And yes, there is "a really useful reason for a credit default swap" -- it's pretty much the same as the really useful reason for the existence of equity markets. In the stock market, there are lots of sellers, and lots of buyers, and the public visibility of the market-clearing price creates a lot of value. The bond market, by contrast, has always been much more illiquid: bond investors tend to be buy-and-hold types (remember those pension funds and insurance companies) who buy up bonds at issue and then hold them to maturity. As a result, it can be very hard to short any given bond, or to get a useful bead on exactly what the market-clearing price on any given company's debt might be. Unless you have a liquid CDS market, which is very useful indeed when it comes to price discovery.The primary purpose of the equity markets is price discovery? I always thought the primary purpose was to raise capital. Or perhaps not only to raise new capital, but to reallocate capital through repurchases and acquisitions.
Even though it is a rather backwards justification of the social benefits of the equity markets, it seems irrefutable that the primary purpose of the bond markets is to assist corporations and governments to finance their activities. The fact that bonds get a credit rating -- which might be useful for something other then buying and selling the bonds per se -- is simply fortuitous, if in fact it is a benefit at all.
The primary purpose of the bond markets is NOT price discovery!
Another example of a benefit is this:
there were the long-term investors -- pension funds [for example] who would sell five-year credit protection with every intention of simply insuring that credit for the full five years, and pocketing the insurance premiums. Those players can't be considered to be speculators...They certainly weren't supposed to be speculators! However, lets examine a hypothetical transaction. A pension fund decided that they couldn't just buy bonds and stocks -- they decided they HAD to emulate Yale and were sold a portable alpha strategy. Your typical pension fund administrator should not be allowed within 500 feet of an investment banker, based on the same logic that applies to keeping children out of casinos. Part of the a portable alpha strategy is a replicating portfolio. The idea is to use derivatives of various types to replicate a benchmark using part of the cash and then use the remainder to buy some pure alpha from a hedge fund. One type of derivative used are credit derivatives.
In theory, a treasury plus a CDS is equivalent to the underlying bond. So you don't need to buy the real bond, you can buy as much exposure to the bond as you would like by buying a CDS. The premium from the bond and the interest from the treasury would give you as much or more then the underlying bond -- even after fees and expenses. Plus it isn't always easy to buy the exact bonds you might prefer in the real world. You might not be able to find a sufficient quantity of the preferred real bond.
It just so happens that some of the higher yielding bonds with investment grade credit ratings were financial entities like Lehman. Which is why there were a lot of Lehman CDS's floating around. A real bond pro would have understood that any outlier is more likely miss rated then miss priced. Or at least could tell the difference. But our naive pension fund buyers were loading up on the highest yield at any specific rating.
However, more to the point, the purpose of the bond markets is to provide financing to real world entities -- businesses and governments, not to grease the wheels of structured finance. And the idea that ALL the pension funds and endowments were going to do better then average by routing every dollar in cash through investment banks and their structured finance units is beyond naive. After all, even though a lot of financial theory assumes a frictionless world of highly efficient markets, someone has to pay for all the trappings of investment banking.
We haven't begun to see the damage these instruments have caused in pension funds and endowments, but we will soon enough.
As far as the liquidity argument is concerned, exactly how much liquidity has the CDS market provided during the credit freeze? If this were such a liquidity enhancer, then what the hell happened?
One thing that we do know is that people could attempt to short bonds via CDS's in quantities that exceeded the par value of the underlying issues by massive amounts. As great as shorting is, perhaps the limitation of shorting no more then the entire amount of the underlying issue should be maintained.
Perhaps some of the more adventurous pension funds might have tried to actively manage their the credit quality of their bond portfolio by selling these overpriced bonds rather than goofing around with portable alpha.
The flaw with the entire notion that derivatives provide much needed liquidity has been totally discredited by the failure of these markets. Only the most ideologically predisposed theorists could argue with a straight face that, if only we had larger credit derivative markets, the credit markets would have continued to function smoothly.
In fact, we just experienced unprecedented MARKET FAILURE.
The thought that people insist on looking for some higher truth -- like price discovery -- in an environment where markets have massively failed is mind boggling.