Friday, March 12, 2010

Demonizing Credit Default Swaps

If you listen to Obama and the left tell the story, the cause of our economic meltdown had nothing to do with Fannie, Freddie, fraudulent bond ratings, or - at the heart of all of these - race based market distortions introduced by Democrats and protected with the race card right up until Fannie and Freddie failed. The left's boogyman is Wall St. greed as expressed through transferring risk to Fannie and Freddie and the use of Credit Default Swaps. And this meme has been picked up in Europe as regards Greece's fiscal meltdown.

I blogged on Credit Default Swaps in a long post on the origins of our economic meltdown here. Credit Default Swaps are basically insurance - a way of managing risk. There is nothing untoward about them - though they failed during the mortgage meltdown because of mark to market accounting rules along with a big assist from fraudulent bond ratings.

Now, the left, and the Europeans, want to place substantial restrictions on Credit Default Swaps. It is suffice, it to say, an unwise idea. This from Prof. Bainbridge:

. . . This is just absurd.

Let's review what credit default swaps are and how they work:

Credit default swaps (CDS) are a form of insurance. Let's say you borrow money from me. I'm worried that you might default. So I hedge that risk by purchasing a CDS. If you end up unable to pay me back, the seller of the CDS will cover my losses. (The insurance analogy admittedly is not exact, but it suffices for present purposes.

As the Journal explained, banning the use of CDSs as a hedging device would have adverse consequences, just as banning insurance would:

Any attempt to restrict CDS trades could result in unintended consequences such as more risk for the financial system and higher borrowing costs for a range of nations and companies, some analysts and investors warn.

Restricting credit-default swap trading could push up borrowing costs for various nations if investors feel they have fewer ways to protect themselves if the bonds' prices decline. . . .

. . . As the Journal explained:

[A] study released Monday by Germany's financial regulator, BaFin, found no evidence that credit-default swaps have been used to speculate against Greek national debt. The study showed the net volume of outstanding credit-default contracts on Greek national debt has remained unchanged since January at about $9 billion. This compares to total Greek government debt of about $400 billion. "The market data do not show massive speculation in CDSs," the regulator concluded. . . .

There is much more. Do read the entire post. The bottom line is that CDS perform an important function, and to regulate them out of existence or to severely circumscribe their use is very likely to have unwanted consequences. And the last thing the world economy needs now is more volatility.

Of course, that is the rational way of looking at it all. For Obama, who has shown that he is quite willing to demonize anyone (Chysler secured debt holders) or anything (insurance companies) for political ends, rationality would seem to be of little consequence.


feeblemind said...

But what happens when the seller of the CDS can't pay when you turn to collect from him? Say AIG for example? Shouldn't you both bear the loss for the folly of making and insuring high risk loans? Where is it written the American Taxpayer has to make things whole for you?

And that's the problem I have with CDS instruments.

suek said...

Guess I'm feebleminded too... If I understand it, it isn't the CDSs themselves that are the problem, it's the fact that those who were selling them didn't have the assets to pay them off when various bundles of mortgages failed. There's also a liability on the part of the mortgage investment bundlers who were not truthful about the bundles. In other words, people were cheating - one way or another - and the biggest "fix" the government could pull in order to stabilize the market would be to prosecute to the fullest those who engaged in deceptive practices.
On the other hand, caveat emptor - the government should not be on the hook for the failures of financial establishments who gambled and lost.

OBloodyHell said...

Agreed. It's not a problem with CDSs, it's with the idea that the government is somehow responsible for supporting them.

FM, it seems to me to be disingenuous to claim that, since the Fed is responsible, then more regulation is needed -- the problem lies in the notion that the Fed should be responsible.

That may not be what you're arguing but it does sound like it.

There's also the matter of "too big to fail" -- this IS something the government does have a say in, since it does deal with the notion that the taxpayers need to bail them out.

The solution there is to discourage things from collecting into such a large part of the market that their failure is a problem. This IS something the fed has gotten lax on of late, and IS something they have some say in regards to, since they do approve of any companies combining into one.

It may be less efficient to keep things apart, but in this case, there is a valid concern that the "new" entity could and or would make mistakes sufficient to rip down the market they're in. In which case business risk supersedes pure efficiency.

OBloodyHell said...

P.S., I think if you control more than 20% of the market then that's probably a bad thing. I use that argument by the fact that the "Big 5" accounting firms, one failed due to its incompetent oversight of Enron, and that didn't create a giant problem. That doesn't mean we need to break up the remaining "big 4", but it does mean we shouldn't allow them to combine into a "big 3" or less...

I think if a company naturally grows larger than 1/5th of the market, then let it be. But if there is an attempt to combine two (large) segments that will become larger than 2/5ths of the market, then that should be discouraged.