Credit Default Swap Market Insanity, Squared

A few months ago I posted about the strange practice of gamblers buying credit default swaps on bonds that they did not own. I wrote how this practice was like buying fire insurance on your neighbor’s house, thereby giving the buying of this insurance the incentive to then burn down said neighbor’s house.

Well, it seems that planet finance has come up with a new, and even more insane, “innovation.” Eric Kraus, who writes colorful commentary on Russian finance at this website (I particularly like what he has to say about the embarrassing state of Western media coverage of Russia), notes that a recent hedge fund bought a bunch of CDS for bonds issued by the Kazakhstan government—that is, bonds that are the equivalent of US Treasury bills, but for Kazakhstan. Ok, sounds good. But there’s a small catch: it turns out that there is no such thing as a Kazakhstan government bond! None have ever been issued. Zero.

It’s one thing to buy insurance on something that you do not own. But it is quite another to buy insurance on something that doesn’t even exist! To return to my fire insurance analogy, it’s as if I bought fire insurance on your house…that you hadn’t even built yet! And I bought that insurance, let’s remember, in the hopes that your house would burn down IMMEDIATELY after construction was completed.

In actuality, the buyer of these phantom CDS do not intend to get paid when Kazakhstan defaults on its non-existent bonds (that is, your un-built house burns down immediately after it is constructed). These gamblers are simply counting on selling their CDS to other gamblers at a profit. They think that the perceived/imaginary risk of default of Kazakh government debt is going to increase in the future because, presumably, the Kazakh economy will go into the tank. They will then be able to sell their CDS contract at a higher price than they bought it for...provided that they can find someone else crazy enough to buy insurance on something that doesn’t exist.