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Author Topic: Solution to the credit default swap problem 3 years too late  (Read 7521 times)
lurkingfear
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« on: April 29, 2012, 1:03:21 PM »

In watching the Frontline documentary on the financial market implosion, I wonder if the following solution occurred to congress:

When the depth of the liabilities for CDS at companies like AGI became apparent, why not make a rule that only those who bought CDS' as insurance get paid out (i.e., those firms who actually owned the mortgage bond for which they are buying the CDS). Those who bought them as straight bets perhaps get their premiums paid back but nothing else. If I called up AGI in 2004 and bought a billion dollar CDS on mortgages that I don't own, and pay, say, a million dollars a year for the 'insurance', I'm only out four million when s*** goes bad. Just like if I call up a bookie and place a bet that I lose: if the bookie so chooses he can absolve me of the debt and no one has lost any money.

What am I missing here? Would the courts not allow it because these were legal contracts?
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dalekk
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« Reply #1 on: April 29, 2012, 2:11:04 PM »

The reason those CDS were going into effect was because of the loss of billions of dollars worth of those underlying securities (home values).  If home values hadn't gone down, there wouldn't have been an issue about the CDS.  The reason the Fed and government stepped in to bail out AIG for over $100 billion was to prevent the complete collapse of the entire financial system.  That bailout money was given to AIG and then immediately paid out to dozens of differnt institutions.  If they just refunded the premiums paid, you would still have nearly every financial institution in the country insolvent or near insolvent.  The government bailed out AIG not to save AIG but to save the entire financial system.  The CDS created the illusion of security for those financial companies which made them take on more risk.  Paying back just the premiums wouldn't really solve anything in 2008-2009.  It was already too late for that. 
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lurkingfear
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« Reply #2 on: April 29, 2012, 2:35:10 PM »

Sure, AIG had to cover the real losses for premiums paid by companies that were actually holding paper on mortgage bonds, but the point I'm making is that many banks and hedge funds bought CDS' not to insure their own investments, but to bet against other people's investments. Those folks don't lose anything except the premium they paid for the bet when people don't pay their mortgages.
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dalekk
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« Reply #3 on: April 29, 2012, 3:21:47 PM »

But many institutions were using those CDS as hedges for other aspects of their operations.  They assumed the CDS were real.  They built their businesses and risk profiles around them.  If they had known that AIG was holding nearly half a trillion dollars of risk (and completely incapable of making good on those CDS), then they most likely would have restructured their risk in different ways.  Not making good on those CDS would have been just as ruinous for firms using them as hedges.  That may not have been the case with all the CDS involved, but it would have been true for many of them.

For example, say I short a stock X.  I'm betting on it going down.  But I want to hedge my bet by investing a very small amount in call options.  If the stock X goes down I make a huge amount of money and forfeit a small amount in the "premium" I paid for the call option to protect myself.  But if the stock X soars, I'm protected against my losses by the call options.  If stock X soars and I come to find out the option was fake and not made good on it, I'm ruined.  I had built my entire portfolio around the assumption that the call option was real and had real value. 

Many institutions were using these CDS as hedges in this way.  Once you introduce the CDS as a way to reduce risk it pollutes the entire system.  Choosing which ones to honor and not honor is really not an option, imo.

Besides that, I'm not sure how you could legally uphold one contract and not another. 
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pigou
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« Reply #4 on: April 29, 2012, 4:39:05 PM »

Sure, AIG had to cover the real losses for premiums paid by companies that were actually holding paper on mortgage bonds, but the point I'm making is that many banks and hedge funds bought CDS' not to insure their own investments, but to bet against other people's investments. Those folks don't lose anything except the premium they paid for the bet when people don't pay their mortgages.
I think the problem is that you may have good reason for buying insurance on debt that you don't own, if you believe that the performance of that debt is correlated with something you do invest in. Imagine, for example, you invest in a mall in Florida. The revenue of that mall is going to depend on how well-off the residents there are. Residents defaulting on their mortgages would be a good sign that they're not going to spend money at the mall either - so if you want to prevent huge losses on your mall, you might want to buy insurance against their debt. That would be a nightmare to unravel, especially given that there's not even a public market for most of these products (i.e. they're not traded on something like the New York Stock Exchange). So there's really no way of knowing who owns what, much less why they bought things or from whom.

More fundamentally, however, you can't have the government deciding who invested in a product for "legitimate" reasons and who just speculated. Ultimately, there's a speculator at one end of every transaction: someone needs to hedge a risk and someone else is willing to put up their assets in the expectation that they pay out less in claims than they collect in premiums and fees.
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parispundit
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« Reply #5 on: May 14, 2012, 2:49:57 AM »

Sure, AIG had to cover the real losses for premiums paid by companies that were actually holding paper on mortgage bonds, but the point I'm making is that many banks and hedge funds bought CDS' not to insure their own investments, but to bet against other people's investments. Those folks don't lose anything except the premium they paid for the bet when people don't pay their mortgages.
I think the problem is that you may have good reason for buying insurance on debt that you don't own, if you believe that the performance of that debt is correlated with something you do invest in. Imagine, for example, you invest in a mall in Florida. The revenue of that mall is going to depend on how well-off the residents there are. Residents defaulting on their mortgages would be a good sign that they're not going to spend money at the mall either - so if you want to prevent huge losses on your mall, you might want to buy insurance against their debt. That would be a nightmare to unravel, especially given that there's not even a public market for most of these products (i.e. they're not traded on something like the New York Stock Exchange). So there's really no way of knowing who owns what, much less why they bought things or from whom.

More fundamentally, however, you can't have the government deciding who invested in a product for "legitimate" reasons and who just speculated. Ultimately, there's a speculator at one end of every transaction: someone needs to hedge a risk and someone else is willing to put up their assets in the expectation that they pay out less in claims than they collect in premiums and fees.

On the other hand, there may be good reason to wonder if the market efficiency created by allowing CDS at all is worth the massive systemic risk created. The best hedge, as the saying goes, is to sell. There is good reason to think that government cannot prevent some form of CDS from excsting, but government should be able to prevent any institution with protected deposits, e.g. banks, from investing in them.
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