A good case for regulating credit default swaps
That sounds like preaching to the choir — I mean, is there anyone out there who thinks Wall Street should continue to barrel along, unwatched and untouched? But I’m going the other direction on this — too many people are talking about banning esoteric instruments outright.
Floyd Norris has a brilliant take on one particularly heinous instrument, naked credit default swaps. These are much like the hated synthetic CDOs, in that they enable people who have absolutely no skin in the game (i.e., who don’t own the underlying bonds themselves) to bet that comopanies or governments will default on their debts.
The way Floyd sees it, credit default swaps — naked or clothed — are not esoteric financial instruments at all. They are insurance, and should be regulated as such. In fact, he thinks they were named swaps expressly to prevent Washington from recognizing what they really are.
Credit-default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of the swap cannot meet its obligations. The seller gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.
But the people who dreamed up credit-default swaps did not like the word insurance. It smacked of regulation and of reserves that insurance companies must set aside in case there were claims. So they called the new thing a swap.
Floyd makes a hard-to-dispute case that if swaps had been considered insurance, thus forcing companies to put aside reserves to cover them, AIG might never have failed. And naked swaps might have been outlawed from the getgo.
Had credit-default swaps been classified as insurance, the concept of “insurable interest” might have been applied. That concept says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest.
What that means, of course, is that you cannot benefit from my death or my homelessness unless you also have a stake in keeping me alive and sheltered. Otherwise, you have one heck of an incentive to shoot me or burn my house down.
Well, as Floyd rightly notes, the same thing applies to swaps that enable investors to rake in money from a company’s insolvency. And he adds another danger that I’d never thought of: undermining bankruptcy laws.
Normally, a creditor wants to keep a company out of bankruptcy if there is a decent chance it can survive. If it does go broke, the creditor wants to maximize the value of the company anyway, so that more will be available to pay creditors.
But what happens if a major creditor, who might even control one class of bonds, has a much larger position in credit-default swaps?
Will he not have interests directly at odds with those of other creditors, since he will do better if the company ends up with less to pay its creditors? Might that creditor seek to, and perhaps be able to, sabotage the company’s best hopes for revival?
Maybe the financial reform bill now moving through reconciliation will tackle the esoteric financial instrument problem in some novel and equally effective way. But if not, I think reclassifying swaps as insurance would be a gigantic step forward.