Credit Default Swap Market Insanity

I was cheered to hear a few days ago about a bill being introduced in Congress that would ban the sale of credit default swaps (CDS) to individuals or institutions that don’t own the underlying bond that the CDS is insuring. But after a lot of kicking and screaming from Wall St. lobbyists, Congress is now saying that the law would only apply for a limited amount of time. This cave to the commission-hungry CDS industry is extremely disappointing. Buying a CDS for a bond that you don’t own is basically a glorified form of gambling that also happens to give the “naked” CDS owner the incentive to undermine the integrity of the bond issuing company through rumor or massive short selling.

Think of a credit default swap as insurance on a house. (The house standing in for a bond that a company like General Electric would issue to raise money to built, say, a factory to make airplane engines). If you are the owner of a house (or GE bond), it makes perfect sense to insure that house in case it burns down (or, in the case of the bond, defaults on the interest payments). But on planet finance, I could call up a hedge fund or a company like AIG (before it imploded) and take out insurance on YOUR house. Why would I do such a silly thing? Well, because I think that any day now, someone might come along and burn down your house; or almost as good for me, I think that a whole bunch of other people will join me in thinking that your house is doomed, thereby driving up the price of insurance on your house and allowing me to sell the insurance I already bought at a profit. And since there is no limit to the amount of insurance that can be written on your house, the total value of the insurance contracts floating out there might eventually exceed the total value of the underlying house! This may seem all well and good for me (the “naked” insurance owner), but from the standpoint of the house owner, it is pure insanity. Looking out the window at a mass of people gambling on the price of insurance for your house, our pathetic little house owner might be excused for thinking that it’s only a matter of time before some loony throws a Molotov cocktail through their bedroom window.

And this is exactly what happened on planet finance. The Molotov cocktails came in the form of false rumors that [insert formerly prominent financial institution] "is on the verge of collapse." Financial evil-doers could also go another route to bring a company to its knees. Because the market for CDS on any given company is not all that big, the price of the CDS insurance could be easily driven higher by a strong wave of manipulative buying. This rise in price would then "signal" to the much bigger market in stock for that company that said company was in deep trouble (“Dude, there are people out there paying an arm and a leg for insurance on Frank's house—that sucker must be going up in flames any second now!). If that same manipulator who was driving up the price of CDS insurance also had a large bet that the stock in the company would go down, they could make a handsome profit when that stock tanked because of the CDS price “signal.” Many people think this type of manipulation contributed to the collapse of Lehman Brothers.

Over 80% of CDS contracts are bought by folks who don’t own the underlying bond. These are not “hedgers,” but gamblers. There is no justifiable need for these gamblers to use the CDS market to make bets against companies—short selling of the stock is a perfectly good substitute. It’s a shame Congress can’t stick to its guns and end this silly practice.