This Is Poison for Our Economy

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.

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Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool. The Fool's disclosure policy is an ace when it comes to Old Maid, but still wouldn't touch a CDS contract with a 10-foot pole.


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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 November 12, 2009, at 6:07 PM, bff426 wrote:

    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"

    I disagree that the risk is more widely distributed. There are a handful of firms that are at the heart of credit default swaps trading. The failure of any one of them will bring all of the others down. That is because the whole system depends on people being able to pay. If I'm Citibank, and I fail, I won't be able to pay J.P. Morgan or Goldman Sachs, or anyone else that I've done business with. They in turn, will not be able to honor their obligations and will go down with me. We need to break up the CDS racket completely.

    If you don't only underlying security, you can't buy insurance on it. The 1st principle of insurance is you need to have an insurable interest i.e. you will lose from the death. I can't take out an insurance policy on your life. Imagine if we could, If I'd noticed that you've been gaining weight -- time to load up on life insurance on Matt. Or, I noticed that Matt started running and is training for a marathon. Time to sell insurance to some other sucker.

    Can we do that? Of course not. What these companies are doing is not hedging, it's gambling. It needs to stop right now. But Obama decided that ramming through the liberal dream of single-payer health care was more important than straightening out our financial system. Meanwhile, he left it to dolts like Chris Dodd.

  • Report this Comment On November 12, 2009, at 6:56 PM, TMFKopp wrote:

    @bff426

    I'd tend to agree with you on the risk spreading. CDSes may do it to some extent, but in the end you really just have a handful of major financial firms (could we say "too big to fail" firms?) holding most of the CDS exposure. With everything else outlined in the article though I figured I'd give them the benefit of the doubt there since spreading financial risk is what proponents would argue.

    Unfortunately, I couldn't get everything I wanted to in here due to space constraints, but for those interested it's fascinating to look at the CDS contracts outstanding, which you can find at the DTCC (http://www.dtcc.com/products/derivserv/data_table_i.php?id=t....

    Some of the companies listed there have far more CDS contracts out on them than they have outstanding debt. AutoZone is just one example where the notional value of the CDS contracts on the company are 10x the value of its debt. Amazing.

    If there were some sort of argument for keeping CDSes at all, there needs to be much stricter regulations on them. At the very least, since they're insurance in all but the name, reserve requirements should be put in place. Even a 5% reserve requirement on CDSes would necessitate a severe cutback in the size of the overall market.

    By the way, I am actually training for a marathon (ok, half marathon), but I've also been eating a lot of red meat lately. So if you can find those folks that will allow you to buy and sell contracts on me, I might suggest going short on the life insurance side, but long on long-dated health insurance. :)

    Matt

  • Report this Comment On November 13, 2009, at 11:02 AM, park94 wrote:

    signs of recovery or not ,This market is soooo manipulated by speculators it doesn't have the least connection to reality anymore. They just rise the prices infinitely , why don't they just raise it all at once who cares, no serious investor is buying anyways all the buying is done by speculators and day traders besides the 70% of the volume that is flash trading.

  • Report this Comment On November 13, 2009, at 11:55 AM, leohaas wrote:

    Excellent explanation of how a CDS works! Mandatory reading...

    Agree 100% with the article. If you want people and companies to act responsibly, you need to ensure they have skin in the game. If you allow shifting the risk, there no longer is any such skin. That is why CDS contracts must be banned. It is also the reason banks should be required to keep mortgages on their books for a reasonable amount of time (say, 5 years) before they can collaterize them!

    A few remarks:

    Regarding: "...unlike real insurance, there are no regulatory requirements for holding collateral to pay out on when a company does default on its debt." 100% true, but a typical CDS requires the seller to hold (and post!) collateral. So you might say that the industry regulated itself. However, it was this requirement that ultimately doomed AIG. It just goes to show that self-regulation does not work!

    Regarding the comment: "I can't take out an insurance policy on your life. Imagine if we could, If I'd noticed that you've been gaining weight -- time to load up on life insurance on Matt." Nice example. I have often used a similar example where I would take out insurance on my neighbor's house (and then pay a lowlife to set it ablaze...). But the life insurance example is not a good one. Matt can sell his life insurance, in which case someone else does have and insurance policy on HIS life!

    Regarding the interest in AZO CDS contracts: someone expects this company to go under! No doubt this person is looking for the aforementioned lowlife...

    Out to investigate AZO puts!

  • Report this Comment On November 14, 2009, at 2:25 AM, GoNuke wrote:

    CDSs are sold as insurance. They are not called insurance because insurance is heavily regulated. There is a reason insurance is heavily regulated. The insurer needs to have adequate reserves to cover potential losses.

    Unregulated insurance has caused plenty of financial crises in the past. That is why it is so heavily regulated.

    CDS should be banned. They are an unregulated form of insurance that places the entire financial system at risk.

    CDSs were used by banks specifically to circumvent bank capital adequacy ratios. All first world countries signed a treaty to create an institution that would create banking regulations. The institution is the Bank of International Settlements in Basel. Each signatory country is supposed to implement the regulations proposed by the BIS. Many or most countries didn't bother to implement the regulations. None the less the BIS did set the capital adequacy standards that banks were supposed to live by. The BIS is supposed to ensure that the world's financial system doesn't due what it just did -take outrageous risks that could sink the world's financial system.

    CDSs created a way around the regulations.

    If CDSs are not banned or regulated like any other form of insurance the financial system could melt down again.

    All the stock market analytical expertise in the world isn't worth a nickel if the global financial system on which it rests collapses.

  • Report this Comment On November 14, 2009, at 2:25 AM, GoNuke wrote:

    CDSs are sold as insurance. They are not called insurance because insurance is heavily regulated. There is a reason insurance is heavily regulated. The insurer needs to have adequate reserves to cover potential losses.

    Unregulated insurance has caused plenty of financial crises in the past. That is why it is so heavily regulated.

    CDS should be banned. They are an unregulated form of insurance that places the entire financial system at risk.

    CDSs were used by banks specifically to circumvent bank capital adequacy ratios. All first world countries signed a treaty to create an institution that would create banking regulations. The institution is the Bank of International Settlements in Basel. Each signatory country is supposed to implement the regulations proposed by the BIS. Many or most countries didn't bother to implement the regulations. None the less the BIS did set the capital adequacy standards that banks were supposed to live by. The BIS is supposed to ensure that the world's financial system doesn't due what it just did -take outrageous risks that could sink the world's financial system.

    CDSs created a way around the regulations.

    If CDSs are not banned or regulated like any other form of insurance the financial system could melt down again.

    All the stock market analytical expertise in the world isn't worth a nickel if the global financial system on which it rests collapses.

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