David Einhorn vs the bloggers on credit default swaps

On Friday, the FT published a piece detailing David Einhorn’s objections to credit default swaps, which he first raised in a recent letter to investors.

And by objections, we mean the boy-genius founder of Greenlight Capital thinks the instruments which have served him so profitably ought to be banned outright.

As he put it:

I think that trying to make safer credit default swaps is like trying to make safer asbestos

The FT story prompted some of the bigger guns in the econo-blogosphere to take a position on either side of the CDS divide.

Here’s Roger Ehrenberg at Information Arbitrage, in a post titled, “Deal with it, Mr. Einhorn“:

David Einhorn is without question an exceptionally bright man and a very astute investor. However, the latest message being delivered from his bully pulpit, proposing a ban on credit default swaps (CDS), is misguided at best and dangerous at worst. Are his motives for putting forth this radical view pure, or perhaps informed by the complexity of being an equity investor in a world where the entire capital structure can be sliced, diced and priced? I have no idea. But banning CDSs is akin to banning Twitter. Are there some negative outcomes associated with using each of these tools? Sure. But do their overall benefits outweigh their costs? I believe so. 

(FT Alphaville would posit that a ban on Twitter might actually be more beneficial than a ban on CDS, but then we’re neither technologists nor venture capitalists)

At the other extreme was Yves Smith, a long-time anti-CDS campaigner, who declared:

Credit default swaps have no redeeming social value

Paul Kedrosky took something of a middle ground, noting CDS were ‘proudly the tool of the Devil again‘:

I agree with David in many ways – and his writing is as fun as usual – but I don’t accept all of David’s reasons (although I agree the ability to so directly influence the path to default can be problematic).

(Kedrosky and Ehrenberg also debated the issue on – you guessed it – Twitter)

Meanwhile, Kid Dynamite offered ‘abstract thoughts on CDS and the fallacy of insuring your neighbor’s house’:

Some companies will see the value of their CDS widen when people fear for the company’s financial health. The CDS is a reflection of the fear, and not the cause of the company’s problems. To suggest that panic from widening CDS levels causes companies to collapse is like saying that avoiding marking assets to market makes them worth whatever we want them to be worth – limiting CDS trading would not alter the underlying health of the company, it would only mask it.

So, since one cannot effect the health of the company by owning CDS – since one cannot murder the company (or burn it down) via a CDS position, the “burning down your neighbor’s house” analogy goes up in smoke as a straw man fallacy.

All told, financial bloggers’ several thousand (mostly) cogent words to the hows, whys and wherefores of credit default swaps – and even the more extreme takes on the subject were largely more accurate than the following piece from BusinessWeek:

Credit Default Swaps Sink Jefferson County

Jefferson got mired in debt because it relied on complex credit default swaps to protect sewer bond issues against a jump in interest rates. When the economy turned sour last year, the default swaps backfired, and chaos ensued. The state so far has refused to throw the county a lifeline. That leaves just two options: declaring bankruptcy or renegotiating the debt with creditors. 

No, no, a thousand times no. Jefferson County’s woes — comprehensively chronicled by BusinessWeek’s new owner, Bloomberg — are attributable to interest rate swaps, and have not a wit to do with CDS.

Sloppy stories that conflate two entirely different kinds of derivatives do little to facilitate informed debate about credit default swaps, and all but guarantee they will continue to be viewed by the public (and Congress) as no more than financial weapons of mass destruction.

Related links:

Einhorn: CDS Part Of The Communist Conspiracy – Dealbreaker
Reading Between The Lines Of David Einhorn’s Attack On CDS – Zero Hedge

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