Credit Default Swaps: Self Regulating?

One common proposal for the new financial regime is regulation of credit default swaps.  A CDS is like life insurance on a bond.  (Here's my simple explanation, and my view of what went wrong with CDSs.)  A good example of a call for regulation is an article by my friend Bert Ely, generally a supporter of market forces.  He proposes that CDSs should only be bought by parties with an "insurable interest."  The analogy is to life insurance.  If you and I are not related, you are not allowed to buy life insurance on my life.

I'm about to tell you how the CDS problem is becoming a non-problem, but first let me quibble about the life insurance parallel.  There's a reason that you cannot buy insurance on my life: it would give you a big financial interest in bumping me off.  That would be bad for the insurance company, and bad for my health.

I don't see the problem with respect to corporate bonds.  I buy a CDS that will pay me if Chrysler goes bust.  I guess that gives me an incentive not to buy a Dodge, but I honestly wouldn't know how to go about killing the corporation.  (The owners, though, were able to do it.)  So there doesn't seem to be the risk involved here that there is with respect to life insurance.

So how does the CDS market learn to behave?  The same way we humans learn most lessons: by getting hurt.  The Wall Street Journal has an interesting account of a CDS deal that taught a number of traders an interesting lesson.  Here's the gist of it:

There were some debt securities backed by subprime loans.  The principal (after some losses and prepayments) amounted to $27 million.  The volume of credit default swaps written against the securities was $130 million.  Obviously, most of the folks buying the CDS on this security did not have an insurable interest, they were simply speculating that the bonds would default.

One investment firm, Amherst Holdings of Austin, was writing many CDSs on the securities.  They probably had sold CDSs that in aggregate far exceeded the $27 million of bonds outstanding.  They were paid a high price, often 80 to 90 cents on the dollar.  That is, the investor who wanted to speculate that these bonds would not be paid off made an upfront payment of 80 cents, in the hope of receiving one dollar later.  Take these numbers and multiply by millions, of course.

Then Amherst did a very clever trade:  they bought the underlying mortgage bonds at full value, 100 cents on the dollar, a price that was tremendously higher than a fair market price.  Why would they overpay?  So that the bonds would not go into default.  All of the CDS money, the 80 or 90 cents times millions of dollars, that Amherst received for writing the swaps?  Amherst kept that money.  They lost money on the bond purchase, but more than made up for it by pocketing the CDS payments.

I love a clever trade that is entirely legal and honest.  The folks on the other side of the trade are crying foul, but I don't see the basis for their complaint.

Why is this trade good for financial markets, and good for the economy?  It reins in the use of CDS by those without insurable interest.  If a CDS had been bought by a bondholder, he would have shrugged.  He doesn't care whether the bond pays off or whether the CDS pays off–he's in the same position either way.  It is only those who were simply gambling that got hurt.  Now they have a reason to be cautious.  And their caution comes without a government regulation preventing the instruments from being used.

Why not simply outlaw them?  CDSs have a role.  They make financial markets deeper, and more liquid.  It may be easier for a bond-holder to reduce his risk by buying a CDS than selling the bond.  Or he may not want to eliminate his risk entirely, just reduce it a little.  The CDS offers flexibility.  Why allow unrelated parties to be involved?  It deepens the market.  More transactions, more volume, and generally more accurate pricing.

The bigger principle, as I explained recently, is that many of our past financial mistakes will not be made again.  Re-read what happened to AIG in my earlier post.  Ask yourself how many companies are doing the AIG think now.  I think we've learned that lesson.