The Problem With Credit Default Swaps

| Wed Mar. 10, 2010 4:42 PM EST

Felix Salmon, who has been a one-man truth squad lately when it comes to credit default swaps, lauds Tuesday's CDS speech by CFTC head Gary Gensler as "by far the best thing written on the subject to date. He's absolutely right about pretty much everything." Among other things, Gensler favors exchange trading for CDS, stronger regulation of all OTC derivatives so that CDS pathologies don't just move elsewhere, and much more restrictive rules on allowing banks to use CDS to meet regulatory capital requirements. All good stuff.

But CDS are basically insurance policies on bonds or other financial instruments, and Gensler thinks that can be a problem too:

At the height of the crisis in the fall of 2008, stock prices, particularly of financial companies, were in a free fall. Some observers believe that CDS figured into that decline. They contend that, as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company’s prospects. This analysis has led some observers to suggest that credit default swap trading should be restricted or even prohibited when the protection buyer does not have an underlying interest.

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that “a mischievous kind of gaming or wagering” had caused “great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.” The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be “null and void to all intents and purposes.”

For a time, however, it remained legal to buy insurance on another person’s life in England. It took another 28 years and a new king, King George III, before Parliament banned insuring a life without an insurable interest.

Interesting! And it's a pretty good analogy that makes the underlying conflict understandable. However, although Gensler acknowledges the problem, he misses the aspect of this that's come to bother me the most: the effect this has on market stability.

Here's the problem: if you own a corporate bond of some kind, but don't want to run even the small risk of default that it carries, you can buy a CDS on that bond. This is basically fine. As Gensler points out, it does have the downside of making bond buyers less careful about due diligence, but that's probably manageable. (And Gensler has some ideas about how to manage it.) But what happens when lots of other people also buy a CDS on that bond? Obviously, you have the problem Gensler mentions, namely that under some circumstances these CDS owners might have a vested interest in helping the bond issuer fail — the same way you might want your house to catch on fire if it's insured for more than it's worth. But you also have another problem: if the bond issuer does default, and there are a hundred speculators who own CDS protection on one of its bond, you've gone from, say, a $10 million event to a $1 billion event. Basically, when things go bad — and eventually they always do — widespread CDS protection can cause things to spiral far more out of control than they would otherwise.

And what's the upside of allowing this? The argument I hear most often is that broad market trading of CDS provides an efficient price discovery mechanism for the underlying securities. Moody's may rate that bond AA, but the CDS market will tell you what traders really think.

I guess I have two questions about that. First, does it really work? Are CDS marks really reliable indicators of creditworthiness? That's debatable. Second, even if they are, is this a big enough benefit to make the instability risk worth it?

I'm no CDS expert, but I wish Gensler had at least addressed this problem. Maybe there's a simple solution. Or maybe the danger is a lot less than I think it is. It's not clear, for example, that CDS instability was a big problem in the 2008 crash. AIG was a big problem, but that's because they sold too much CDS without proper risk management or enough capital to back it up, not because speculators were loading up on specific issues.

So: Does widespread use of CDS make the financial system inherently less stable? Or is this just another of the endless slanders that CDS has to endure? Conversation on this topic welcome.