People are talking about regulating credit default swaps (CDS) .
They include Collin Petersen D-Minn who proposes making it illegal to own a CDS without owning the underlying instrument (this is absolutely standard for other kinds of insurance).
and George Soros who supports the proposal.
(via Felix Salmon)
A problem, I think, is that it is not clear how people can be forced to keep the underlying instrument, to use it to buy only one CDS etc.
I think there is a very simple regulation which will do the trick. For all future CDSs, the writer of the CDS is required to make scheduled payments on the instrument to the owner of the CDS if and only if the instrument is in default, and the CDS holder hands over the CDS and the insured instrument. This is called a physical settlement CDS. The regulation says that all CDSs written from now on are phyisical settlement CDSs no matter what is said or written in any contract whatsoever or anywhere else.
The time to check that someone really has suffered damage is when they file a claim. Then the insurer and the insured have diametrically opposite incentives and won’t collude to evade the regulation.
Soros has interesting thoughts on the damage done by CDSs which I quote and discuss after the jump
Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.
The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract.
No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS. These asymmetries are difficult to reconcile with the efficient market hypothesis, the notion that securities prices accurately reflect all known information.
The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.
Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.
This is a bit odd. Doubts about AIGs solvency should have reduced the value of CDSs written by AIG. The argument must work via an assumption that there was an attack on the world financial system or something, where fear meant demand for CDSs which brought down AIG which caused fear.
The argument about asymmetric returns is hard to reconcile with the assumption (never ever made by Soros) that people rationally maximize the expected discounted present value of a stream of utility which is a concave function of consumption. Obviously Soros thinks that there are compulsive gamblers out there messing up financial markets. I agree.
I don’t see the “No arbitrage can correct the mispricing. That can be clearly seen in US and UK government bonds, whose actual price is much higher than that implied by CDS.” argument. It seems to me that writing CDSs on US and UK government bonds is about as close to riskless arbitrage as one ever gets. Of course that’s what they thought at AIG too. Given the requirement on posting collateral, one needs deep pockets to profit from the mispricing. I think the US should insure UK debt and vice versa. I’m sure they’d both make a profit.