Ever since the financial crisis began there has been talk about the need for financial reform. In particular, a certain kind of financial instruments called derivatives have been attacked  as too risky; a plaything for risk-loving speculators who are gambling with other people’s money.

First of all I’d like to say that that view of derivatives is a result of misinformation. As a matter of fact, derivatives can be used to make a portfolio LESS risky (through hedging and diversification), not more. I’m not about to start a lecture on portfolio management (actually, maybe I am), I just wanted to make that clear.

Now in this post I’d like to discuss one of the most criticized and least understood derivatives: Credit default swaps. The inspiration to this post came from a recent chat I had with one of my professors. Basically what happened was I had an idea for how CDS could be improved, and he went on to state that CDS doesn’t really work at all and that the concept is unlikely to survive the crisis (just like portfolio insurance, which was really popular in the 1980’s but died out after the stock market crash in -87). Now, I don’t completely agree with him on this, but he did make a couple of very interesting points that needs to be discussed.

First of all, what is a credit default swap? What it basically means is that if, for instance, you buy a bond and you’re not sure if the government or corporation is going to pay back (you think there’s a risk of bankruptcy), you can buy a CDS as a protection against default. If the government/corporation does default, then the guy you bought the CDS from will have to compensate you. Sure, the return will be a little lower (because of the cost of buying the CDS), but on the other hand, you’ll get your money no matter what. You get a risk-free return, normally much higher than the normal risk-free return.

Sounds too good to be true? It is. CDS are supposed to measure default risk; a high CDS yield means a high default risk and vice versa. CDS is therefore a kind of insurance; and of course, if you want to insure yourself against a greek default, you’ll have to pay more than if you’re insuring yourself against a norwegian default (Norway has one of the healthiest economies in the world).

What’s the problem?

Let’s say you’re insuring your car worth $10,000. There’s about a 1 % chance you’ll lose the car in a given year (hit by lightning, crashed, stolen – doesn’t matter for this purpose). So, you’re willing to pay about $100 per year to insure the car. The insurance company will then reimburse you if you somehow lose your car. As a matter of fact, you’d probably be willing to pay a bit more than $100, because you’re risk averse and buying insurance means at least you’ll never risk losing the entire $10,000 the car is worth.

Now, let’s assume there’s a 50 % risk the insurance company will default if forced to pay you the $10,000. How much would you be willing to pay for the insurance? Probably around $50. The insurance is not as protecting as it was in the first scenario, when you were guraranteed the money in case something happened to your car.

So what does this have to do with CDS?

One big problem with CDS is that the issuers of the swaps would themselves default, if a big country were to default. Goldman Sachs for instance has issued millions of CDS, but if the US were to default on its debt, Goldman Sachs and all their competitors (JP Morgan, BOA etc) would all fail (because they happen to hold a lot of american bonds, and because their health is very much dependent on the health of the US economy). And so, everyone who’s bought a CDS from any of these investment banks would find their swaps were suddenly worthless.

To summarize the problem: The price of a CDS can mislead people about the actual default risk; it may be that investors are not buying a CDS because they fear the issuer isn’t going to survive a default, not because they don’t think a default is going to happen. Since investment banks are responsible for issuing the swaps, and since probably every IB on the globe would explode if the US were to default, then no-one can really promise to pay something in the event of a US default. Therefore, the price of a CDS on US bonds may become depressed – it only attracts investors who believe that 1) there is a significant risk of a US default and 2)  that the investment banking industry would survive such a default. That’s not a whole lot of people.

If someone offered you an “end of the world insurance”, would you buy it? You’d pay him $100 now, and in case the world were to end within the next five years, you’d get $10,000. Of course you wouldn’t (unless you’re an environmentalist – they’re not very bright). If the world were to end, the guy you bought the insurance for would presumably die and all his assets perish, so he wouldn’t be able to pay you the $10,000 – and you and all your relatives would die too, so even if he could, what use would the money be to you?

The US defaulting is essentially an “end of the world” scenario – it would mean a financial apocalypse greater than the world has ever seen before. Insuring yourself against a US default through a CDS makes just as little sense as buying an “end of the world insurance”. Every bank issuing a CDS on the US would themselves go bust if a default were to happen, and in addition to that, the dollar would probably not be worth a whole lot – so the money you get, if you get any, would be worth much less than the money you originally paid.

If it’s a smaller country than the US – say, Iceland – then a CDS just might work. The thing is, the investment bank that issues the CDS must be able to survive a default by the country that the CDS is written on.

Now the important question is: Regulation or not? I’d imagine some Ron Paul Republicans and libertarians in general might argue that if someone wants to buy a worthless insurance, that’s none of the government’s business. After all, if we allow the government to take away our right to buy worthless insurance, soon they will have probably taken away our right to buy not only food but books that the government considers to be equally worthless (libertarians have a really twisted kind of “road to serfdom”-logic when it comes to these issues).

I can’t really argue with the libertarians as they oppose any kind of financial regulation. Well, I could, but that would be off topic. Most conservatives would agree that some regulation is necessary, to prevent fraud for example. While we as conservatives may not like financial regulation, we still don’t want to allow ponzi schemes, right? We were as outraged as everyone else by Madoff’s fraud, and we agree that the government should track down and stop such schemes.

My point here is that a CDS on a US bond is really no better than a ponzi scheme. It may not have the same structure, and there may not be a bad intention behind the CDS, but it is at the end of the day a fraud. You’re asked to pay for something that you’re never going to get.

Should we then ban credit default swaps? Many on the left would argue we should, but then they want to ban really just about everything they don’t understand. I personally believe that while CDS should not be banned, if you issue them, you should be forced to prove that you can withstand a default. If Goldman Sachs wants to issue a CDS on a greek government bond, they’ll have to prove not only that they can pay up whatever they might owe the guy on the other side of the deal in case of a default, but also that they can survive the direct and indirect consequences such a default would have. In the case of Greece, maybe they could. In the case of the US, they definitely couldn’t. I’m just talking about simple stress tests and risk analysis, nothing overly complicated when you think about it.

This isn’t going to destroy America’s competitiveness (because seriously, who can compete with America when it comes to finance?), nor is it going to raise the cost of doing business. It will simply get rid of another fraud. As conservatives, we are supposed to be tough on crime. That should apply to any crime, including white collar frauds like these swaps.

Let’s get tough on them. Thank you for reading.

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