Saturday, February 7, 2009

Waldmann on CDS

Robert Waldmann responds to my comments on CDS (which were a continuation of an exchange in the comments section). I must admit, though, I'm a bit puzzled by some of his responses. This, for instance:

In particular I think the pricing of debt implied by the CDS market was totally wrong.
Based on what? All the evidence suggests that the CDS market provides the most accurate prices, so this criticism doesn't really hold water. I'm also not entirely sure what Waldmann means by this:
If markets were efficient, then it would be very useful to look up a market price. If they are not efficient but not totally massively utterly wrong except as often as a stopped clock is right, then price discovery is socially useful. I don't think that market price discovery is socially useful.
He seems to be arguing that the price discovery provided by the CDS market isn't socially useful because CDS prices are completely and hopelessly wrong. But as I noted above, it's simply not true that CDS prices are hopelessly wrong. Back to Waldmann:
Also I'm not sure that any socially useful purpose is served by knowing exactly what bonds are worth. I'd say a socially useful interaction of bonds and financial markets is that people can buy a balanced portfolio of bonds -- a bond index fund when they are young and sell it when they retire.
Look, I understand that in the current environment, people want to avoid saying things like, "financial markets are useful because they efficiently allocate capital." But at the same time, saying that accurate bond prices are socially useful doesn't exactly make you an Efficient Markets apostle. And believe me, I'm no Efficient Markets apostle. How would Waldmann know whether his "balanced portfolio of bonds" is actually "balanced" without accurate bond prices? Accurate bond prices help lenders decide which businesses to lend money to. It's as simple as that. I'm not arguing that bond prices are accurate, just that accurate bond prices are socially useful. And while correcting small mispricings may not seem terribly useful to Waldmann, I assure you that the banks and other large investors that have billions of dollars of bonds would strongly disagree. A "small mispricing" in the bond market is probably larger than a lot of people's annual income. As for Waldmann's concerns about volatility, I'd point him to the study in the Journal of Fixed Income that I highlighted last week.


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