A good case for regulating credit default swaps
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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.
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This piece encourages socialism. The free market will allow these instruments to be bought and sold rationally, if institutions were allowed to fail. They would have there own risk management mechanisms to address these concerns. Free markets are far better than government-operated (or controlled) corporations. These institutions are either extensions of government or they are treated like free people with all the inherent rights and privileges. You cannot have it both ways. Also, friendly reminder: spell check. Yooz an ivy leeger, no?
But the free market did NOT foster rational decisions. Yes, I caught your caveat — IF institutions are allowed to fail. If we’d let AIG, BofA, etc., etc., follow Lehman down the tubes, the consequences would have been more dire than I can contemplate. I hate bailouts too — but sometimes you just have to hold your nose…
In response to another comment. See in context »And remember, I’m not for banning nakes CDS’s. I’m for putting them under the umbrella of insurance regulation. That’s not socialistic at all.
And hey, people like me are essential to the economy — full employment for copy editors! I recently confused breach and breech in a post, prompting a friend to tease my about dropping trou in public…
The insurance biznis is rapidly becoming a government controlled industry. Watch what you espouse, comrade dimples!
In response to another comment. See in context »ah, would that it were. Remember, I was all for the public option. And in fact, I think the whole concept of health insurance is obsolete — I think the government should simply pay the hospitals directly. (But I’ll negotiate on that…)
In response to another comment. See in context »Leon,
You state that free markets are far better than government operated corporations but you give no proof. I disagree, I think that history has consistently showed that governmental organizations are better than free markets in areas such as:
the military,
parks
education
Frankly, you can combine systems and only people who deny reality can’t see that the optimum solution to any problem is unlikely to be at the extremes.
In response to another comment. See in context »So the optimum solution lies somewhere between the thinking of Ayn Rand and Vlad Lenin?
In response to another comment. See in context »that sure includes an awful lot of territory, no? so yeah…sure it does
In response to another comment. See in context »Leon…
[aside–at 3-score and 8, I’ve grown less eager to make comments on folks’ spelling, as I now find my fingers type some words ‘automatically’ while my mind is workin’ overtime. Point one finger forward, three are pointing back at yourself, and the thumb, I guess, is asking for divine intervention.
You wrote, in sentence #2: “They would have there own risk….”
Should be possessive, “their own risk”. And spell-check won’t flag there/their/they’re mistakes ‘cuz they’re all spelled correctly. Just used incorrectly.
And like the rest of us, “Ivy Leaguers” write and spell about as well as the rest of the generations after my own. That is to say, very badly. I think it has to do with the lack of Latin instruction, lack of phonic training, sentence-parsing, all that there good stuff.
As to Claudia’s content, I would go further than classifying these credit default swap contracts as insurance. This is bookies’ work, trying to “balance the book” on particular bets.
As I see it–perhaps simple-mindedly–the only thing that can be considered “an investment” is the very first time a stock is sold by a company to a consumer, or the very first time a bond is “sold” by the company to a coupon-clipper. In these transactions, money goes directly from the consumer/citizen to the corporation (which is now a person, too, which allows for some very exciting things (banning corporations younger than 18 years old from driving, drinking alcoholic beverages, voting, entering into contracts, being drafted, being arrested for cocaine and pot ingestion, etc. The Nine haven’t said anything about how you determine the sex of a corporation yet, but I’m sure they will, real soon now).
EVERY action thereafter is a bet–betting on someone else’s failure, betting that you can sell the stock/bond for more than you paid for it, etc. But NONE of that money is invested in the corporation. Unless the corporation is gambling in its own stock, the money doesn’t ever reach the corporation again.
I heard one BBC columnist say something to the effect that “So, really, the stock market is just a big side show and has nothing to do with keeping industry going.” And his interviewee replied, “Yes, but it has such a great daily scorecard.”
Which is why we all should start calling our “financial, insurance, real estate” (FIRE) sector Casino Wall Street. Only the smallest percentage of transactions put money into the hands of the corporations and IOUs in the hands of those who loaned them their money.
Everything else is aleatory. And, essentially, sucking money out of the economy. IMHO, the FIRE sector should be about 1% to 2% of our economy, not the supposedly 19% or so it’s said now to be. And, indeed, if it IS that large a slice of our economy–one fifth of it–and it’s just a big gambling casino, any increase/decrease in its “revenues” should be weighed as an inverse relationship to our nation’s economic health. That is, as Casino Wall Street’s (or the Gang of Ten’s) profits increase, the economic health of the economy should be written DOWN by that amount, as CSW’s gains are the economy’s losses. Conversely, when CSW loses, that should be chalked up as a win, a good thing, for the economy.
Finally, please define what you mean by “socialism.” Would you define the fifth adjuration to our government listed in the Preamble to the US Constitution, “promote the general Welfare,” to be “socialism”?
Would you describe the courts and legal system the citizens support with their taxes–the ones that enforce Casino Wall Street’s gambling contracts–as “socialism” for the “capitalists”?
Also, please define “free market.” I sort of understand the phrase in theory, but I’ve never seen one “on the ground,” in real life. We have hundreds, if not thousands, of laws, rules, regs, practices which are designed to give one person, group, sector an advantage over other people, groups, sectors.
We have bank subsidies, granted secretly by the private so-called “federal reserve system” (which is not federal, there is no reserve–it’s all ’system’); food subsidies in the form of marketing group orders, agribusiness subsidies, mining subsidies (extraction rights given to some/many at far, far below the “fair market price” of those minerals, ores, resources on “the open market.” The so-called “fed” has its secret Open Market Committee, a delightful oxymoron of its very own).
What are paved highways, paid for by all, but subsidies for agriculture (I would say manufacturing, but do we have manufacturers in the United States anymore?), subsidies for Casino Wall Street (driving to work) and all public transportation.
Our railroads, such as they are, were boosted by government subsidies, use of eminent domain to take private land for “public” purposes. And the railroad “barons” grew wealthy, and fat (I think that’s the right causal order).
So again, Leonkelly, how do you define “socialism,” and “free market”? The natural tendency of “capitalism” is a rapacious monopoly; failing that, an oligarchy (often conspiratorial, as with oil, agribusiness, etc., price-fixing, insider gambling in Casino Wall Street).
By my lights, there has been a wholesale acquiescence of “Le Media Grande” in the fable(s) told by the oligarchs. This “free market” you speak of is really the emperor with no clothes. You are perhaps holding up his non-existent train with all the others. And only the young (perhaps with a slingshot and dead mouse in his pocket) had the moxie to declare that the emperor had no clothes. He only used the evidence before his eyes–which is not always reliable, but in this case was so.
For the others in the emperor’s retinue, and his subjects, a forcible denial of what was also before their eyes. Individual thinking, individual responsibility, individual expression had to be suppressed, given up, foregone, abdicated.
Just as we all do when we speak of “investors” after the first sale, of “capitalism,” of “Wall Street” without the word “Casino” preceding it: Casino Wall Street. And as with all casinos, the ‘house’ always wins. “Counters” are turned away (they unbalance the odds against the gambler); the slots are rigged, dice can be loaded, electromagnets or other simpler friction devices used on the craps tables and roulette wheels, etc.
It would probably do no harm to anyone but the employees at Casino Wall Street if third-party sales of stocks and bonds were eliminated entirely, as purely aleatory, without redeeming social value, as definitely NOT “promoting the GENERAL Welfare.” And definitely not permitting all of the people in ‘We the People” to “secure the Blessings of Liberty to ourselves and our Posterity.”
In response to another comment. See in context »PS: I forgot to mention “oil depletion allowances.” Anyone here an expert on those? Something like depreciation in real estate?
The oil folks get to reduce their income by some substantial percentage because they’re “reducing the value of their oil wells” by taking oil out and selling it. So the more they extract from the earth (or the marshes & beaches of Southeastern US) the less “profit” they make, ‘cuz they’re “depleting” their assets. What a sweet deal THAT is, no?
Now, is that “socialism,” or “the free market”?
Some call it “privatization of profit, socialization of risk,” or more simply, Heads, they win, tails, we lose.
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