Media coverage compounds the confusion about financial problems. Take a recent piece by Floyd Norris, probably the best informed of the New York Times finance columnists.
“Credit-default swaps are, in reality, insurance,” he writes in “Naked Truth on Default Swaps”. The seller of a credit default swap pays the buyer of the contract if there is a default on the specified bond. Mr. Norris asks: shouldn’t CDS be subject to the principle that “you cannot buy insurance on my life, or on my house, unless you have an insurable interest”?
That would mean that you should not be able to buy a default swap on a bond unless you own the bond. But this is a false deduction, because in practice even life insurance does not work on the insurable interest principle.
There is a lively secondary market in life policies, where you can sell me the policy on your life. This will happen if you want money now and I’m willing to pay you more than the insurance company would for surrendering the policy. While there is some controversy, research shows that this life settlement market works to policyholders’ advantage, though not insurance companies’.
If default swaps follow the life insurance model, they can be held by anyone willing to pay the price. In fact the financial regulation bill that is about to become law mandates registration, central clearing and – where feasible – exchange-listing of the derivatives. This has the advantage of making their prices public and facilitating trades.
As for “naked” buying of CDS, meaning buying the swaps without owning the bonds, the US Senate voted down a proposed ban. Mr. Norris appears to take issue with this vote but then turns around and writes that he doesn’t know whether an insurable interest should be required for swaps. Given that it is not generally required for life insurance, requiring it for CDS would be extreme. The NYT column, however, shows no awareness of the life settlement market and what that might imply for default swaps.
Focusing on naked buyers obscures the real issue, which is not about the buyers but rather the sellers of swap contracts. As Mr. Norris mentions, AIG is the prime example of the danger of selling CDS without having the capital reserves to make payments in case debtors don’t meet obligations. The question of how much capital CDS sellers should have is separate from the question of who buys the contracts. Regardless of whether the buyers were naked or not, AIG was in trouble once defaults on mortgage-backed notes increased.
So naked buying is not the problem and banning it makes no sense. Why, then, is it the subject of pundit cogitations?
Gary Gensler, chairman of the Commodities Future Trading Commission, is cited by Mr. Norris on insurable interest. The CFTC is trying to protect its turf from encroachment by the Securities and Exchange Commission, now that the financial bill joins the two bureaucracies at the hip as regulators of derivatives. One guess is that the CFTC may see “nakedness” as an area for extending its oversight.
If CDS follows the life settlement pattern, it will work fairly efficiently. Despite news stories expressing distaste at some people buying other people’s life insurance, the buyers do not cause sellers to die prematurely in order to cash in on the policies! The life settlement market is sufficiently well established that the Internal Revenue Service issues rulings to clarify the tax treatment of the transactions.
Mr. Norris suggests Wall Street called the derivatives “swaps” instead of insurance in the spirit of Humpty Dumpty using a word to mean just what he chooses it to mean. Here’s a quote from another Lewis Carroll creation, the Duchess in Alice in Wonderland: “Take care of the sense, and the sounds will take care of themselves.”
CDS are instruments, and like any tool they can be misused. The sensible thing is to have clearinghouses for the contracts and make sure the sellers put up reserves. Apart from that, the sounds are just senseless noise.