Comment by flourpower | Hacker News Reader

Comment by flourpower | Hacker News Reader

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I think this tendency to mythologize certain financial derivatives is weird. The concept of a macro is way more complex than the concept of a credit default swap. To demonstrate, here is (in my opinion) an explanation of credit default swaps that a person with no financial background should be able to understand.

A bond is a contract created and sold by an "issuer". The issuer can be a government or a company. Ownership of the bond entitles you to payments from the issuer. The specific number and size of payments varies from bond to bond. Once the issuer sells the bond to someone, that person can sell the bond to anyone else they want.

A credit default swap is a contract between two parties (neither of which is necessarily the aforementioned issuer) that are usually called the protection buyer and the protection seller. This contract is made in reference to someone called the reference entity. The protection buyer agrees to make a series of payments to the protection seller in exchange for the protection seller's promise that, in the case of a "credit event", they will give the protection buyer either some specified amount of money or some specified amount of bonds. The nature of the payments and the meaning of "credit event" vary from contract to contract, but generally a "credit event" is understood to have occurred if the reference entity (which is always an issuer) fails to make payments on some of the bonds it has sold. Either party in the contract is free to find someone else to take up their side of the trade at whatever price they can negotiate.

The only thing you needed to know to understand that was what a contract was, but if you want to understand macros, you really need to know what an interpreter is.

It's also complicated by the legal framework. My (limited) understanding of the problems with CDOs in 2008 was that multiple buyers could purchase insurance on the same bond. It's like if I could buy fire insurance on your house. If a lot of us did that and your house burned down, the insurer would have been on the hook for many times the cost of the underlying asset. This is why we had to bail out AIG.

When it's spelled out like that, the idea seems preposterous. But the legal framework allowed it -- in certain contexts. AIG et al call them "CDOs" instead of just "insurance" so they could avoid the more-restrictive legal framework governing the insurance industry.

And given that a typical CDO is the size of a Manhattan phone book (remember those?), there obviously is a lot of nuance that a lot of people did not understand.

You're thinking of CDS, not CDO. CDS stands for credit default swap(s) and CDO stands for collateralized debt obligation. You're right that a CDO would be really big if you printed out a formal specification, but that's because a CDO is special trust where the trustee buys and sells different securitized products and tranches out the payments to shareholders in the trust.

Also - AIG could have made the same mistake with conventional home insurance. Say they only keep 100 dollars of cash around and they decide to insure a million houses, each with a value of one dollar. If one ten thousandth of the houses burn down, AIG goes bankrupt. So it's not true that selling a dollar notional of home insurance is less risky than selling a dollar notional of CDS, because it could easily be the case that the expected payout on the CDS is higher. CDS are just harder to price. There are very robust statistics about houses burning down - the statistics on whether homeowners would default were a lot trickier to deal with.

I think you're right about the basics of what a CDS is, but this doesn't really cover it. You also need to understand how the price of a CDS moves and why. Which can lead to much more complicated systems.

You're right, of course, but my point (and maybe I didn't make it very effectively) was that to acquire a similarly thorough understanding of macros would require way more information - I wasn't trying to make the point that a complete description of CDS could be given in a couple of paragraphs.

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