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Credit Default Swaps: Instruments of Financial Mayhem

March 1, 2012

By John K Rooney

Insurable interest is a necessary and legal component of insurance contracts, differentiating insurance from gambling.  It means the buyer of insurance has an interest in protecting the property or person being insured.  For instance, you can buy a fire insurance policy on your house, but not on your neighbor’s house.  People typically have an interest in protecting their house from fire, as opposed to a house owned by someone else.  In fact, a policy holder may have an incentive to burn down another man’s’ house if they could collect the insurance proceeds from the loss that only damaged their neighbor.  Clearly, this would be destructive to society.

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Credit default swaps (CDS) are like insurance policies that insure debt obligations (e.g. bonds), however, they are bought and sold regardless of insurable interest.  A hedge fund might buy credit default swaps on Lehman Brothers bonds, for example, actually hoping the bank will get into trouble (Lehman did fail).  When Lehman came under pressure, the value of their CDS contracts rose reflecting the likelihood the sellers of the “policies” would have to pony up money to pay off the CDS buyers. Before the recent market crash some investment banks knowingly packaged and sold the most risky sub-prime mortgages, with the help of AAA rubber stamping rating agencies.  Then they bought credit default swaps on these same issues anticipating the mortgage tranches to blow up.  Most buyers of debt insurance have no insurable interest in the underlying investment, since they are not using CDS for hedging purposes.  These traders expect to profit if the company’s bonds go into default, triggering the payoff.  That is, provided the bank or hedge fund that wrote the swaps are sound enough to pay the promised benefits to CDS holders.  On the other hand, hedgers who hold the underlying bonds are seeking to be made whole if there is a default on their investment.  They have a more legitimate reason to buy CDS, but they represent a small minority.

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During the 2008 market crash, some banks and hedge funds that held CDS contracts were short-selling the underlying stocks like Lehman Brothers, hoping a panic would drive the shares down further and force insolvencies.  These bear raids caused financial stocks to plummet, sending CDS prices through the roof as defaults seemed imminent.  All astute speculators know that banking is a confidence game.  Consequently, many of these buyers of debt insurance made out like bandits while John Q Public was left holding the bailout bag.  You and your children are bearing the burden of colossal CDS losses that, in turn, brought about increased government debt and inflation.

The Dodd-Frank financial reform act was supposed to help solve the systemic risk problem exacerbated by the gigantic CDS market, but it comes far short of the goal.  A few bones tossed to the pack like reduced debit card fees were diversions to appease the mob.  The too big to fails are even bigger and the global web of CDS contracts, generally sold without insurable interest, continues to threaten the economy.  Whereas the casino has been regulated and organized to some extent, and new margin requirements may weed out a few weak players, systemic risk is still monstrous.  One notable change is that while profits still go to the bankers who will buy more influence in Washington, the risk has been transferred to the public.  The “house” is now, more or less, officially backed by United States taxpayers.

I recommend we find a way to eradicate the irredeemable CDS market, that merely lines the pockets of financial manipulators.  Another alternative is to bring these financial instruments under states’ insurance jurisdiction.  Contracts would require insurable interest, such as holding an associated debt instrument, before purchase.   Additionally, writers of debt “insurance” would have to be adequately capitalized like other insurers.  This would eliminate almost all writers of CDS.

Do you welcome the probability of $5.00 – $7.00 a gallon gasoline?  That extra $30 you are spending at the grocer is a direct result of inflation from financial excesses and bailouts.  If America does not put an end to credit default swaps, what we have seen recently may just be the preview.

John K Rooney

Tri-Cities Liberty Alliance

Petersburg, VA

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