Monday, March 12, 2012

Credit Default Swaps: Insurance Masquerading As A Financial Product

Yesterday's Washington Post article by Barry Ritholtz provided some useful history and background on credit-default swaps (CDS).

Washington Post: Credit default swaps are insurance products. It's time we regulated them as such.

It's well worth reading and makes a strong case for regulating CDS the same way as other insurance products.

In the article, Ritholtz makes the following points:

- CDS obtained their favored status as unregulated insurance policies thanks to the Commodity Futures Modernization Act of 2000 (CFMA). They continue to be, effectively, unregulated insurance policies.

 - The act was built on the assumption that markets could self-regulate (I think it is fair to say we've learned otherwise) and, as a result, basically eliminated all relevant regulations.

 - Commodity Exchange Act of 1936 was modified so derivative transactions were exempted from regulations as "futures" and "securities" (via fed securities laws).

 - CFMA exempted credit-defaults swaps and other derivatives from regulation by state insurance regulators.

So that means...

- CDS can be traded like any financial products but is not considered a security.
- CDS can be used to hedge future prices but is not considered a futures contract.
- CDS pays in the event of a specific loss but is not considered an insurance policy.

Makes sense, right?

Well, not surprisingly this "innovation" changed behavior in the industry. The article also points out insurance companies have to typically set aside reserves to cover losses. With swaps there is no such requirement.

Ritholtz goes on to write that "they are still exempt from all insurance regulatory oversight," even though they are "thinly disguised insurance products" with the added bonus that they lack reserve requirements.

Why does this matter? Ultimately, the problem is reserves (or the lack thereof).*

If treated like the insurance products that they are, insurance regulators would impose appropriate reserve requirements. This, of course, would reassure participants that the institutions on the hook are actually capable of paying down the road. It seems fairly obvious that this would increase the health, stability, and effectiveness of the financial system.

First and foremost, the increasingly complex and vital financial system is built upon trust and confidence. If system-wide robustness is in doubt it can't function optimally. As it stands now, knowing whether there is a systemically crucial institution liable for something it's incapable of  absorbing isn't easy for anyone to judge. It opens the door for rumors and raw emotion to set the agenda in lieu of facts and rationality.

We should know from recent experience that, at least during chaotic markets, this matters a whole bunch.

The mere fact that it's so difficult to figure out who's potentially liable for what creates damaging uncertainty.

That uncertainty, during times of economic stress, potentially amplifies the size of the problem.

We've already learned that during times of financial crisis what starts as a seemingly manageable problem takes on an unpredictable life of its own.

Check out the full article.

Adam

Related prior posts:
Buffett: Credit Default Swaps Potentially "Very Anti-social" Instruments
The Bond Market Rules
Sinking Seaworthy Ships

* Lack of reserves certainly aren't the only problem with CDS. It's an established principle for an insurance company to not let someone insure something they don't own because they do not have an insurable interest. England figured out centuries ago it's a good idea to remove the ability to profit from another's loss and the possibility of misconduct associated with it. Human nature hasn't changed. Warren Buffett made this point in an interview last year on CNBC: "...you can't go out and insure my house against fire because you do not have an insurable interest, as they call it in the trade. Because once you insure my house against fire and you may decide that, you know, that maybe dropping a few matches around my lawn might be a good idea."  Yet, with credit default swaps, one can take out insurance on a bond without actually owning that bond. So someone that doesn't own an underlying corporate or sovereign bond have been able to place a bet against it via the purchase of a credit default swap then directly benefit if a default occurs. It's rather similar to being able to insure someone else's home and directly benefiting from something bad happening to it. These side bets, it seems, have the potential to be massively destabilizing though there is far from universal agreement on this. Some argue that wise limits to reign this sort of thing in is plainly needed (if not an outright ban); others argue for quite the opposite. I'll take the recently adopted outright ban on sovereign debt sooner than later. It may not be sufficient but it's a start.
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