Credit Default Swaps - Love 'Em, Ban 'Em, or Tax 'Em?

I have repeatedly argued that over-the-counter credit default swaps (CDS) - or at least at least "naked" CDS - should be banned ("naked CDS" is the term I coined to describe the situation where the buyer is not the referenced entity. I will not comment on whether or not there is a real economic benefit when the referenced company buys CDS concerning itself or its suppliers as an insurance policy; I will leave that analysis to the CDS experts).

Says Who?

I'm in good company, of course, as many economists and financial advisors have warned of the dangers of CDS:

• A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown

• Warren Buffett called them “weapons of mass destruction” in 2003

• Warren Buffett’s sidekick Charles T. Munger, has called the CDS prohibition the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it”

• Former Federal Reserve Chairman Alan Greenspan - after being one of their biggest cheerleaders - now says CDS are dangerous

• Former SEC chairman Christopher Cox said "The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis''

• Newsweek called CDS "The Monster that Ate Wall Street"

• President Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives “have threatened the entire financial system”

• George Soros says the market is still unsafe, and that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so-called short sales.

• U.S. Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.

• Nobel prize-winning economist Myron Scholes - who developed much of the pricing structure used in CDS - said that existing over-the-counter CDS were so dangerous that they should be “blown up or burned”, and we should start fresh

• In perhaps the most anti-derivatives statement of all, Nassim Nicholas Taleb said this month, "To curb volatility in financial markets some financial products 'should not trade,' including complex derivatives."

But CDS seller are now saying everything is fine, that they are making changes which reduce risk, and that the danger has passed.

As an article in Bloomberg noted this week:

A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster.

So are CDS really safe now?

Not So Safe

Well, initially, before we can even begin to have an intelligent discussion about this issue, it is important to note that - according to Satyajit Das, a leading credit default swap expert - the commonly-accepted figures for the CDS losses suffered due to Lehman's bankruptcy have been understated. He also says that the justifications for the value of CDS for the economy are phony.

And it is also important to acknowledge that the government's proposed regulations of CDS (if they ever pass) won't really fix the problem. Indeed, Das says that the new credit default swap regulations not only won't help stabilize the economy, they might actually help to destabilize it.

And it should be remembered that the overwhelming majority of derivatives are held by just 5 banks. So the people behind the effort to reassure everyone that CDS are safe again are the too big to fail banks, desperate to restart the toxic asset and exotic instrument gravy train.

And the big financial firms and the government are both desperate to increase leverage, rather than allowing the deleveraging play out. See this, this, this, this and this.

As Nouriel Roubini said last month:

This is a crisis of solvency, not just liquidity, but true deleveraging has not begun yet because the losses of financial institutions have been socialised and put on government balance sheets. This limits the ability of banks to lend, households to spend and companies to invest...

The releveraging of the public sector through its build-up of large fiscal deficits risks crowding out a recovery in private sector spending.

CDS are an important way of creating leverage (for example, last year, the market for credit default swaps was larger than the entire world economy). So there is a huge (although wrong-headed, in my opinion) incentive to underplay the risks of CDS.

It is also possible to argue (although I haven't seen this argument validated by any experts) that CDS are inherently destabilizing for the financial system since they increase interconnectivity.

And don't forget that credit default swap counterparties drive company after company into bankruptcy, and that - once a company the counterparties are betting against goes bankrupt - the counterparties cut in line in front of all of the bankruptcy creditors to get paid (and see this and this). In other words, there are other problems caused by CDS other than destabilizing the economy as a whole.

Interesting Alternatives

Two of the most interesting proposals in dealing with CDS come from Paul Volcker and Yves Smith.

Volcker argues that banks which receive taxpayer bailouts should not be heavily exposed to derivatives trading.

Yves Smith says that the best approach would be to significantly tax credit default swaps. She argues that that would shrink the CDS market - and the associated risks - faster than anything else. The more I think about it, the more Smith's approach makes sense.

The Bigger Problem

Perhaps most importantly, CDS sellers - like the big sellers of other financial products - know that the government will bail them out if CDS crash again. So they have strong incentives to sell them and to recreate huge levels of leverage.

Indeed, the same dynamic that led to the S&L crisis also led to last year's CDS crisis, and will lead to the next crisis as well. So - while CDS might be a particularly dangerous type of "weapon of mass destruction" (in Buffet's words) - the financial looters will probably find some way to loot on the public's dime, no matter what happens to CDS, unless they are they are meaningfully reigned in (or broken up).

In other words, the bottom line is that - yes - CDS are still dangerous. But - just as a killer, unless restrained, could use a paper weight to kill - the too-big-to-fails would just use some other instrument even if naked over-the-counter CDS are banned or tamed. Taking away a convicted murderer's gun might be a good first step. But if he is still free to cause harm, he may very well kill again.