Monday, March 15, 2010

Credit Default Swamps

Since the whole Greece debacle, there has been a lot of talk about Credit Default Swaps (aka CDRs). Many European officials believe that CDRs exasperated problems in the Eurozone by allowing investors to speculate against Greece and other struggling members of the EU. Although there is still some debate on what impact CDRs had on the situation, there seems to be growing consensus that CDRs need to be regulated.

First lets look at what CDRs actually are. In the simplest of terms, they are bond insurance. For example, if I buy a Canadian bond, and I’m worried that Canada will default on their debt (and therefore won’t be able to pay me once the bond matures), I can buy a CDR, which will pay me in the event that Canada defaults. For investors, it can be a good way to hedge.

As is the nature of insurance, CDRs for certain bonds are costlier than others. To insure a Canadian bond would be cheap since the risk is minimal with Canada’s mature and reasonably well to do economy. Insuring a bond from some tumultuous nation with a weak economy will cost a good deal. This is why the cost of a CDR is how some people measure economic strength.

Unlike most forms of insurance, you aren’t required to own the underlying asset. For example, if I believe that Canada will default on its debt; I can buy a CDR and profit if Canada defaults. Unlike my first example, this situation doesn’t involve burning money on the bonds themselves, which makes the whole ordeal more profitable. These are called “naked” swaps.

The best way for me to articulate how demented the concept of “naked” swaps are is to give a little hypothetical. Imagine that you were never required to own underlying assets for any form of insurance. People could speculate about everything. I hear there’s a hurricane coming to Louisiana; I’m going to buy flood insurance for thousands of homes in New Orleans. I could buy insurance for every Asian woman’s’ car in the US. Geico commercials instead of selling you on the idea of saving money would have that annoying little lizard saying, “Buy ‘teenagers in sports cars’ insurance right here.” I could go and buy life insurance policies for nearly dead people. (Although that is sort of happening already.)

The major consequence of my hypothetical is that it would make insurance too expensive. Speculation about the quality of Asian women drivers would price them off the road. Speculation about flooding in New Orleans would price people out of their homes. Buying insurance for things you don’t own isn’t insurance. It’s gambling, which is a perfectly fine activity, but it isn’t something financial intermediaries should be involved with.

CDRs are one of the major reasons for AIG’s collapse, “The credit default swaps on this kind of CDO account for the lion's share of AIG's problems with default insurance.” If AIG wants to sell CDRs they should be able to, but just like Geico and every other insurance company, AIG should have to make sure people actually own the assets they’re insuring before they sell it to them.

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