Here's How Messed Up Our Financial System Is

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"If I were in charge, I'd take away everything from banks that wasn't boring. Completely shut down [credit default swaps] 100%. What's the harm in this? The world worked just fine without them. We don't need an economy that resembles a vast poker tournament."
-- Charlie Munger, May 2009

Credit default swaps (CDSes) are insurance policies on various debt products -- everything from subprime mortgages to U.S. government debt. A seller agrees to compensate a buyer if debt goes into default. It's not too different from car insurance: two parties swap risk for a premium. And just like car insurance, it can be a great tool to efficiently spread risk to those who want it from those who can't handle it.  

So why does Munger, Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) co-chairman, want them banned?

See, in everyday life, you can't insure things you don't own. Thankfully, your neighbor can't take out homeowners insurance on your house. If the entire town could buy insurance on one house, they'd have a huge incentive to make sure it was destroyed. They'd burn it down, blow it up, bulldoze it, what have you, pocket gobs of insurance claims for their trouble, and happily move onto the next town. For good reason, laws prohibit this.

With credit default swaps, there are no such laws. Investors can take out infinite amounts of insurance on debt products they don't own. This seriously distorts the motives and incentives between buyers and sellers. CDSes often don't act as insurance, but a tool to manipulate stupidly large amounts of money and rip gaping holes in the financial system, a la AIG (NYSE: AIG  ) . 

The Wall Street Journal recently reported an almost comical example of this. It tells the story of a tiny Texas brokerage firm called Amherst Holdings which, likely along with other CDS underwriters, took a $27 million debt security and sold $130 million of credit default protection on it. Big banks like RBS (NYSE: RBS  ) JPMorgan Chase (NYSE: JPM  ) and Bank of America (NYSE: BAC  ) bought these CDSes. The debt, when reviewed, was total garbage and almost certain to default, so the banks had no problem paying up for the insurance.

Now, think about this for a moment: Amherst, and likely other CDS counterparties, pocketed $130 million to insure $27 million worth of bonds. So what do you think Amherst did? Exploiting a small loophole, it used the proceeds to have the underlying bonds bought back at par, which instantly rendered the credit default swaps worthless.

It was incentivized to do this because the amount it took in from CDS proceeds substantially exceeded the bond's par value, so it could burn millions of dollars buying out the bonds and still make a tidy profit. By making the bonds whole, there was zero chance of default, so Amherst's insurance obligation disappeared.

Of course, there really was no insurance involved. There wasn't even an investment. As Munger notes in the opening quote, it's simply a vast, unregulated game of poker. Spun the other way, CDS buyers have an incentive to make sure underlying debt defaults. They can achieve this by buying CDSes for multiple times a company's debt load and causing a run on its assets. Indeed, this is exactly what many believe ultimately pushed Lehman Brothers into bankruptcy.

In the utopic minds of those who created them, credit default swaps prevent meltdowns and mitigate risk. In reality, scarcely anything in our economy possesses a greater risk of bringing down the house. Thanks to the ability to insure debt for multiple times its value, the notional size of the CDS market is more than $38 trillion, or nearly three times U.S. GDP. That's $126,000 for every man, woman, and child in America. This is quite literally a poker game multiple times the size of the entire economy.

Yet we've still done very little to fix it. CDSes are still sold, bought, and traded in staggeringly large sums based on rules dictated by those who created them. As Goldman Sachs' (NYSE: GS  ) annual report states, "The market for credit default swaps is relatively new, although very large, and it has proven to be extremely volatile and currently lacks a high degree of structure or transparency." Whoo-hoo!

Read that quote again, remind yourself what got us here in the first place, pound your head on the table, and ask yourself why we hold frequent congressional hearings to quibble over things like executive pay, but sweep issues like credit default swaps under the table and hope they fix themselves.

What do you think? Is it time to heed Munger's advice and totally ban credit default swaps? Feel free to share your feelings in the comment section below.

Related Foolishness:

 Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

Read/Post Comments (41) | Recommend This Article (175)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 15, 2009, at 4:45 PM, motrehallag wrote:

    darn right .Provide a great public service and sent a copy of this article to every member of congress

  • Report this Comment On June 15, 2009, at 5:02 PM, TMFTomGardner wrote:

    Morgan, what do I think? I think you've expressed the problem -- with creative eloquence. Here's the problem. 99% of adult Americans do not understand credit default swaps. And how would they? They can't see the wild speculation taking place digitally around them. They are naturally very unfamiliar with the terms. And most reporting coverage of the problem makes no attempt to put things in clear terms and pictures for the audience. If, instead, everyone were told the story of neighbors buying insurance on a house, then destroying it for profit (and pleasure?)....we might get movement on new and completely reasonable forms of regulation. If you don't get the people behind it, it's tough to beat the banking lobby.

  • Report this Comment On June 15, 2009, at 5:30 PM, FinancialFellow wrote:

    Here's a very straight forward explanation of credit default swaps:

  • Report this Comment On June 15, 2009, at 5:52 PM, shenoy2206 wrote:

    Yes, we should start a movement to get this banned. My understanding of CDS became clear with the example provided insuring 1 house multiple times & then burning it down for making a profit.

    We should get this information to the the regulators to get this banned at earliest.

  • Report this Comment On June 15, 2009, at 6:03 PM, DDHv wrote:

    CDSs should go. Banks should be in the business of lubricating the economy, not gambling on it.

    BTW, here is a definition of the difference between risk-taking and gambling. With risk-taking, you are taking a chance on something real, with the aim of being a positive sum game. With gambling, you are shifting assets around, with the total game always being zero-sum or worse. Risk-taking is needed. Gambling kills value.

  • Report this Comment On June 15, 2009, at 8:09 PM, IRABound wrote:

    "Is it time to heed Munger's advice and totally ban credit default swaps?"

    Absolutely! It's pure and simple gambling and banks have no business operating this way. Banks are suppose to be held to ethical standards when dealing with the public's money and their trust.

  • Report this Comment On June 15, 2009, at 9:08 PM, NoMoeMoney wrote:

    Sorry but the cat is already out of the bag (and running wild). If the CDS market is 38 TRILLION then you'll never be rid of them. They're spread out all over the world and the only way to make them worthless would be to destroy any preceived worth in them. I don't think the people or institutions that own them are gonna be very happy about that, especially since the credit rating agencys were giving them triple A status not too long ago. Nope, they will be the skeletons in the closet for a long time and if you destroy them, you will destroy the world.

  • Report this Comment On June 15, 2009, at 9:51 PM, ArbOfValue wrote:

    It would be silly to ban CDS, they do have a legit purpose (hedging) even if sometimes used to gamble (and what's wrong with gambling? Are we going to ban TA and daytrading next?). In this case, it's hilarious that the buyers did such a poor job of risk evaluation,but this kind of stuff happens with equities too. The buyers may have been trying to hedge against a general decline in mortgages, without realizing here the size of the remaining mortgages made it too easy to manipulate.

  • Report this Comment On June 15, 2009, at 9:56 PM, lwbaum wrote:

    NoMoeMoney, you bring up a good point: that companies holding huge amounts of CDS will struggle against any regulation to eliminate them and make their investment worthless. But, from the little I know, CDS are usually term insurance, often for periods of 1 year at a time. Therefore, regulation could phase them out over a year or two by simply preventing NEW CDS while allowing trading of current CDS until their terms expire within a year.

  • Report this Comment On June 16, 2009, at 1:16 AM, carolina1954 wrote:

    Excellent article. CDSs should be banned, or, at a minimum, regulated as an insurance product requiring reserves against losses and with an insurable interest requirement for purchasers. The Amherst firm, perversely, may be performing a public service by ripping off powerful entities like BofA and JPM. When they start whining, maybe the government will listen in time to prevent another AIG-type disaster, or worse.

    --C. David Kirby

  • Report this Comment On June 16, 2009, at 1:39 AM, CMFTomBooker wrote:

    Great article.

    CDSs are the 21st Century version of sports betting. And you don't have to organize teams or leagues to do it. They have no business reason to exist beyond the counterparties in the debt transaction. They are bets, not insurance. If they were insurance, we would be calling them Credit Default Insurance. But that wouldn't be any fun.

    Look at the power of these things, and the people who want to play with them. We pumped $170B into AIG to keep them alive, just so they could pay off $30B?, $40B?, of defaults to Goldman Sachs, JPMorgan etc.

    There are some serious people who want to keep these things alive. Bernanke and Paulson had the Law of the Land changed so they could save AIG. It was an Act of Congress. The Central Bank and Government are scared to death of these things.

    Now that these things map the world, how do you regulate them? They are in play, in every market and back alley worldwide. (Remember AIG payouts also went to foreign banks and Sovereign Funds. All we have proved so far, is that we are willing to run interference for their damage, before and after the fact. We are Enablers for junkies, who are passing the meth and syringes around the table, while driving our financial system bus.

    Some tough love is in order, by the government. But how do you restrict an imaginary market, without setting it off? I doubt there is anybody in DC willing to take that chance. Based on everything they have done, it is more likely they will become Commissioner of the Credit Default Swap League, rather than a Regulator.

    Then it will become international team sports.

    "This morning at 2 AM EST, the US attacked the United Kingdom, just before the London Treasury Market opened. The UK markets were freaked out and frozen. As a result, the British government defaulted on coupon payments to notes rumored to be in the amount equivalent to $700B US dollars.

    US Gen. Hank "The Swapmaker" Jackson had a brief statement following the invasion..

    ' Hey, it was a tough game. We won ugly, but we won. Just want to assure the folks at home, that this one should be a 5-bagger in CDSs. That's a good $3.5T going towards the National Debt. Discounting a couple of $100B going to the Brits for being good sportsmen. Plus they have some tidying up to do. We're really sorry about that Big Clock thing. We had some rookies in the Tank Squads who got a little carried away when they were firing warning shots over Parliament. Kids...What can I say?'

    ' Our troops will be leaving shortly, in fact, it has already begun. We will be heading for the German borders. It's merely precautionary. We just want to help the German banks find their wallets, to make good on the default payments.

    'Oh, and a shout out to our buds in France. We'll be seeing you day after tomorrow. But that's a "maybe" if you wire your share of the payout by end of US business today, We're trying to keep our bill-to-book tight on receivables and payouts.'

    In other news, Goldman Sachs couped an estimated $322M in CDSs on a GMAC lawn tractor loan to Arnold Holflaffer of Poplar's Bluff, MS."

    I really had something responsible and substantive to say. But it kinda' steadily slipped away from me.

    It happens sometimes.


  • Report this Comment On June 16, 2009, at 8:31 AM, ajstudebaker wrote:

    Why not allow someone holding a particular bond to get a CDS on it, so that the amount insured would never exceed the total face value of the bond issue? Municipal bond insurance seems to work fine that way.

    That said, I don't find CDSs particularly useful. If you can't sleep well at night with speculative bonds in your portfolio, buy bonds of J&J or another rock-solid company. Don't buy a CC rated bond and get a CDS on it.

  • Report this Comment On June 16, 2009, at 9:01 AM, catoismymotor wrote:

    It is because of this mess I am focusing on Canadian financial institutions. Good article.

  • Report this Comment On June 16, 2009, at 10:14 AM, mpendragon wrote:

    Given what the CDSs were generally made to insure I think investors would be better off with bundling old-fashion CDs and selling them off in segments in something similar to a money market account with the same or a slightly higher yield. The yield should be about the same as would be expected from mortgage-backed securities if those mortgage-backed securities had real insurance with real risk assessment and real regulation behind them.

    It wouldn't be entirely risk-free as a failing bank's CDs are transferred by the government to another institution with typically a lower yield for the remainder of the CD but the principle is protected.

  • Report this Comment On June 16, 2009, at 11:12 AM, RHaganC wrote:

    Regulate the hell out of like the insurance industry is. That'll bring it back down to reality. Licences mandatory to do business in it (bar entry to keep people out of it). Report their rates to the states. Tax the hell out of it.

    It'll get back to normal, just like insurance.

  • Report this Comment On June 16, 2009, at 11:52 AM, RaulChapin wrote:

    Morgan, you usually make sense, this time in my opinion you did not.

    Banning CDS because they are not easily understood or because they can be manipulated is like banning higher calculus because most people do not care to understand it or baseball bats because they are sometimes used to hit people over the head.

    CDS should be regulated, like any other contract. One main thing that should be regulated is that NO ONE should be allowed to enter into more contracts that they can with Certainty fulfill. If I pay an alarm monitoring service, i want to be 100% sure that when my alarm goes off, there will be someone monitoring it... promising to monitor my alarm but only hiring people from 8 pm to 8 am because most of the break ins happen in those hours would just not do!

    Further more, if you sell insurance on a house, and you pocket enough money to buy the house and still have profit left, this is not illegal... the moron who bough the insurance from you instead of keeping the cash in the bank and rebuilding the house if it ever burned down is just that, an idiot... you have done no harm.

    The people that manipulate markets to cause bankrupcies for a profit, should be judged, if there is no law that makes them liable, then that is the law that we should be cheering for, however I really think "actions done to cause harm to others for personal profit" must already have plenty of related legislation and case law... BUT saying the law is there and only needs to be enforced does not win votes or readership... so lets Blame the CDS and pray the goverment can put a bandaid large enough to make us believe that a difference was actually made.

  • Report this Comment On June 16, 2009, at 9:00 PM, dariusjedburg wrote:

    As always, if Charlie says something definitely stinks. He warned about savings and loans before it nearly busted the economy, he warned on the tech boom, he warned on the real estate and motgage markets...Congress, please pay attention this time around!

  • Report this Comment On June 16, 2009, at 10:29 PM, EagleRidge123 wrote:

    I am stunned at how gullible the writers of many of these comments are, believing that somehow CDSs actually are a valuable tool to be preserved. Munger is right in what he is saying. There are also other instruments within the world of derivatives that need to be taken out as well. The total value of the derivatives market is estimated to be $596 Trillion (SEC estimate), of which an unknown, yet presumably substantial, portion are toxic. As Hernando DeSoto, the Peruvian economist, suggests, we need to do the math. The derivatives market is a house of cards. Self delusion is not a pretty thing. Wake up, those of you who are still drinking the Kool-Aid.

  • Report this Comment On June 17, 2009, at 1:05 PM, Classof1964 wrote:

    Credit Default Swaps are an example of the worst kind of special interest action at the expense of the public. Most states outlawed CDSs as gambling after the Crash of 1907 in which CDSs played a significant part. In 1999 someone got a congressman to insert a short paragraph in a so called commodity reform act, legalizing CDSs, thus federal law overriding all those state laws that had worked for nearly a century. I doubt that Congress has the will to outlaw them completely, so the real test will be to set limits to them, make them transparent (no more AIGs), and have the issuers have very substantial money to back them up.

  • Report this Comment On June 17, 2009, at 5:13 PM, RaulChapin wrote:

    EagleRidge123 we might not necessarily be gullible, we might actually be wiser than you think in knowing that it is not the tool but its use that creates the harm... you might be gullible in thinking that banning CDS would actually prevent speculators to find other ways to leverage their companies beyond reason.


    Berkshire Hathaway has some Derivatives, the guys managing them know what they are doing and are using the tool well. AIG had derivatives, the people managing them were either stupid or reckless... don't blame the tool blame the misuse of it.

    Also, many banks have savings accounts that pay people something like say S&P - x% with a guaranteed principal. These products are used by people who are willing to get 0% return or better but not worse... it can be your standard Joe, without derivatives this kind of product would be extremely hard to offer... how about fixed rate mortgages... that is also a derivative, people are willing to bet that the interest rate average will be lower than the fixed rate, so they purchase such derivatives... homeowners who do not want to risk being unable to afford their mortgage pay more on average but keep the risk away.

    Class of 1964:

    Gambling is allowed in many other cases... such as lotteries and casinos. People or companies are not allowed to go into a casino or get lottery tickets with money that a) does not belong to them or b) they do not have... they are not even allowed to say something as ridiculous as: I only have to have 50% of the money I am going to gamble because statistically i will win 1 in 2 times... Banks and insurance companies are allowed to do this, its called the fractional reserve system... it makes credit cheaper, but savings riskier... you lend out say 80% of the money that you have in deposits and you GAMBLE that the depositors will only ask for it back inmediately 20% of the time... when they do otherwise you have a bank-run and uncle sam coming to the rescue.

    Anyway, my point, allow people to go into contracts that would otherwise seem like bets... just make sure they have resources to cover said contracts and if they don't prosecute them for fraud... the other party to the contract risks his possible returns and even principal, the same way they do when they enter into other contracts and the default party has no resources to cover the damages caused by default.

  • Report this Comment On June 19, 2009, at 3:49 AM, Angry0as0hell wrote:

    CDSs are not inherently bad. If they are/were actually used as a form of insurance, then they serve a constructive purpose. But yes, they have been misused and abused. As rightfully pointed out, almost anyone can create a CDS without actually having any connection to the underlying security, and that is a problem as the value of CDSs dwarf the value of the asset being 'hedged' and even of the real economy, which brings me to my point.

    Another problem, not pointed out by anyone else in this thread is the lack of reserves held by firms underwriting CDS contracts. Actual insurance contracts, such as AIG's original business, requires reserves to be held by the firm issuing insurance - that is a highly regulated market with strict rules on reserve requirements. As far as I am aware, because the market for them is mostly unregulated, CDS contracts do not have reserve requirements. And this is perhaps a bigger problem. Your typical life insurance or health insurance has enough people and covers enough ground such that risk is not often correlated - just because Party A gets sick does not mean Party B will get sick. However with a CDS contract, the risks often were/are very correlated (although perhaps not fully recognized at the time). In a recession, the risk of corporate default goes up and tends to be highly correlated. When the housing bubble burst, prices fell all around the country and defaults occurred everywhere (although people typically did not expect a national decline - that and mortgages were issued to people who should never have been approved). Because a CDS contract covers correlated risk, reserve requirements should be higher than a typical insurance contract - but they are not. What was so scary about the issue with mortgages was the leverage - some mortgages bought with 0% down were technically already infinitely levered and then MBS were created with more leverage before CDOs or CDSs are brought into the picture. See the problem?

    There is also the additional problem of how to price CDOs once they have been created. We need a transparent market to figure out what those already created are worth, but do not have such a market. And the interested parties, like a Goldman Sachs, would prefer anything but a transparent market as they make big profits due to the margins available in trading these complex contracts. As such, we do not fully know what the value of MBSs, CDOs and CDSs already created are truly worth. And the FASB made things even worse by loosing mark-to-market rules. How can we know if a firm is truly solvent if we do not know the value of the contracts on their books?

    Anyhow, I owe most of this knowledge to Harry Markowitz, the economist behind Modern Portfolio Theory and a critic of financial engineering.

  • Report this Comment On June 19, 2009, at 5:32 PM, saf412 wrote:

    I have no problem with credit default swaps if the people selling the risk coverage would actually cover the risks. Us little guys saw our retirement savings get cut in half, but we weren't offered any no-risk deals. This is another example of the big boys trying to tell us we don't understand "high finance"...just like the stockholder phone calls I listened to a few years ago when the CEO of WAMU was trying to tell us that sub-prime lending was going to make us all rich....I got out....and I don't understand high finance, but do understand smoke and mirrors.

  • Report this Comment On June 20, 2009, at 11:53 AM, phmcdev wrote:

    anyone who favors CDSes is either selling them, or doesn't understand the downside implications. Congress is looking the other way, much the same as they did with Fannie Mae and Freddie Mac, because of the campaign contributions they receive from those ruining the economy.

  • Report this Comment On June 20, 2009, at 5:06 PM, MyMoney33 wrote:

    Once again the Bankers show us their true gambleholic character. Unless regulated they will destroy the system .... again. BAN NEW CDS

  • Report this Comment On June 21, 2009, at 5:18 AM, LovinMe wrote:

    Another thing that is screwed up. The person who opens your accounts is paid incentive to shove products down your throat. Their all smiles and screws. You get both.

  • Report this Comment On June 21, 2009, at 6:14 PM, Chickenpookie wrote:

    Why don't the US government and Berkshire work the same deal Amherst did?

    I like Amherst, how can I get in on their deal?

  • Report this Comment On June 28, 2009, at 10:51 AM, drelijr wrote:


  • Report this Comment On June 29, 2009, at 12:10 AM, depsee wrote:

    Once again just another example of how the markets, banking, economy, government, and life in general has became no more than a CRAPS table in Vegas.

  • Report this Comment On June 29, 2009, at 4:01 PM, greaterfactotum wrote:

    Make CDS like lloyds. You sell it, then you are PERSONALLY responsible for it. Once that law is in affect, further regulation becomes unnecessary. And when I say PERSONALLY, I mean any assets that you or your family control, in this country or any other. Hell, make it stronger.

    I am sure that there could be variations on this. But our greatest problem is that the state has created entities that limit liability but not profits. Why???

  • Report this Comment On July 02, 2009, at 5:15 PM, ham1198 wrote:

    Understandable Explanation of Derivative Markets

    Heidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

    She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

    Word gets around about Heidi's "drink now, pay later" marketing strategy and as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit .

    By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

    A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

    At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international securities markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics.

    Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

    One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

    Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations, she is forced into

    bankruptcy. The bar closes and the eleven employees lose their jobs.

    Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed

    bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

    The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations. Her beer supplier is taken over by a competitor who immediately closes the local plant and lays off 150 workers.

    Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from the Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

    Now, do you understand?

  • Report this Comment On July 02, 2009, at 6:37 PM, halbiz wrote:

    Goldman Sachs has a history of taking Taxpayers to the cleaners. (You might want to read "Rolling Stone's" latest issue about GS's Shennanigans over the last 8 Financial Disasters). Fascinating story of infuriating greed and cronyism at its worst. We need to let our Representative know this must not continue onto the next Disaster.

    Goldman Sacha is not a bank, but seems to be an Insider Trading Firm and Government Department that acts like a virtually unregulated entity when it comes to the production and trading of highly profitable (for GS) and seemingly unlimited derivative products.

    Ratings Companies? Their charters must be limited to rating only real debts and real assets, not Derivative Products.

    Our whole system has become more dependent on Derivative Products because of the money that can be made buying and selling them and the increased leverage they allow.

    Let your Congressman know in writing that Derivatives of all kinds must be regulated, cleared, reported, and realistic limits must be placed on what a financial firm of any kind can trade as well as hold (especially if they receive Taxpayer guarantees).

    Is the Firm an insured Bank or a Casino?

    Regulation, Disclosure and Transparency.... these were basically unregulated products with few legal requirements. Congress had a hand in this (maybe two), for letting Depression Era restrictions be thrown out in favor of something called "Reform".

    Return the uptick rule for Shorting Stocks, the separation of Guaranteed Banks from Securities Firms and Insurance Companies, and insist upon Derivatives Clearing and Reporting facilities and enforcement.

    Derivatives in general have a problem: they are not shares of a real asset, like a company, a piece of machinery, a house, etc. They are only "Derived" from real assets and debts.

    The number of shares of an asset are normally controlled, regulated, and limited. The mortgage on a house should only have one default guarantee, not dozens. How could multiple policies with geometric coverage on the same asset or debt still be allowed to be legal?

    The amount of derivates that can be sold is almost limitless. The leverage and amount of buying and selling is almost limitless. The potential losses are almost unlimited when selling certain derivatives. And this is taxpayer guaranteed Banking and Insurance practices? Shouldn't be, should it?

  • Report this Comment On July 06, 2009, at 8:56 AM, WINGNUT104 wrote:

    Bravo-Zulu for Halbiz on the comments! All of this idiocy should be outlawed! Why are all these greedy corporations and individuals fooling themselves? It's all going to come home to haunt them in the long run---unfortunately, it is going to haunt we who know better too!

  • Report this Comment On July 06, 2009, at 3:46 PM, zxdfmlp wrote:

    Treat them as insurance. Allow people to own them to the extent they have an insurable interest.

    Allow them to be sold by selected well capitalized companies (e.g., insurance companies) to a limited extent consistent with regulated risk management and proof that they can cover in event of default.

    Just as anyone long a bond could buy a CDS to cover their position, allow anyone who is short a bond to buy coverage for their short position.

  • Report this Comment On July 06, 2009, at 6:08 PM, WileyCyote wrote:

    The idea of complaining about executive pay is something that everyone can relate to. Since we have a school system that teaches absolutely NOTHING about money, very few are going to even try to understand the basics of "Credit Default Swaps"

    When any "tool" comes into being that promises lots of bucks, the moochers and looters convene. They have convened. Lacking any courage and guts whatsoever, the current "Govmint" will just keep trying to draw our attention to other minor issues.

    Ayn Rand was right! Maybe it is indeed time for Atlas to Shrug.

  • Report this Comment On July 07, 2009, at 5:45 PM, Palmair wrote:

    The problem isn't necessarily with the credit default swaps. Rather, it's with the policy that allows for multiple CDSes on the same risk. If the system was changed, such that the maximum credit default swap(s) that could be placed on a potential loss was the total of the loss (not multiples of it), and no more, the gaming aspect would be substantially reduced and the swaps could then be used properly for their intended purpose.

  • Report this Comment On July 10, 2009, at 2:57 PM, rhmart wrote:

    Nice, down-to-earth explanation of CDS. Thanks. One of the problems, as already noted, is that the average American does not understand this instrument. However, many people who should have --including CEOs of prominent companies -- didn't understand them either.

    I'm all for improved and more effective regulations, but I think we have to resist the urge to throw out the baby with the bath water. Just as there is a rightful place for subprime mortgages -- it was mainly the layering of risks and widespread availability of the product that led to its undoing -- there is a rightful place for CDS.

    Many have commented on the casino-style incentives imbedded in CDS participation. True enough. So we might want to consider banning CDS for other than true risk protection purposes or perhaps allowing CDS for both risk protection and speculative purposes PROVIDED participants pony up adequate reserves against loss, e.g., via some sort of exchange on the order of the CME.

    I tend to favor the latter approach as it retains both the risk-taking and risk-seeking features of our capitalist system. If folks are willing to risk losing their money on CDS, then, for the most part, they should be allowed to. The issue going forward is to make sure they don't risk losing our -- meaning taxpayers' -- money. So a more regulated CDS market might do the trick.

  • Report this Comment On July 12, 2009, at 8:38 PM, ruckrover wrote:

    Yes - lobbyists are the problem. The USA is a plutocracy moreso than most other democracies. Plutocracies are inherently unstable as they are based on vested self-interest of the few over the many.

  • Report this Comment On July 15, 2009, at 11:55 AM, mark40517 wrote:

    The real problem with America isn't money. The real problem, when you get right to the heart of the matter, is the fact that we are in a state of total denial. Collectively, we will only wake up when a disaster hits us right in the face.

    The last round of elections bears this out. We are electing people based on popularity ( which directly translates to the government handing them every benefit) rather than someone who will tell us the bailouts, handouts and excesses are over.

    If Andrew Jackson, the President that paid off the national debt and had the government operating at a profit, were alive today, he would never have a chance in Hell to get elected. He was a man that was an orphan and by sheer guts, will and determination rose through the ranks and made something of himself. He didn't receive any help from the government or anyone else for that matter.

    Americans, look at us today. Everyone is entitled, insured or spoken for on so many different levels that a whopping 36% of us believe in socialism. Do you think President Obama would last more than 2 minutes if he told everybody, "that's it no more!"

    As for the CDS situation, all I can say about that is, if you ban this instrument, someone will come up with a different angle or loophole or even the same scheme with a different title. The Hydra needs to feed. Cut off one hungry head and another duplicate with a different name pops up.

    Don't believe me?

    Take a look at the Global poverty fund introduced by then Senator Obama and approved by then President Bush. It is a global tax. They don't want to introduce more taxes, so we'll just call them "funds" now.

    Democratic republics don't last long historically, so you better enjoy and appreciate this one while you have it.

    Man: Mr. Franklin, you've been working hard on our new Constitution, what kind of government will we have when you are done?

    Franklin: A republic....IF WE CAN KEEP IT.

  • Report this Comment On July 15, 2009, at 9:11 PM, susan449 wrote:

    BAN CREDIT DEFAULT SWAPS!!!!! I am starting a movement!! This is the MAIN REASON we are in this mess!! Is anyone out there as mad as I am?!! COME ON! Don't be a SHEEP anymore!! The whole system in America has set us up so that a few 100,000 greedy ******* could stay rich. Our whole education system was set up to train us to be the SLAVES we are.....the "American Dream is a FRAUD!!!!" The word "Graduation" actually comes from Gradual Indoctrination.....into the system of molding your mind to not think an original thought so that you can go to your (slavehouse) jobs and think you are living the Dream!! The dream of buying a HOUSE and STUFF and get locked into the credit system for the rest of your life! **** the credit scoring is BS!! I woke up!!! I'm FREE!!!!!!!! Don't believe the lies anymore!!!! Tune into Coast to Coast AM radio....learn the truth....Live Free!!! Thank You for your time to read this!!

  • Report this Comment On October 11, 2009, at 4:19 PM, neutrinoman wrote:

    The solution is simple:

    1. You should be able to buy derivatives only on debt and other financial products that you own.

    2. CDSs and other derivatives should be registered on exchanges. Even OTC transactions are made transparent when at least some of the derivative activity is on an open exchange.

    3. Require minimum collateral and reserves for issuers of CDSs.

  • Report this Comment On October 15, 2009, at 11:13 AM, FedUp7 wrote:

    C'mon people. We're losing English skills faster than Obama is losing credibility. It's not CDSes or CDSs -- it's CDS's. And yes, I agree they have to go. It's no wonder we're shafted with thing like this allowed.

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