Janet Tavakoli, ’81, on ‘How to Blow Up the World’

Because she wrote the book Credit Derivatives & Synthetic Structures, Janet Tavakoli, ’81, is regarded by some as “author of the manual on how to blow up the world,” Tavakoli told the Finance Roundtable at Gleacher Center on November 10.

“In one of his early 21st century annual reports, Warren Buffet called credit derivatives ‘weapons of mass destruction,’” she said. “That sound bite has just invaded the finance community, but it’s just a sound bite. President Bush didn’t find weapons of mass destruction in Iraq, and you’re not going to find them in the finance market either.”

Tavakoli, president of Tavakoli Structured Finance, prefers to call credit derivatives “surgical strikes against portfolio credit risks.”

“I think the fun in credit derivatives is exploiting the anomaly,” she said. “I like to tell people that anything you want to know about life you can learn by studying finance. At their best, credit derivatives help us get something we all want in a life partner: Below-average volatility and above-average performance.”

Tavakoli warned interested investors against accepting the standard documentation of credit default swap markets. “I see a lot of room for misunderstanding,” she said. “If you are in a credit derivatives contract, I don’t think you should treat it as a commoditized contract. Otherwise, you’re likely to have a lot of basis risk. If you have a specific problem and something specific that you’re trying to hedge, this is an over-the-counter market, so take out your pen and rewrite the terms.”

Calculating the probability of default and the recovery rate in case of default are the keys to estimating credit losses, Tavakoli said. “What people have been using in the market is asset correlation,” she said. “That’s pretty worthless, because what we really want is default correlation. If we guess probability of default correctly, we don’t even need default correlation.”

—Phil Rockrohr