I am writing this document at a hotel where the ICBI financial conference "Risk Capital 2007" is taking place (Note 1: ICBI Risk Capital 2007.) Consultants and representatives of financial institutions from all over the world attend this conference. And the chairman of the Basel Committee on Banking Supervision gave a lecture, though this event was hosted by the private sector. The event seemed to be a great opportunity for regulation authorities to communicate with the private sector. These events are interesting in that you can hear the real opinions of people working in the financial services sector. I would like to introduce one of many interesting themes that came up at this event.
The new BIS regulation (Basel II) goes into effect in various nations this fiscal year and onward. This regulation will change the minimum capital requirement for financial institutions depending on the credit level of their assets. (Please refer to chart below.)
BStart of Basel II will Increase Significance of EC (Economic Capital) Management
According to a presentation by Deutsche Bank, the fluctuation margin will be a whopping 15%. Doesn't it seem significant when you see it in numbers like that?
After the implementation of Basel II, financial institutions will have to consider four types of capital. The four types are (1) market capitalization (2) capitalization on their accounting books (3) minimum capital requirements under the BIS regulation (4) capital calculated under an internal model. Market participants largely believe that the figures for number (3) and (4) differ because Basel II itself does not reflect the true risk volume. Regulation authorities are also turning a blind eye to that (The second pillar (Pillar II) financial institution's self-management and monitoring inspection) so each financial institution is conducting risk management according to internal standards different from those complying to the BIS regulation. (Note 2: The Problems of Pillar II & III) For reference, the figure calculated under (4) tends to be much smaller than the figure calculated under (3). According to a presentation by Citibank, the minimum capital requirement set by the BIS regulation is four times larger when comparing the true risk volume. (Note 3: Are Minimum Capital Requirement Under BIS Regulation Too Excessive? )
That is why the implementation of Basel II will create new tasks - determining the Latitude of the figure calculated in (3), then calculating (4) and allocating them by business unit. Because it was not clear who had the professional authority to conduct these tasks, Deutsche Bank has abolished the conventional ALM committee and launched a new committee called the Capital and Risk Committee, which will have all the authority over EC (Economic Capital) allocation. (Please refer to the chart below.)
Abolishing ALCO and Launching LEMG
According to Deutsche Bank, loan positions are calculated daily and transferred to the LEMG (Loan Exposure Management Group.) The LEMG is to take responsibility for either hedging in the market in the framework set by the CRC or taking it off the books. As people with experience in banking probably already know, there are obvious loopholes to this type of idealistic theory (Note 4: Is the Deutsche Bank Method Correct?) or have bad timing (Note 5: The Importance of CRO.) We should take note of how spread banking, which Japan adopted in the 1990s, has again become anachronistic.
In other words, this means that the roles of Board of Directors and management meetings at banks will change. In the past, the minimum capital requirement wouldn't have changed much, as we have noted in the chart above. That is why an ALM committee meeting was held just once every three months to allocate EC just for show. And bank managers only had to confirm appropriate limits. To exaggerate a bit, bank managers did not have to make business-related decisions during meetings aimed at discussing management. This is why banks did not need to have highly skilled workers in management.
But when Basel II is implemented, EC will change drastically. Banks will need their top management to make business decisions such as where to allocate excess EC (who to lend to), where to recover insufficient EC from, sacrifice profit and take them off the books and buy protection. This is why banks without smart management who have a good sense of the market and is willing to hold off positions during their term will have a tough time. Such banks will see their earnings fall sharply behind their rivals and be targeted for takeovers at the end of one economic cycle. This may become a reality for some banks.
On the other hand, the start of Basel II can be good news for bank managers who have accepted reality and feel ready to take on the new challenges. BASEL II rules can be interpreted as follows: If a rating is lowered due to some kind of external factor (economic changes) regarding the portfolio managed near the upper limits of the risk asset amount complying with the BASEL II framework, banks can increase lending to high-rated clients (which won't consume risk capital) but should recover loans to low-rated clients (which consume risk capital.) Regardless of whether the economic cycle is to blame or not, the problem of total lending and allocation to borrowers will be calculated mechanically as long as you provide the extrapolated scenario. The result is unbiased. That is why theoretically, "criticisms against real estate loans" and "criticism against credit crunches" - seen when the asset-inflated bubble economy collapsed - would be considered out of the question. Macro economic problems are the authority's problems, and financial institutions should float along when an economic bubble is created. And when banks foresee the collapse of an economic bubble, they have to recover loans or take them off the books. Otherwise - as noted earlier - they might be beaten out by rival banks, their share prices will fall, and they will become targets for a takeover. So if another economic bubble occurs, financial institutions should "go with the bubble." (Note 6: Will the Next Bubble and Collapse of the Next Bubble Be Caused By Policymaking Authorities?) Don't you think it is very simple and straight-forward? CPM - which has become a recent trend - should be nurtured in this way. (Note 7: The Scary Facts of CDS Leverage)
I first attended this type of meeting in 1990, dispatched from the bank I was working at then. And I have been attending these conferences irregularly ever since. The number of participants at conferences focusing on risk management has been dwindling until two or three years ago, perhaps because most financial institutions are done complying with BASEL II. This year's conference - titled "Risk Capital 2007" - was held in Paris between June 25th and 29th, 2007, attended by roughly 300 people.
But there are no new topics. I believe that the number of participants recovered due to the focus of risk management switching from technical theory to business theory. Sessions focusing on numerical calculations have lost popularity as most regular participants feel they already know everything there is to know. On the other hand, topics like how to reduce risks and anything to do with organizational structure attract a lot of participants. Though there are clearly no innovative solutions to these problems, participants wanted to hear from others who had similar problems.
Japanese participants always have a weak presence at these conferences, which I believe is a great waste. Most Japanese participants are regulars. They consist of us, two groups from major financial institutions, consultants and several first-timers. On the other hand, (non-Japanese) Asian participants have been increasing recently and have become a major force at these conferences. In the case of Japanese financial institutions, only understanding bosses will allow their subordinates to attend these conferences as part of work. Most Japanese financial institutions regard attendance at these conferences as a reward for hard work. We believe that these conferences are worth attending if one works in financial institutions. Especially conferences held every June to July and December - which many companies attend - even if one out of two, let's say, may not be very good. If any young banker needs to convince his or her boss to shoulder the costs for attending these conferences, please feel free to contact us. I would be happy to share some ideas from when I was a young banker on how to get my employers to shoulder the costs.
Pillar II of Basel II seems to be especially littered with problems. Evaluations are made by regulators, which may lead to unfairness among financial institutions. (This is the so-called problem of "leveling the playing field.") EU member states especially have powerful enemies (the London Stock Exchange, New York Stock Exchange) outside their regions and have less inter-market barriers compared with the Tokyo Stock Exchange. It seems that the regulators are also keeping a keen eye on the British FSA's attitudes and the compatibility of the US GAAP, and are seriously considering ways to lure profit to their respective countries.
On the other hand, Japan doesn't seem to be thinking of any such strategies. So far, it doesn't look like Japan's private sector will be complaining. There have been news reports about how some people in government are "trying to think seriously about the financial sector's national interest". But because Japan is an island country where red tape and government workers have immense power, the private sector seems to be blindly complying to new rules simply because "that's the way it's been decided".
The chairman of the Basel Committee on Banking Supervision has been "convincing" participants in a serious manner, but Pillar III often gets forgotten. Perhaps because many people in the gossip-loving private sector believe that Basel II itself is a failure. But we believe Pillar III - the problem of disclosure - will become a popular topic in the future.
Note 3: Are Capital Requirement Under BIS Regulation Too Excessive?
If we were to summarize the opinion of Citibank employees, it would look something like this: The drop in ratings and the increase in CDS spread tend to happen simultaneously. That's why it's hard to imagine that the perfectly correlated market supposed under Basel II will actually happen. Credit items are liquid, and as long as they can be sold in the market, the one year time horizon is too long.
That's what Citibank is saying. But this complaint came from the start of the Basel II-style IDR in the trading account, and is not a statement that the entire market necessarily agrees with. The Citibank employee who made the comment at the conference got a question from another participants saying "What about sub-prime mortgages?" and was caught struggling for an answer. We also think this statement is exaggerated. There are many loopholes in this statement that we can point out, such as Delphi, Ford, and GM getting their ratings lowered to speculative grade and the Amaranth case.
If you take the banking structure of Deutsche Bank, you can say it would be wise to centrally dispatch workers to LEMG, reduce the authority of each branch and introduce commission-based sales. This kind of thinking might work at a brokerage or in corporate banking. But it wouldn't work when your clients are SME (small and medium-sized enterprises) or individuals. On-site risk management is crucial to securing a profit margin, and it would be a huge problem if transactions were made without considering the maintenance of risk management. A simple example of this would be the recent banks run by local governments that were established to respond to complaints of credit crunches but have relied too heavily on scoring loans.
We believe that the presence of US Bankers Trust, which Deutsche Bank purchased earlier, had a strong presence behind Deutsche Bank's decision to implement such drastic reforms. US Bankers Trust leaned toward a top-heavy strategy, failed to win market approval in the end, saw business deteriorate and ended up being acquired.
When written like this, it may seem like nothing good will come out of this. But we believe the idea itself is not bad. What is important is that we choose the most appropriate measure suitable for the current plight, instead of implementing management reforms that are too radical and too showy, much like ideas proposed by consultants. That may not be fun for ordinary Japanese banks, but this is probably the moderate measure.
The reason why this type of CMP-like thinking is bad timing right now is because the world needs expanded risk assets, which is a 180-degree turn from the late 1990s to about 2000 when risk assets were shrinking. If you adopt CPM now, it might be good in the long run, but it will shrink profit in the short term. Would any bank manager be happy with falling ROE? Pillar III is the mechanism that stops this and achieves Pareto equilibrium. That is why we feel Pillar III is important as we proceed with CPM.
It is possible to have a business that is "showing profit growth on the accounting books but is doing awful in terms of Pillar III." So the role of the CRO will become as important as the role of the CFO. It is especially difficult to explain topics like performance and risk management to top management. This part is important because organizations are made up of people. Furthermore, you should forget about the opinions of unskilled analysts, economic reporters and analysts at an early stage. What happens when people outside the financial world - from politicians to editorial reporters - are not qualified? It would be really annoying for all of us if the media prompted "a version 2.0 of the bubble economy and the lost 20 years."
But it's true you can't manage a financial institution with just will and theory. When the economy is growing, the theoretical risk-return optimization point for financial institutions is at a level where the air-headed media would evaluate the bank as having "weak earnings." That's because the expected profitability at commercial banks is not so high to begin with. Therefore, there is a way to meet conditions set by regulators yet commit a moral hazard at a level where it may feel comfortable in terms of a newspaper editorial (demagogue or not.) In other words, it's not a BIS regulation but financial institutions need to seek an optimization point with reputational risks in mind.
There is probably no need to offer the following explanation to people who have had to comply with regulations. The BIS minimum capital requirement regulation's weak point is that cyclicality - in other words, the economic cycle - and minimum required capital have a direct correlation. To put it simply, lending grows during an economic growth period as long as we abide by BIS regulations, and lending shrinks when the economy is in a downturn. So the gap widens even more between mountain and valley shapes on a chart showing the economic cycle. If you need a bit more explanation, please refer to page 20 in the handout distributed at the lecture titled, The Present and Future of VaR, EaR Systems (First half) - Symposium organized by the Center for Research in Advanced Financial Technology at Tokyo Institute of Technology "Credit Risk Management: Its operations and theory".
I would like to take this opportunity to recommend a Japanese movie titled, "Bubble he Go! Time Machine wa Drum Shiki (Translated as: Go to the Bubble! The time machine is drum style)" (Directed by Yasuo Baba and released in 2007.) This film details how the economic bubble collapsed after the then-Ministry of Finance issued a notice in April 1990 about regulating the total volume of real estate loans, how the Japanese economy fell into a crisis, how the nation's debts expanded, how the income gap between citizens widened (is this collapse of the bubble really to blame for this?), how a former Long-Term Credit Bank of Japan banker turns into a bill collector who goes after (Japanese actress) Ryoko Hirosue (Former LTCB bankers should be angry about this!), and how the Japanese soccer team loses in Doha, Qatar. The film brilliantly paints the truth behind the collapse of the bubble economy. In other words, as the main protagonist Ryoko Hirosue screams in the film, "You shouldn't suddenly stop an economic bubble." The true cause of the bubble's collapse is the failure of macro-economic policy implementation. Of course, it's difficult to say whether that one notice to regulate the total volume of real estate loans alone had caused the bubble to collapse, but the plot is not bad. The film was so well plotted, we wondered whether there was an adviser or a bubble expert such as Hoichoi Productions, which made a long-term column (With a title roughly translated as "Moody Concept") starting in 1981 when the then Big Comic Spirits was turned into a monthly publication. (It is now a weekly publication.) As a modern economic film, I believe it was much better than the US film, "Enron: The Smartest Guys in the Room " released in 2005.
We regret that Japan's macro-economic policies had been correctly implemented during the bubble economy years. But why did the policies fail? You can find out one reason if you sit in Tokyo Metropolitan Hibiya Library and read compressed copies of the financial daily, the Nikkei Shimbun, from those bubble economy years. The business world was also overly excited, but the media added fuel to fire. So many articles made readers feel like those who weren't investing their money actively were fools. When the government implemented weak belt-tightening measures, then imposed a major regulation on total lending volume, credit expansion began taking a 180-degree turn. The media then shamelessly began going back on their previous statements and began publishing myopic criticism. What's regrettable is that experts had been pointing out from an early stage that the injection of public funds and other credit supplementing measures were the magic cure for the economy. But back then (and even now) even if people feel that newspapers were wrong, they don't say anything for fear of the media, the fourth estate. That's because if they were told that "a newspaper reporter was looking into your background," anyone would be petrified, regardless of whether the person had noticed whether he or she was actually being followed or looked into. The media blames the collapse of the economic bubble on the banks' real estate loans or prolonged credit crunches, or the problem with housing loan companies. Through editorials and commentaries, the media was even criticizing the credit supplementing measures, which should have been implemented at once from the start, insisting that such measures were shady or should be implemented cautiously. It's not clear whether this was newspaper opinion or the opinion of staff members working on the then popular TV news program called "News Station," but it is not difficult to imagine how people were afraid of voicing their opinion. Reading the comments now - decades later - it feels foolish. The cyclicality led by the media is apparent here and you can understand why the policies were not going anywhere. Young reporters at the Nikkei Shimbun are supposed to be really smart, yet perhaps they are too busy with internal matters, the higher up the corporate ladder they go it seems they become more oblivious to day-to-day goings of the real world. Like the bankers of those days, perhaps the Nikkei reporters could not stop their bosses from acting out. That is why we strongly recommend going to the Hibiya Library to understand the bubble. As a pun to the original movie title, I would say, "Go to the Bubble! From the Hibiya Library."
For those of you who don't remember or know the bubble economy days, and therefore do not have a feel for the times, you can instead read articles published before and after the collapse of the IT bubble in the spring of 2000. University students who don't know the IT bubble should check the Nikkei Shimbun's morning editions for the advertisement of Internet-protocol phone service provider Kinmirai Tsuushin Inc., which went bust after the Tokyo Metropolitan Police Department raided it in December 2006. The ad was placed several days before the company went under. Junior high and high school students who don't know Kinmirai Tsuushin should read articles about Second Life, operator of an online virtual world. Kinmirai Tsuushin's business plan of placing modems at home - which was no different from a pyramid scheme - was advertised on the front page of a major daily newspaper. Anyone who knows a little about the Internet, even those who were junior high school students then, should have noticed that something was fishy about this business and that they shouldn't get involved. And this is not a comment that can only be made in hindsight. Why didn't anyone tell people that there was something wrong with this business? Readers have no way of checking whether it was the newspaper editors' judgment, or whether there was pressure from the ad agency. The real Second Life was very different from the Second Life the newspaper depicted it to be. A vending machine that sells a car popular in terms of corporate commercials or newspapers is mostly ignored in the virtual world. (If you would like to confirm this, please search the word Nissan and teleport.) And to forcibly build up hype, the company even made a dedicated blog for these businesses. This must have been the result of a newspaper and an ad-seeking ad agency collaborating to write an article that would please the automaker's PR department chief who didn't know much about the Internet. In reality, we believe that some readers were shrugging their shoulders during the IT bubble and after the collapse of the economic bubble. As the Japanese proverb goes, "if you don't want any trouble, you shouldn't get close."
After the implementation of Basel II, it would have clearly been a contradiction, in terms of policy, to place responsibility on banks. When the current economic expansion changes into an economic contraction, what we will need is timely macro-economic policy and not the management effort of individual banks. So we should wait for smart government bureaucrats and a policy adjustment bodies although apparently, working for the central government has become an unpopular job. There are words to describe the fourth estate and people working for the fourth estate. But unlike the times during World War II, newspapers are now only one form of many forms of media including the Internet. People immediately talk about controlling the freedom of speech, but we should stop the outrageous activities of media outlets that are not worth protecting. (And we need to determine which media outlets are worth protecting.) And we shouldn't allow ourselves to be confused by the comments of scholars who act more like critics. The truth is, even people like Iwao Nakatani, famous for his beginner-level macro-economics, and Yukio Noguchi, prominent author of the series of books starting with the word "Cho" in Japanese (such as the most efficient way to study English or use time), and Kazuhito Ikeo of Nippon Finance Association make weird comments if you read their documents over a long period of time. On the other hand, we need to get experts and staff members, people who know a lot about the real world to express their opinions more, either over a blog or bulletin board.
However, worldly change is very scary. We feel that the number of people who enthusiastically read the Nikkei Shimbun is steadily on the decline. Even as I look around me, my colleague Tsutsui (formerly an employee at Sumitomo Bank) has stopped subscribing to the evening edition of the Nikkei long time ago. He has said that he will stop reading the morning editions as well, but is apparently reading the Asahi Shimbun's newspaper published for elementary school children. Even I, a fan of Nikkei Shimbun publications, have changed my reading habits to the following: It's been years since I began skipping Nikkei's editorials. (I don't read the editorials but I read the columns.) What I read first is the installments of serialized newspaper novels on the last page. I'm not joking. Even on the rare occasions when the Nikkei editorial jumps into my eyes (usually on Saturdays or Sundays when I have time), I think that magazines like SPA! or R25 - though they don't have the class that Nikkei has - are more accurate in terms of analysis. When I am on the train and see an ad for Shukan SPA! and see a headline that sounds interesting, I sometimes buy a copy. (This is as embarrassing as buying a copy of AERA and other women's magazines.) I have been steering away from Newsweek Japan's Japanese version, which I have been reading since the magazine's founding, because its articles are so awful. (In the middle of the Enron case, the magazine encouraged readers to learn about investing from America. And there is a misguided column written by an American living in Ogikubo. Because of these articles, it has become embarrassing to read Newsweek Japan on the trains.) For economic news, Bloomberg (the Japanese version) and Reuters (the Japanese version) are the best. Overseas news, especially, tend to come out wrong when filtered through Nikkei publications. For example, if you want to know about the U.S., watch CNN without going through a Japanese filter. Read Reuters first if you don't want to read biased news, because there are rumors that the Nikkei's top editors have a strong bias toward Richard Armitage (a high-ranking US government official.) I used to read the Chosun, a Korean paper, when there were disputes between Japan and South Korea. I have set all the major newspapers into my iGoogle page (formerly known as the Google personalized homepage.) I read general news on the Internet so I hardly ever read the Nikkei for general news. The Nikkei Shimbun's science and technology pages sometimes include unbelievable mistakes, so I never take them seriously. Hardcore science and technology fans should read Scientific American (I have been reading the Japanese magazine version of this without fail since I was in high school) and nature.com (this one I have never read.) For light reading about science and technology, one should read Slashdot (often abbreviated as /.) or CNET. Sometimes I peak into @IT or PC Watch because I want to read unprofessional articles about IT. As for financial news, I can get WSJ, FT, Barron's, FAZ, and the People's Daily from my set up on iGoogle. So I get information online before I read the Nikkei Shimbun's morning edition. Even ii has an online version (It's not the same as magazines, but if you want to know about hedge funds, you should forget the Nikkei Shimbun and read ii instead.) I read a couple of blogs as well, but because work-related issues wear me out, I have been enjoying "Fudosan Gyokai no Aruki kata (translated as "The way to get around the real estate industry"), "Kin Tetsuhiko no Life Style Running (translated as "Testuhiko Kin's Life Style Running.") as well as "Daily Portal Z." I don't read anything by so-called alpha bloggers because they tend to publish one good article once in a while like eye-catching fireworks and then just end right there. The articles I do like in the Nikkei Shimbun are the political articles which are deep in the closed world of Japan's so-called kisha clubs (journalists' clubs where only registered journalists can get information.) If I don't have time to read the Nikkei Shimbun's political pages, I just watch "Mino Monta no Asa Zuba," a show on TBS (which I think politicians are more conscious of compared with the Nikkei Shimbun.) Even if I don't have time, I read the Nikkei Shimbun's serialized novel called "Sekai wo Tsukutta Otoko: Genghis Khan" (translated as "Genghis Khan: the man who built the world.") (The novel before this one was not suitable for the morning edition although it provided a lot of good topics.) I also highly praise the Asahi Shimbun's newspaper for elementary school children, and the NHK Shukan Kodomo News (translated as "NHK's Weekly Children's News") which starts at 6:10pm every Saturday. It really makes me think about how difficult it is to explain the significance of M&As, the pension problem, the Iraq War, or the Minamata disease from a child's perspective. (You can't explain it unless you really understand the issues.) I don't watch any other TV shows right now, because I don't have time. I'm busy reading, (I'm a book worm) working, and running (I run a total of 250km a month. The distance you run won't betray you.) I don't Net surf as much as before because all the aforementioned Internet information is compiled onto one screen, thanks to iGoogle. I don't tell the younger generation or new recruits to read the Nikkei Shimbun recently. Instead, I think it's time to tell our new recruits to add certain news sources to their iGoogle accounts. I am telling my wife to use cell phones, insisting that "computers will soon disappear." (Whether or not iPhone will be the device to replace computers is a separate issue. But I think iPhones will replace smart phones like BlackBerry, which are widely used in North America.) Come to think of it, I have bought every Apple product (iMac, iPod, Intel Mac and others) on the day they were released on the market. There are now fewer people who understand what it means when I say, "It's like the Monday edition of the Nikkei Shimbun." According to Shukan Diamond, the Nikkei Financial Daily had considered discontinuing publications due to the decline in circulation and ad revenue. (Shukan Diamond's April 28/May 5th combined edition.) This reminds me, I had also turned down an offer to write for the Nikkei Financial Daily. Like the Nikkan Kogyo Shimbun (which fell into a financial crisis in 2003), the Nikkei Industrial Daily is de-facto funded entirely by ads. (There is a rumor that they will make articles out of anything if you just give them a topic.) So I wonder what the future lies for the Nikkei Industrial Daily. Is the paper getting a lot of ads? Come to think of it, lately we don't hear the question, "Have you read that article in the Nikkei Industrial Daily?" when talking to people from other companies. Do people read that paper anymore? At this rate - although the Nikkei BP is brilliant - will there be no need for the Nikkei Shimbun in the near future? We are in an age when major banks already had been targets of takeovers. How long can the Nikkei Shimbun fight against the free market economy using the power of its major shareholder and using the employee stock holder system as a shield in an age when even the Wall Street Journal may be bought out if many people choose the Internet as their medium of choice and the paper receives a baptism of sorts from the market? ... I don't know about recent graduates, top managers in their 50s and employees who have been shunted off their company's career track, but this is how hard-working company employees in their 20s to 40s feel about the media. (Or they should: else they won't be able to survive in this world.)
That's why when I flip the pages of the Nikkei Shimbun, I see a basic prophecy of a downfall. "Mene mene tekel upharsin" - like the blazing white words written on a picture at the London National Gallery. When X-day gets closer, when the next economic bubble builds up or collapses, we may not need to be conscious of luring public opinion in one way or another through a paper medium. When that happens, there may come a day when the Nikkei Shimbun will deteriorate to just another blogger, and a real debate about macro economic policy will fire up over the world wide web. But public opinion alone cannot maintain the world. Policy adjustment bodies are important.
Note 7: The Scary Facts of CDS Leverage
Although there is less hesitation now, derivatives of government bonds - in other words, bond futures and bond options - are sold in lots several tens of times the value of the original bond. The market for derivatives is far larger than that of the original asset.
CDS is the same. The derivative markets are much larger than the markets for the original corporate bonds or loan pools. That is why the markets for CDS/CLO/CDO are much larger and much more profitable than liquid bond markets. That is why these markets are great opportunities for financial institutions. When you look at CPMs, even if the market for original assets is underdeveloped, one can expect an effective hedging of CDS in terms of lots. What becomes problematic then is what regulators call "the market in abnormal conditions."
At the aforementioned conference, some people had pointed out this issue - though not very eloquently. The market has never experienced a crash of a CDS market that had developed rapidly built on original assets that are less liquid compared with government bonds. So what would happen if the market recoils like it did on the infamous Black Monday in 1987? Or would CDS or their original assets - CDO and loan pools - never recoil?
The Scary US Sub-Prime Market
However, we are not trying to say that CDS hedging is dangerous just because of these fears. Historically, we have gained knowledge through experiencing the dangers of doing derivatives all the way to IO/PO after making derivatives of this derivative of this derivative and so forth. And similarly - as history teaches us - the development and establishment of the original asset's markets is essential for derivatives to work. And - aside from overly done derivatives - derivatives that have secured liquidity can contribute to stabilizing the market. You can see this if you look at the one-day market movements of Oct. 19, 1987. CDS is essential for CPM to work efficiently. That's why market participants also feel a need for CDSs, like other derivatives, to be baptized by the market and prove their effectiveness in hedging.
By the way, the sequel to the 1987 Hollywood movie "Wall Street" is expected to be released in 2007. We are already looking forward to the release of this film.
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