Why some of the notorious financial instruments that helped bring down the financial system in 2008 really aren’t so bad.

Question: What is short selling, and should it be allowed?
 
Robert Engle: Well if you’ve got information about a company, or you believe that a company is undervalued, you can go out and buy their stock and you can make some profit on it.  And if a lot of people feel like this company is undervalued and go out and buy the stock, the stock price will go up reflecting the higher value of this company.  You might have information because you trade with them or because you’ve done some research on them. 

On the other hand, if you have information that a company is not as good as its stock market valuation, you don’t have a way to sell that stock unless you already own it.  And so that information doesn’t get incorporated in the company’s stock price as fast if you don’t allow short selling.  And so allowing short selling is allowing people to sell – instead of having to buy the stock and then sell it, which doesn’t do much; allow them to sell it, and then buy it.  In which case they can express that information and the idea is that you would get more accurate valuation of companies by letting people express both their positive information and their negative information through either long or short selling. 

Question: Is the collateralized debt obligation really such a bad thing?

Robert Engle: Oh I think it’s a wonderful creation.  The collateralized debt obligation, the CDO, is a structure which allows you to more or less continuously choose how much risk you want to take in a whole batch of securities.  And the reason why they got us into so much trouble is that it’s hard to figure out how much risk you really are taking.  And so, you could construct these things made with sub prime loans and believe that you weren’t taking any risk at all, even though all the loans in there were lousy.  So, I think what we need is better understanding of how to do risk analysis of a CDO, but that they still can perform a very valuable function because they can aggregate these risks and pass them around so that mortgages or other kinds of loans can be packaged and sold to investors all over the world, who in most times, would justify a small amount of each one.  They don’t – It turned out they thought they were so good they bought large amounts of them and then took enormous losses on them.

Question: Can you explain collateralized debt obligations?

Robert Engle: I have a little example I like to tell.  I don’t know whether you want to hear it or not, but it’s like from cooking.  Something may be on the Cooking Channel.  You combine in a glass some sand, some water, and some high class Tuscan Extra Virgin Olive Oil.  And you shake it all up and you ask somebody, how much would you pay for a little bit of this?  And the answer is, not too much because you’re gonna get sand and water in with your oil.  But if you wait, it’ll settle out and if you take it from the top, you’ll get oil.  And if you take it from the bottom, you’ll get sand.  So, the roll of the CDO is that, you’ve got all these **** and you don’t know which ones are the oil and which ones are the sand.  But over time, oil rises to the top and the triple A, or the senior **** have very few defaults and the equity **** at the bottom have lots of defaults.  So, you pay different amounts depending on whether you’re going to take it from the bottom or take it from the top. 

But it happened that no one expected was it got shaken up again.  It didn’t have time to settle out.  We had housing markets that deteriorated volatilities went up, correlations up, as soon as all these different parts were correlated, then the top is no better than the bottom.  It’s only if it settles out that the top is better than the bottom.  And so the failure of risk management was to recognize – was not to recognize that there could be increasing correlations and increasing volatility that would make the mixture more, more homogeneous and therefore less desirable.

Question: What are the benefits of credit default swaps?

Robert Engle: There are all these risks that we face in our businesses.  Some of them might be that a bond we own defaults, but much more important, I think, are that we sell things to another company and they go bankrupt before they can pay us.  We provide coffee to the lunchroom at some company, but you work up quite a bill after awhile, so what do you do if they go bankrupt?  Credit default swap gives you something to do.  You can buy some credit default swaps from them to protect yourself against the bankruptcy of people who owe you money.  And so this credit default swap gives you the ability to reduce your risks by paying a small fee.  And if you pay attention to where your exposures are, you might tend up buying credit default swaps against a variety of people that you – companies that you deal with. 

 So, this is the way it can reduce risks for all sorts of different kinds of activities.  And really not just for people who happen to be bond holders.  That’s why I don’t think the idea of requiring these to be only sold to people who have already own the bonds, in other words, this naked position that the Germans have recently put into their financial regulation and has been discussed here.  I don’t think that makes any sense. 

So what is the role that credit default swaps can play in an economy?  Well my feeling is that if these things actually will now be traded on either exchanges or some kind of central clearing, they are going to be a very good measure of the credit worthiness of different companies.  A better measure, in my opinion than rating agencies provide.  I think the credit default swaps can take the place of the rating agencies who really have missed the ball in this procedure and are quite conflicted by the way the ratings are paid for.  So, I would like to see credit default swaps become an evermore important way of understanding credit risk in the economy.

Recorded May 25, 2010
Interviewed by Andrew Dermont