Dean Baker has up a good post on credit default swaps (CDSs). He notes that CDSs transfer risk from the party best able to understand it to those who don’t understand it and that CDSs often don’t, actually, provide useful information on default risk.
Credit default swaps, at the end of the day are just insurance. They insure against loss of money due to default. Thus, they should be regulated like insurance.
Ae standard rule of insurance underwriting is that someone buying insurance must NEVER be better off if the event occurs than if it doesn’t. Ideally, they should always take a loss, the insurance should not make them completely whole.
This means, if you want to keep CDSs (and I’m fine with banning them outright), that:
1) no naked CDS’s should be written. ie. you can’t bet on a company going under unless you have loaned money to that company. You can’t sell a CDS to someone who doesn’t have that risk.
2) you cannot have a CDS whose value equals the value of your loans, otherwise you will want the business to fail. I would suggest an absolute maximum of 80% of the value of the loans. There’s a case for less.
I used to work in life insurance. In life insurance there are many studies which show that people who are worth more dead than alive, tend to die more often than they should. I am entirely confident the same is true of companies and government debt defaults. Since companies defaulting when they could survive is not in the public interest, credit default swaps need to be regulated so that it isn’t in the interest of holders of CDSs to put a knife into companies which would otherwise live, or to yawn and say “nope, not making a deal, we’re better of with you dead. Too bad what happens to the unsecured creditors, workers, stockholders and everyone else.”
minstrel hussain boy
here’s how i saw life insurance. i was talking with my earnest and well-meaning agent and he was heavy duty into the schpiel, i stopped him and said:
“ok. let me get this straight. i’m betting you that i’m gonna die, you’re betting me that i’m gonna live. we ante up quarterly and i spend the next three months hoping you win…”
Ian Welsh
hahaha
Exactly, MB!
Life insurance is where the customer bets he’s going to die before the life insurance company thinks he is!
If you win, you lose!
(Or, as I used to joke, when a life insurance company writes you about how sorry they are your spouse/parent/whoever died, you may rest assured they mean it from the bottom of their cold calculating heart.)
PPDCUS
Good recommendations all, Ian.
Unfortunately the odds are nil that effective regulation will reverse this dynamic by first protecting the real economy from predation by the financial & government capture economies in America.
These incentives only appear perversely toxic to the former, not the latter two economies, which depend on them for exponentially disproportionate returns while risk is laid off on others.
Frank is no Pecora. Obama is no FDR.
And Elizabeth Warren is Brooksley Born.
MyInsuranceLife
How sad. Yes, it is true. However, that is how it works with any type of insurance. Take for example car insurance, it is the exact same thing. But when you don’t have it, you always end up wishing you did. I recommend looking into something with cash value or an ROP (return of premium) policy, that way it’s a win-win.