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MORE CDS CHATTER….Megan McArdle, who has been skeptical of the role of credit default swaps in the financial meltdown, publishes an email today from a reader that, I think, gets it about right:

As someone with a front-row seat to this crisis, let me say that there are people who trade CDS and do not understand crucial details of contract terms and bond seniority….Moreover, street-side participants in CDS have realized that they are counterparties to obligations they often don’t understand, and this has certainly played a role in both a) their unwillingness to extend credit and b) their inability to get credit from lenders who are uncertain of what their CDS obligations mean. THAT is why Buffett called them “financial weapons of mass destruction” — not because they START a war, but because they have immense capacity to radically ESCALATE it.

….[After the fall of Lehman Brothers] everyone started worrying about collateral, and then discovered that they were not able to properly worry about collateral, since they did not fully understand derivative collateral requirements. All they knew is that they were facing something big and scary, and so — once again collectively and naively — we all stopped lending just to be safe.

This is, roughly speaking, my understanding of what happened too. The CDS market is a highly useful one, but it’s too opaque; it’s too hard to truly know what your CDS counterparty risk really is; and collateral requirements can amplify a downward spiral and cause bank failures that otherwise wouldn’t have happened. There are regulatory answers for all these things, and although they probably wouldn’t eliminate problems in the future (nothing can do that, I imagine), they might reduce them considerably.

On another note, Megan has apparently cast her vote for “CDSs” as the plural of CDS. I’d opt for “CDSes” myself, but I’m open to anything that’s an actual, rather than an implied, plural. Perhaps this will start a trend.

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