk and that the UPS improved their crummy power enough to fix the sound. On the other hand, it may simply have been years since I last actually "listened" to the music and it always sounded fine if I would only bother to listen to it.

All of this "connects" because my next two commentaries are about recent innovations in radio. Next month, I take on XM radio, which I am most fond of even if their satellites go on the fritz. In August, it's Internet radio time, especially as delivered by Roku's SoundBridge products (I own two of them-they were on Tweeter's clearance table last year.) I may have more to write about radio after that because I've retired from market prognostication and most of my retailing adventures involve Amazon and newegg these days.