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Minyan Mailbag: Derivatives and Debt


...the level of debt and derivatives of debt have become monstrous and will eventualy overtake the system.


Dear Professor Sedacca,

Given the recent discussion of exposure, I wanted to know what you thought of this article.

The parts that whacked my eyeballs:

"Lisa Watkinson, head of structured credit business development at Lehman Brothers, says that in the unsecured CDS market, the total exposure underlying derivatives contracts has mushroomed to become worth a multiple of the value of the actual unsecured debt trading in the cash, or physical, market."


"Yet despite its potential, one problem for the LCDS market so far has been a shortage of buyers of protection, such as lenders hedging loan exposure or investors taking a negative view of credit. "[At a recent conference] the joke was there were 400 in attendance, but 398 were protection sellers and only two buyers," says Mr Price. But he adds that the situation is now improving. "Things have started to even out more."


"In addition, betting against the credit performance of leveraged loans no longer seems the non-starter it did for a time.

Default rates declined in recent years and remain at historical lows, but are now widely expected to start ticking higher. That means LCDS protection, typically bought under a five-year contract, could become more valuable."

Supposedly banks are now starting to buy these things. What impact do you think they have on the distribution of risk?

Thanks, as usual, for your time and insight,

~Minyan Candice


I think it is a very intelligent yet very difficult question to answer. So let me keep it simple. I think the level of debt and derivatives of debt have become monstrous and will eventualy overtake the system. Simple arithmatic. What causes it? No clue - some 'event,' I would imagine.

Timing is impossible. For example, debt to GDP has gone from 100% to 200% to 300% to 320% of GDP, yet it keeps rolling? When does it end at 500%? 1000%? No idea and it's too dangerous to guess. I just know that people don't know what they own and hence won't have a bidder when they need one - the Street won't buy 'em back - been there, done that on both sides. At any rate, yes, it is a time bomb, but how long is the fuse? Your guess is as good as mine. It is why we are focused on quality and intend to stay that way for quite a while. Thanks for the feedback.


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