The financial WMD's

Last week, I asked What's on your mind?, in hopes of finding out what's perplexing you, what questions aren't being answered, what issues aren't being covered. So I'm starting to respond to the questions that came in. The first one comes from Larry, who asks, are credit default swaps still legal?

The simple answer is yes, they are. I doubt all CDS's will be outlawed, but there's a lot of support for, at the very least, much stricter regulation. Despite being extremely complicated, you can boil CDS's down to two words: insurance and gambling, both of which are much more regulated than credit default swaps.

In case you need a quick primer -- A CDS is an insurance contract taken out on someone's debt. Let's say I hold debt in company A, but I'm worried about the company defaulting. I can pay a monthly premium to someone like AIG, and in the event company A does default on the bonds, I will be made whole by AIG. It's simple risk management.

The problem is that it isn't just me taking out insurance on the debt I hold. Company B, C, D, and hedge funds E and F take out some insurance too. They don't hold a single bond, but they get paid if company A defaults. It's a side bet -- absolutely and unequivocally straight up gambling -- and many of these contracts were created in less than the time it takes to spin a roulette wheel. They multiplied so fast that the total value of the market was measured in tens of trillions of dollars. The result is a financial system super-glued together.

I found a Fortune article from last September that's a good explanation of why CDS's became, as Warren Buffett once put it, weapons of mass destruction. From the article:

One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart...

"People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."

Three letters - AIG. AIG didn't set aside the money to cover all the contracts it was writing.
AIG assumed no houses would burn down. In a new Wall Street Journal column, George Soros says that's why the side bets have to be outlawed:

Only those who own the underlying bonds ought to be allowed to buy (credit default swaps). Instituting this rule would tame a destructive force and cut the price of the swaps. It would also save the U.S. Treasury a lot of money by reducing the loss on AIG's outstanding positions without abrogating any contracts.

It's kind of like naked short selling, which the SEC has essentially banned with heavy regulation. Short selling is still legal, but selling short without first actually borrowing the shares or proving they can be borrowed, isn't. Of course, some people claim that naked short selling still goes on despite the SEC's regulations.

But I think there's a good case that CDS's should be banned altogether. If you buy up debt, you take the risk of losing it all. No hedging allowed. The Insightful Trader says CDSs have eroded the incentive to keep companies out of bankruptcy. And they discourage doing good credit analysis on corporate bonds:

So now you have dumb bond buyers not bothering to do their homework because they expect insurers to bail them out -- and smart bond buyers sometimes buying weak credits because they can get bailed out, too. Both of which distort the bond pricing system which should give us clues about which companies are sound and which are not.

Some people think CDS's should be traded on an exchange to fix the problem of pricing and get the value of these contracts out in the open. Despite the possible advantages, I'd have serious reservations about opening up a new mechanism for trading these things. The priority should be to simplify, either by banning or heavily restricting them.

If you'd like an excellent visual explainer on CDS's, here's Paddy Hirsch's Whiteboard on them:

Untangling credit default swaps from Marketplace on Vimeo.

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