Thursday, August 26, 2010

Credit Default Swaps as Insurance Products

I was involved in a very interesting thread in a diary that lost its way in my opinion because it advocated martial law At this point in the Bush presidency I wouldn’t give him the power of martial law if men from Mars invaded. What was more interesting was the discussion of a financial vehicle called a Credit Default Swap or CDS.

A CDS contract can be likened to an insurance policy purchased by a creditor against the possibility of the debtor not paying. I believe a huge and unaddresed cause of our financial crisis arose because any party was given the ability to purchase a CDS contract. What happens when I lend money to my brother and his enemy can bet my brother won’t pay me back and kills him? This is the condition we have and have allowed with CDS’s. Wiki defines a CDS like this.

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" makes periodic payments to the "seller" in exchange for the right to a payoff if there is a default[2] or credit event in respect of a third party or "reference entity".
In the event of default in the reference entity:
• the buyer typically delivers the defaulted asset to the seller for a payment of the par value. This is known as "physical settlement".
• Or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation. This is known as "cash settlement".
While little known to most individual investors, credit default swaps are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against bond defaults -- a buyer doesn't necessarily have to own a bond to buy the credit default swap that insures it. When traders buy swap protection, they're speculating a loan or bond will fail; when they sell swaps, they're betting that a borrower's ability to pay will improve.

These are insurance products. They insure against a debtor not paying a debt, but as insurance products they lack two aspects vital to any insurance contract. These products flaunt a very important concept of insurance that the person receiving the benefit of an insurance policy be made whole after an event and not profit. You can’t sell a person who only earns 1000 dollars a month a disability policy worth 2000 per month. They will go on disability and make a profit. These products also lack any form of insurable interest. Say I’m given the ability to purchase an insurance policy against the ability of any company I choose to pay its debt, and I’m wealthy say a hedge fund, what would stop me from short selling Lehman Brothers into oblivion while earning a tremendous profit from a CDS that says Lehman won’t pay its bills. I see this as the situation as has prevailed.

What if we were to treat the CDS’s as the insurance vehicles they are and regulate them as such. We could then have all contracts examined for “insurable interest” those parties with said interest would be paid, but those who didn’t those I suspect are the bad actors in this affair would not. How about they take the loss and not the American taxpayer.

I have a very sneaking suspicion that it is those people lining up at AIG’s window collecting on these things who need to lose. So I ask my fellow Kossacks what would happen if those without insurable interest did not get paid, and do they deserve to profit on a loss they didn’t incur? Why can't a group of lawyers examine these CDS's to see if they are not indeed insurance contracts. Why can't we have judges examine the provisions of the CDS's and beneficiaries of them for bad actors. Why can't we give these parties back their premiums as opposed to the keys to our treasury?

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