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My Sunday Washington Post Business Section column is out. This morning, we look at CDS — how they became such a dangerous aspect of the financial firmament.

The print version had the full headline Credit-default swaps are masquerading as financial products. They should be regulated as insurance products. (The online version is merely Credit default swaps are insurance products. It’s time we regulated them as such.).

Here’s an excerpt from the column:

“Despite the CFMA’s horrific fatality toll, it has never been overturned. Parts of it were modified by Dodd-Frank regulations, but not the insurance exemptions. Today, these swaps are cleared through exchanges or clearinghouses — but they are still exempt from all insurance regulatory oversight. Which is bizarre, because they are little more than thinly disguised insurance products, with the CFMA kicker that there is no reserve requirement.

Which brings us more or less up to date — and onto more topical issues, such as Greece. Two weeks ago, the International Swaps and Derivatives Association said that “based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”

That is an odd statement about a tradable asset — based on evidence? Typically, an option or futures contract expires, and it either is in or out of the money. Any tradable asset — stocks, bonds, futures, options, funds, etc. — settles on its own. There is a market price the asset closes at, a total volume of sales, and a final print for the day, month, quarter and year. No interpretation is required. Why on earth would anyone need a committee ruling for a trade?”

The full column goes into the tortured history of CDS.

The Post had a little fun with the dead tree version — here is the art work:
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click for ginormous version of print edition

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Source:
Credit default swaps are insurance products. It’s time we regulated them as such.
Barry Ritholtz
Washington Post, May 11 2012
http://www.washingtonpost.com/business/credit-default-swaps-are-insurance-products-its-time-we-regulated-them-as-such/2012/03/05/gIQAAUo83R_story_1.html

Washington Post, May 11 2012 (PDF)

Category: Apprenticed Investor, Bailouts, Derivatives

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

22 Responses to “Credit-default swaps are masquerading as financial products”

  1. Sechel says:

    Except CDS their not-insurance products. Insurance products are regulated and reserved against. There’s a great deal that Credit Default Swaps market has in common with the now banned bucket shop trading that occurred prior to the Great Depression.

    The reality is that a great deal of CDS is bought by banks to reduce regulatory capital. This also gives them something in common with the now exposed reinsurance scam of AIG where Spitzer uncovered side-letters, private undisclosed agreements that undid the reinsurance.

  2. BusSchDean says:

    Excellent piece! When do other responsible people in the finance industry sign the petition in support of it?

  3. scottinnj says:

    nice column as usual.

    But just to follow up – didn’t we try this with the mono line insurers like MBIA and they were unable to meet their claims on the policies they wrote on RMBS? They were regulated – arguably poorly regulated – and when they could not meet their obligations, they went into Chapter 11 where the courts will figure out what they can pay. Of course those weren’t CDS. Is that the model you think we should to go?

    I never quite figured out why AIG was ‘too big to fail’ while MBIA, FGIC et al – whose par exposure wasn’t that different than AIG in RMBS – were allowed to fail. Obviously there was a difference in that MBIA et al did not have to post collateral, and the cynic would also argue the difference was that Goldman Sachs didn’t trade with the mono lines they traded with AIG (due to the collateral requirements).

    And do bring the Groucho glasses to your next TV appearance!

  4. BR,

    these Pieces, that you are providing to WaPo, definitely, raise their ‘Batting Average’..

    though, along the line of..

    http://www.youtube.com/watch?v=AtZTGfOhB7Y&list=UU8eFERtcxPZ-M3Cxkh7zhtQ&index=9&feature=plcp

    Lauren Lyster is doing a ‘Word of the Day’-piece (~5:00 mins.)(one of a Series, this one..”re-Hypothecation”)

    maybe, you could do similar? a Video ~Show ‘n Tell on some of these Topics you are expounding upon..

    “You Know, For Kids!” ~

  5. Moss says:

    It all comes down to the fact that the Banksters and others can trade them without properly accounting for the risk of issuing them. Money for nothing. A complete farce much like a three card Monty game.

  6. blackjaquekerouac says:

    “a question of semantics.” how interesting. Go talk to LKofEnglish at Seeking Alpha then. The fact is “they are issued by banks and financial institutions for the purpose of increasing liquidity in the marketplace.” Period. “That is not an insurance product” moron…and writing as such in the Washington Post to said effect does not make it so. Of course…”you can regulate them all you want” BUT THIS IS A CONTRACT…nothing more…NOTHING LESS either. Go ahead: “stick a Judge in there and see what he does.” The politician has already spent the money of course…

  7. farmera1 says:

    Just wonder how many times the government will have to save these products before the light goes on and it is decided that there just might, just might be something wrong with these things.

    The LTCM debacle in 1998 was the direct result of using unregulated derivatives to speculate.

    http://en.wikipedia.org/wiki/LCTM

    “LTCM was founded in 1994 by John Meriwether, the former vice-chairman and head of bond trading at Salomon Brothers. Board of directors members included Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a “new method to determine the value of derivatives”.[4] Initially successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis requiring financial intervention by the Federal Reserve Bank, and the fund closed in early 2000.”

    “Seeing no options left the Federal Reserve Bank of New York organized a bailout of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.[24] The principal negotiator for LTCM was general counsel James G. Rickards.[25] The contributions from the various institutions were as follows:[26][27]“

  8. farmera1 says:

    I especially like the sign in my local insurance agents office:

    YOU CAN”T INSURE SOMETHING YOU DON”T OWN

    Too bad AIG, the bankers and hedge funds don’t know this is a rule. Writing unregulated derivatives on things you don’t own is done all the time. Too bad these blow up every few years and the government has to step in to “save” these 1% ers.

  9. Petey Wheatstraw says:

    Insurance products? Financial products? (Rule of thumb: Whenever you hear the words “financial product,” convert your cash to something of real value and hide it or live on it).

    They are better described as land mines.

    Don’t agree? Wait until somebody steps on one.

    blackjaquekerouac:

    What’s the point in reading or responding to someone you consider a moron? Would seem to paint you as an imbecile or an idiot (each being a matter of severity of the same underlying defect).

    “. . . they are issued by banks and financial institutions for the purpose of increasing liquidity in the marketplace.”

    Please explain how this works, and how they do not function exactly as insurance or bets for or against losses based on chicanery. Please explain how insurance is based on anything BUT a contract. Insurance IS a financial product. Nothing more, nothing less.

  10. TacomaHighlands says:

    Superb article Barry. Washington State, specifically Sen. Maria Cantwell, has done a good job on this in the past. Her tangles on the subject coincided with the energy giant Enron, whose collapse after an accounting scandal dovetailed with her arrival to the Senate in 2001. She fought for the Snohomish County Public Utility District during its long court battle with Enron over $116 million in fees stemming from the company’s manipulation of energy markets to inflate electricity rates. The utility settled by paying a fraction of the money Enron demanded. It was unfortunate she didn’t sit on the Banking or Ag committees.

  11. jayhoag says:

    Good piece. A question: why was 2/3s of AIG’s book of CDS bought bu European banks or institutions?

  12. Petey,

    at the EOD, some, actually, are Epsilon- Semi-Morons..

    good thing about that, though, is ‘they’ tend to make themselves, readily, know -able/-n..

    something tells me that BR needn’t ‘worry’, on that Score..

    others? might be in Need of a Mirror..

  13. land says:

    A brief take by Martin Hutchinson that’s worth a look at:

    * Ban the things altogether – a proposal that features the virtue of simplicity, and has little economic cost (since credit default swaps don’t really do the job they were designed for, as I’ll show you in a moment).
    * Ban the sale of a “naked” credit default swap – meaning one in which the party doesn’t own the underlying debt (since it would bring the CDS market in line with the insurance market, where it has since 1774 been illegal to buy a life insurance policy on a stranger – ostensibly because the chance of an “accident” is too great).
    * Or require banks to assess the full value of their CDS obligations as loans, and count the appropriate percentage of them against capital, making it difficult for huge volumes of CDS trading to develop (since it would become hugely expensive for banks to write them).

    http://goldnews.bullionvault.com/cds_ban_062820115

  14. Sechel says:

    B.R.
    Did you catch the guy on Zero Hedge attempting to obfuscate the issue. 2nd rate sophistry at best if you ask me.

    http://www.zerohedge.com/news/cds-insurance-contracts

  15. louis says:

    “Just wonder how many times the government will have to save these products ”

    That’s the problem, the products are the government now.

  16. willid3 says:

    insurance products are contracts. insurance is coverage for when some thing goes wrong (like car insurance covers your car for accidents?), what other finance product covers some thing going wrong?

  17. louis says:

    Yes when something goes wrong, like providing federally backed insurance for mortgage lenders.

    Hopefully nothing goes wrong.

  18. [...] Barry on Credit Default Swaps masquerading as financial products.  (TBP) [...]

  19. drtomaso says:

    I can assure you that those on the buying end of these contracts do not treat them like insurance. There has been a mad scramble to bring risk systems street wide up to the task of understanding our counterparty risk- ie: who do I have contracts with and what is the likelihood they will be able to make good on their comitments?

    The CDS is not and never will be insurance. Its a contract- its sometimes useful to think of it like insurance, but thats just an allegory for the purposes of explaining how they work. Its a derivative contract, and the buyer is exposed to the risk the counterparty might not be able to pay. The fact that no one seemed to price this risk right in the late unpleasantness is not a failing of the tool- its a failure of the parties involved.

    Moving these from the OTC markets to the exchanges will go a long way to mitigating this risk- the exchanges will, just like with futures contracts, options and other listed derivatives, require capital in the form of margin to decrease the possibility of failure to pay. They will also standardize the terms and make these much simpler contracts to deal with.

  20. ellwood2011 says:

    How much secondary trading really goes on in CDS? I don’t know and would like to be pointed to the data. I would guess not a lotof true secondary trading, as in I bought this contract last month at 7 and it’s moved up to 9 so now I am selling to a third party for 9. As distinguished from the bilateral opening and closing of contracts between the CDS writer and the holder.

  21. drtomaso says:

    My guess would be that it is very low. Remember that many of the OTC transactions, while using standardized contract language and forms, are still unique to the contract and parties involved- so you’re more likely to call up your counterparty and unwind the trade, or enter into an statistically offsetting position with another counterparty. Further, because they are not traded on an exchange, it will be difficult to find out the volume of trades cause there are minimal reporting requirements.

    Again, moving to an exchange model would mean these things would have to be boilerplate standard, and would greatly increase the ability to trade these on secondary markets.

  22. AtlasRocked says:

    Seems like they should be illegal. With insurance, you are buying something that you lose wealth on if it is destroyed/damaged/devalued. Only the person losing the wealth can buy the policy. Well except life insurance, the beneficiary doesn’t have the buy the policy – but they make a profit if the insured person dies.

    If 100 people buy CDS that pay if “company A” dies, don’t 100 people have a vested interest in bringing about the death of “company A”?
    —————————-

    Your article states that , regarding Self regulation beliefs ” … Managers would never do anything that would put the shareholders at risk, and if they did it would suitable punished by the shareholders”

    Don’t managers take risk on new products and investments of company manpower and money all the time? That’s their job to take risk on new product and service investments right?

    Didn’t the deregulation crowd believe the shareholders would be **punished**, not that they would flee? Didn’t the bailouts actually DESTROY what the deregulation fans felt should happen?: The shareholders get punished with losses, not bailed out? (I’m not a deregulation fan as you can see above.)

    Shareholder don’t get frightened of the unknown, they buy a company because of past performance, fundamentals, risk, etc., they don’t typically get inside word on a new product or fiscal instrument, so isn’t the idea the shareholders would flee **before** a deregulation effect is known preposterous? Isn’t the key feedback for deregulation advocates the actual crash and loss due to stupid choices, a process hidden by bailouts?