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There have been a lot of legitimate signs that our economy is starting to emerge from what has been one of the worst U.S. recessions since the 1930s. What hasn't been as clear is whether we've learned anything at all from the laughably absurd risk-taking that precipitated the financial crisis.
There are plenty of signs that the government has been out to lunch when it comes to really cracking down on Wall Street's crazy ways. We could point to the fact that banks like Bank of America (NYSE: BAC ) , which were considered "too big to fail," have become too-bigger-to-fail by absorbing Countrywide and Merrill Lynch. Or we could look at the massive trading profits that Goldman Sachs (NYSE: GS ) continues to reap behind closed doors.
But if you ask me, one of the biggest signs of "see no evil, hear no evil" today is the fact that credit default swaps -- the financial product that brought AIG (NYSE: AIG ) to its knees -- are still alive and well.
Here, have some risk
The basic idea behind credit default swaps (CDSes) is that you can shift the risk of a defaulting entity onto someone else.
An example might look like this: JPMorgan Chase (NYSE: JPM ) buys some of Caterpillar's (NYSE: CAT ) debt. Holding that debt comes with the risk that Caterpillar may default. But JPMorgan can call up Citigroup (NYSE: C ) and purchase a CDS contract from it that will require Citi to pay JPMorgan all or part of the defaulted amount if Cat does go down. In exchange, JPMorgan pays Citi a premium for that protection.
Sounds like insurance, right?
Not quite. You see, a quirk of CDS contracts is that you don't actually have to own the debt for which you're buying protection. That means Citi can then turn around and go to Morgan Stanley (NYSE: MS ) and buy some protection for itself to hedge the CDS that it just wrote for JPMorgan. In fact, JPMorgan never really had to own any Caterpillar debt in the first place; it can buy CDS protection from Citi simply to speculate on Cat's demise.
What's even better for all of these companies playing around with CDS contracts is that, unlike real insurance, there are no regulatory requirements for holding collateral to pay out on when a company does default on its debt. That means the sky's the limit for how much CDS paper these folks can churn out. Right, AIG?
Three-card monte, anyone?
Proponents of credit default swaps will unfailingly refer to the added liquidity that CDS contracts provide, as well as the increased ability for businesses to get loans. And this is all true. After all, if a bank can make a loan, then pass most of the risk to someone else, it's not only going to be more apt to make the loan in the first place, but also to offer a better rate.
But we need to ask whether we really want this in our economy. Lending money should involve a lender evaluating a potential borrower and making a sober, conservative assessment of whether the loan should be made, and what kind of interest rate adequately captures the risk of that loan. If a bank knows it's just going to pass on that risk as soon as it makes the loan, why bother putting in as much work on the front end?
Might businesses be hurt if CDSes disappeared? Sure. But perhaps many businesses out there shouldn't qualify for loans in the first place, or at least should be required to pay higher interest rates.
Compounding the situation, the risk that's passed on never actually disappears -- it just gets redistributed. Banks, insurers, pension funds, hedge funds, and any number of other players toss around this risk like so many card players in a game of Old Maid, hoping that they're not the one left with the maid when the game ends.
What we end up with is a group of highly complex financial companies juggling these paper assets, creating a financial system that potentially has more risk -- albeit more widely distributed risk -- than would otherwise be the case. This may be a fun game for top dogs in the financial world, who may have a knack for avoiding getting caught with the maid. But for the economy as a whole, its only result is increased risk and misaligned incentives.
If the government is really serious about change -- not idle jawboning or political grandstanding, but real change -- it's time for credit default swap contracts to join the Flock of Seagulls hairdo in the museum of bad ideas.
Adam Wiederman thinks there's yet another asset bubble brewing that could burst in 2010. He gives you the scoop on how to avoid being caught in the fallout.