OK, you’re officially clueless about the entire financial system. Have you ever even set foot inside an investment bank or an asset management firm?

This is hilarious. No doubt you have and like so many of your colleagues you probably never saw the housing bubble coming (which we benighted souls saw in 2005) until it burst in the summer of 2007. And I’m sure like them you correctly foresaw that it was no big deal and that markets had already factored it in by Fall 2007. Our talk of recession at the time, you folks, thought with your deep wisdom to be alarmist nonsense. I hope you see where I am going with this. You are making a claim to expert knowledge but if you have been disastrously and consistently wrong it is a ludicrous claim to make.

That the world’s biggest insurance company goes kablooey over its CDS exposure is just a blip for you. Again defending those in the market who have been wrong about everything, that have essentially collapsed the financial system, you might, I don’t know, just listen occasionally to those of us who got it right. A startling concept for you I’m sure.

Rock on Masaccio.

Being a taxpayer who now has “skin in the game” with my government’s investments in some of these investment banking firms and asset management gives me and every one of us every right to be involved in “serious discussions of the economy.” My personal opinion is that most of the innovative instruments like derivatives and these CDS’s ought to be outlawed. If you disagree, if you have constructive things to say in correction or even in criticism, I know I’d like to hear from someone who claims knowledge and expertise. But please do not talk down to people like massacio or people like myself who are not investment or finance professionals.

“Bonds are thinly traded?”

Corporate bonds, yes.

“According to the DTCC, there are a total of 101,559 CDSs with respect to the top 1000 reference entities, an average of 1001 each. The report says that there are 5,574 contracts outstanding for GM.”

That’s before netting. TriOptima — the firm that does compression runs — estimates that net CDS is about 1/10th of gross (though it differs depending on the underlying). Until the DTCC starts publishing data on novations, their numbers are useless.

“We know that taxpayers are footing the bill for the AIG CDSs, hoping that the Treasury will get that money back. Therefore I think the burden is on you to show that the possible improvement in price discovery, and any other benefit you think CDSs have, is worth the risks imposed on taxpayers. I don’t think so. Why do you?”

The problem with AIG was that they were the only major CDS player that only sold protection. Every other major CDS dealer hedges their exposure through novations; that’s Risk Management 101. Insurance companies are prohibited from selling their CDS contracts — i.e., buying an offsetting CDS through a novation. The monolines get around this by writing financial guaranty insurance on transformers that do their CDS bidding. For some bizarre reason, AIG chose not to use a captive transformer, and instead used AIG Financial Products as its CDS arm. That arrangement still didn’t allow them to sell their CDS, which meant they were stuck as a huge net seller on the Day the Music Died. That’s why AIG failed. However, AIG’s failure says something about the stupidity of AIG; it doesn’t say anything about the usefulness of CDS. AIG was a special case in the CDS market; no other major CDS dealer doesn’t sell the CDS they write to hedge their net exposure.

AIG’s failure doesn’t prove that CDS are useless, just like WaMu’s failure doesn’t prove that mortgages are useless. I can distinguish between inherently toxic financial instruments (like mezz CDOs) and misuse of valuable financial instruments. Can you?

We know that taxpayers are footing the bill for the AIG CDSs, hoping that the Treasury will get that money back. Therefore I think the burden is on you to show that the possible improvement in price discovery, and any other benefit you think CDSs have, is worth the risks imposed on taxpayers. I don’t think so. Why do you?

“It’s always good to see a true believer, especially one who can hang on to market fundamentalism in the face of reality.”

I’m a market fundamentalist because I think price discovery is a good thing? Huh? On the ideological spectrum, I’m roughly on par with Paul Krugman. What’s especially ironic is that you’re relying on the same exceedingly simplistic economic arguments that are the signature of market fundamentalists. It’s called “nuance,” kid. The world isn’t black-and-white.

You weren’t arguing that the CDS market doesn’t achieve price discovery, you were arguing that the whole idea of price discovery for creditworthiness being beneficial is wrong. And that’s just silly. If you have a (serious) argument for why CDS spreads don’t accurately price creditworthiness, then let’s hear it. But I doubt you do, given your obvious lack of knowledge about the basic workings of the CDS market.

“Maybe you can explain how the value of giant bets on bond prices is a better way of setting prices than an auction market.”

It’s sad that I have to explain it, but I will. Corporate bonds are thinly traded, because the number of issues of a given corporate bond is very small, and because they’re a lot more expensive than, say, stocks. The initial auction accurately prices the bond at the time of issue, but believe it or not, the creditworthiness of debtors often changes over time (it’s true, I swear). Because corporate bonds are thinly traded, the much thicker CDS market more accurately prices creditworthiness. If you don’t think accurately pricing corporate debt is valuable to the real economy, then you simply don’t belong in serious discussions about the economy.

“The covenants in bank loans permit on-site inspection of the day to day operations and financials of the borrower. Who has a clearer picture of creditworthiness, that banker, or some MBAs at JPMorgan Chase looking at weeks old financials and information spread around by word of mouth, and whatever leaks to the Wall Street Journal, supplemented by general information about the economy and the industry and whatever they can google?”

OK, you’re officially clueless about the entire financial system. Have you ever even set foot inside an investment bank or an asset management firm?

As for Stiglitz’s comments about opacity, I already said that opacity is the biggest problem in the CDS market. I agree that opacity, along with the exceedingly tight-coupling in the financial markets, is at the root of the financial crisis. But the biggest contributor in that regard — by far — was CDOs. Mezzanine, senior, and super-senior tranches of CDOs are now worthless. But the CDS market is still working pretty well.

I suggest you take some time to learn about the CDS market before you write another fact-free post about it.

Keynes prescription was to have “the State, which is in a position to calculate the marginal efficiency of capital goods on long views and on the basis of general social advantage, taking an ever greater responsibility for directly organizing investment; since it seems likely that the flucuations in the market estimation of the marginal efficiency of capital, calculated on the principles I have described above, will be too great to be offset by ny practicable changes in the rate of interest.”