An invitation from the Banking Lobby: Enter the Matrix

I've been reading Congressional testimony on derivatives and I couldn't help but imagine the initial sales talk that took place some time before the action in The Matrix.

While credit derivatives are often pejoratively described in the media as a “bet”, it is important to realize that one could equally describe all investments as “bets”. When we buy the stock of a corporation, we are “betting” that the stock will be worth more in the future than what we paid.

The matrix has been carefully designed to simulate the world with which you are familiar. Any differences you perceive are not actually differences ...

The fact that the underlying credit is NOT a party to the agreement and, further, that neither the protection buyer nor the protection seller needs to own the debt of the entity, has also recently been subject to a great deal of media hyperbole. This fact is frequently and shrilly cited as evidence that credit derivatives are a “bet”. But exactly the same statement could be made about futures contracts or stock options – neither the purchaser or the seller of those contracts needs to hold a position in the underlying commodity or stock

You may be familiar with the matrix already in the form of an alternate reality games: there is really no need to distinguish between the matrix and harmless entertainment.

Consider Bank B which wants to diversify its credit exposure but does not have a relationship with the quality of credits it desires. Bank B can sell protection through a credit default swap as an alternative to making loans or buying bonds. This is economically equivalent to lending directly to the desired credits. [Read: While we don't actually lend any money, our derivatives are "economically equivalent to lending".]

When you enter the matrix we can assure you that you and your constituents will not notice that anything has changed.

It is important to remember that credit default swaps, like all derivative contracts, are zero sum contracts – the loss of one party in the contract exactly equals the gain of the other party. In aggregate, therefore, the losses incurred by protection providers equal the gains realized by protection buyers, making the overall CDS market a “closed system”, where gross losses equal gross gains, and both, when added, net to zero. This is in contrast to the cash bond market where credit losses result in permanent loss of value. [Read: Since it is unimaginable for a counterparty to go bankrupt, we have successfully created a financial product with no possibility of "permanent loss".]

Moving to the matrix brings with it great advantages. In a world without gravity, you can jump tall buildings at a single bound ...

The actual number that we should focus on is the gross replacement value of all outstanding credit default swaps, which according to the BBA was a little over $2 trillion at the end of 2007, or just under 3.5% of the notional amount for that period. That number represents the cost of replacing all the existing contracts in the market, just as the market price of an equity security represents the price at which it can be bought or sold in the open market. It is equal to the difference between the present value of fixed-rate premium payments to be made by protection buyers and the present value of the credit event-driven payments that the market expects will be made by protection sellers over the life of the swaps. [Read: Since everybody knows that we have perfected the models used to determine expected losses, you can feel confident that our prices are at least as accurate as simple stock market valuations.]

... or even dodge bullets.

In fact, according to the BBA, dealer positions represent more than 50% of the
of the credit default swap market and, as can best be determined from public
disclosures, have nearly equally balanced CDS exposures, consistent with the
dealer business model.

What? You're worried that when you and your constituents are all in the matrix, you'll be too dependent on the machines. Don't be ridiculous. As best can be determined from public disclosures, the machines are behaving consistent with our expectations. What could possibly go wrong?