Credit Default Swaps: Risk-Inducing, Or Risk-Stabilizing?

How much blame should the CDS market get?

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Like bankers' pay, credit default swaps were quickly blamed as one of the culprits of the financial crisis early on, but as the dust has settled people are seeing that they're more complicated. Rene Stulz of Ohio State has a new NBER working paper out that looks at the various costs and benefits of over-the-counter credit default swaps, and he comes to the conclusion that, barring further empirical research, the problem may have been not enough of a derivatives market in 2008, not too much:

Investors and financial institutions generally believed that ex ante AAA tranches of securitization had a very small probability of default. Ex post, it turned out that many AAA tranches unexpectedly lost a lot of value. Because these tranches were held in large amounts by levered institutions, the losses on these tranches led to knock-on losses, reduced confidence in financial institutions, and made it harder for banks to make loans. In all this, derivatives exposures at times increased uncertainty about the financial health of some institutions and led to losses at some institutions, but they also enabled institutions to hedge and hence to reduce the impact of the fall in subprime securities and in other securities. It may well be that more robust derivatives markets in housing would have produced useful information for investors that would have changed the evolution of housing markets before the crash and would have enabled investors to hedge against drops in house prices.

Stulz also makes some good points in response to those calling for regulation of derivatives trading through clearinghouses, rather than OTC:

the resources of U.S. clearinghouses are limited and they would have been strained by the ongoing problems of AIG. For instance, CME Clearing, the largest futures clearing house in the U.S., can draw on resources of $64 billion to cope with failures. The taxpayer bailout of AIG is a multiple of that amount... the problems of AIG would not have been avoided by the availability of a clearing house.