Why Ban Credit Default Swaps ?

Why ? Because that are unnatural instruments whose sole purpose is leveraged speculation, and the counterparty obligations entangle and propagate one financial institution's troubles to other.

What is a Credit Default Swap ("CDS") ?

In simple terms, it's a contract on possible future default by X providing for small ongoing and/or a upfront payment by the Buyer to the Seller. Then if X defaults (as defined in the contract) during the term of the CD swap (say, 5 years), then Seller must pay Buyer a large amount. For example, a credit default swap for $100 million on company X might require annual payments of 0.5% of that amount by Buyer to Seller, or $500,000 per year. If company X defaults within the specified time, Seller must pay Buyer for losses on $100 million of company X debt. That loss amount is settled at an auction, where the value of company X debt after defaults compared to its face amount determined the loss. If company X debt is worth 20% of face amount, then the loss is 80% making the CDS payment on default $80 million.

That's quite a payment for that crummy $500,000 per year. This asymmetry causes enormous problems.

What is the commercial purpose for such a contract ?

Are there natural buyers and sellers ?

Natural Buyers

These could be bondholders of debt of company X and any other entity that company X owes money to, such as lessors, commercial vendors, etc. There are plenty of these.

Natural Sellers

Hmmm ... who would effectively insure risk of default of company X ? Hmmmm ... ta da dum ta da di dum ... buzzzzzzzz. Time's up ! No one.

That's a big problem. These contracts have no natural commercial existence. Gosh, no wonder they did not exist for over two centuries of modern commerce and finance. Perhaps more, since Lloyd's of London has existed for over 300 years.

Why is this risk not like a simple insurance risk ?

Because each individual risk is hugely correlated with each other. A CDS is more like flood insurance, or volcano insurance, or nuclear contamination insurance. One default of a company impacts the whole network of its customers & vendors. And in a financial panic, a huge swath of companies can default. Gosh .. what just happened in 2008 ? Without government support, a large number of companies would have technically defaulted on debt as the commercial paper market collapsed.

All CDS risk is too highly correlated to be insurable, just like floods. Who provides flood insurance ? The government.

What Moral Hazards Arise from CDS ?

Normally in insurance, one cannot buy insurance unless one has an insurable risk. I can't buy fire insurance on my neighbor's house, since I lose nothing if his house burns. But a hedge fund can buy a CDS now to speculate on and profit from financial troubles of company X. And that same hedge fund could buy up its debt at pennies on the dollar (before default), then refuse to negotiate better terms and cause a default. That's bad.

Also, as company X experiences problems, the hedge funds can "gang-buy" that company's CDS. Without any natural sellers, the CDS market will be quickly flooded, making its debt seem far riskier than the cash market for its debt might otherwise be. So if the hedge fund is short a millions of shares of company X stock, the increased appearance of financial distress caused by overloading the CDS market with buy orders would likely cause the stock to drop precipitously. The beefers profit by creating credit problems via CDS.

This actually happened in many examples in 2008.

What to Do ?

Ban credit default swaps. Make credit insurance a true insurance contract with rules on having insurable interest (such as actually owning the bonds to collect), and tight rules on capital and diversification to make payoff prospects very strong. Regulate the contract like insurance and regulate writers of such insurance as insurance. That's what it is.

Word of the Day

"Asseverate" - verb, transitive [$10] and "asseveration" - noun [$10]
Asseverate means to declare solemnly or emphatically.
Asseveration is an instance of such.
Sentence: Bunkerman hereby asseverates with impeccable logic that all credit default swaps should be banned as unnatural and harmful products for undue speculation.