This post is in response to Bagus' article entited: The Social Function of Credit-Default Swaps which can be read at www.mises.org/daily/4502
Parochial adj; very limited or narrow in scope or outlook
example: Philipp Bagus
Correctly, Bagus points out the self-validating nature of naked credit default swaps. In other words, they can increase distrust in banks by betting against them, forcing the banks to offer a wider spread. Where Bagus goes wrong is his conclusion that this makes CDS’s powerful corrective instruments that discipline banks.
The problem with the analysis is that it only looks at who is buying the CDS, never at who is selling. The seller is taking on the risk of default by insuring against default. Yet the companies that are doing this are not insurance companies- anyone can issue this insurance. This is not the case with most insurance. Insurance companies are regulated and are forced to hold reserves against the risk they are taking on and the quality of those reserves is monitored. In this way, people who take out insurance know what the odds are that they will collect from the insurance companies. Or, what the odds are of default.
The first problem with unregulated (and therefore unreserved) insurance such as CDS is the systemic risk that can be caused by bankruptcy of the CDS seller. AIG was a huge seller of CDS – and when they went bad the whole company went under- this means that anyone else that had investments and legitimate insurance with AIG would have lost everything – causing more bankruptcies, and so on.
The problem with naked CDS is this: If you write normal insurance on a house or a person’s life, you can only be required to pay it off once - that is a person can only die once. With naked CDS’s, a $100 million bond can be insured by anyone that bets against it. This could mean that a stupid company (which deserves to go out of business), that insures the $100 million ten times over could end up with $1 billion of debt if the bond defaults. This one stupid company can take down many many others, putting the overall economy at risk, and some would say forcing the government (taxpayer) to intervene.
The second problem, which Bagus touched on but not to its full extent, is that a naked CDS can be a problem even if they are written by an intelligent insurance company with normal reserves. A smart hedge fund can start buying CDS’s on a quality credit. They could buy $1 billion dollars even though there is only a $100 million dollar bond, and they could do this with 100 different providers. Since there is no exchange or clearing house, all of this is done with private contracts and so no one knows what is going on except the big buyer. The price will be pushed up, indicating higher risk for the seller, but there really isn’t higher risk, it’s just one buyer trying to successfully rig the market. This leads to the legitimate insurance company owning a less valuable asset (their CDS contract), and thus having to put up more reserves. If this happens enough, the insurance companies have financial difficulty, and you can have a financial crisis.
To make a proper analysis one must look at both the buyer and the seller. This is where Bagus went wrong, and this is why he comes to the wrong conclusion.
Forever pissing off PHDs,
Sylvester McMonkey McBean
