The End of CDS?

| Wed Jul. 15, 2009 11:02 AM EDT

Do you think the country would be better off if credit default swaps were banned?  Apparently so does someone in the House, who inserted language into the Waxman-Markey climate bill that would outlaw them.  The intent of the language, apparently, is to ban "naked swaps"; that is, to allow people to buy CDS insurance only on credit instruments that they themselves own.  But the actual language goes further.  Zach Carter reports:

Today, if a bank is worried that a debtor might default on a loan, it can still go to a CDS issuer like American International Group Inc. and buy insurance on that debt. But completely unrelated firms with no interest in the underlying loan can also go to AIG and bet that the debt will not be repaid. This kind of bet is known as a "naked swap" and, by 2007, the market for naked swaps was completely out of control. The notional value of the CDS market had exploded to over $62 trillion, according to the Depository Trust and Clearing Corporation, well in excess of the entire global economic output for a full year.

"Let's say there's $1 trillion worth of obligations in the economy. You can use CDS to create $5 trillion worth of additional obligations," said Joseph Pastore III, a managing partner with the Fox Rothschild LLP law firm who works with CDS. "When you melt it all down, and there's only $1 trillion worth of cash and $5 trillion worth of obligations, it causes absolute economic devastation."

Here's the key passage from Waxman-Markey, buried on page 1,070 of the 1,428-page bill introduced in the Senate on July 6:

[Blah blah blah....]

"Clearly, the intent was to limit the multiplier effect of CDS by requiring only those parties with a risk to be able to insure the risk," Pastore told SNL.

But the restrictions apply to "any person" who would "enter into" a CDS contract, not merely to any company that would purchase one. That means banks are allowed to hedge risks by purchasing CDS, but CDS issuers like AIG are actually forbidden from selling them. When AIG offers insurance protection, AIG is not hedging anything; it's just making a speculative bet that a certain debt will not be repaid. In practice, then, Waxman-Markey would ban any credit default swap whatsoever, hedge or bet.

"A literal reading of it would prevent anyone from entering into a CDS contract, because the party that owns the underlying instrument needs to find somebody else to enter into the swap agreement with," Pastore told SNL.

I assume this language will get cleaned up, and even if it doesn't the courts will likely rule that "enter into" merely means "buy."  But maybe not!  Maybe Waxman-Markey will obliterate the CDS market entirely.  Stay tuned.

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