Money Morning's Martin Hutchinson just posted an article explaining why market players, and the U.S. Congress, needs to support Rep. Maxine Waters' (D-CA) bill banning credit default swaps.
So, just what are credit default swaps? In a few words they're supposed to be insurance contracts for the complex financial instruments that helped bring down the market. Why do they need to be banned? Because no one could pay out on the contracts when the market meltdown occurred. Here's a synopsis of the credit default swap market (which appeared in my book, p. 228), which helps explain why.
Can you imagine buying car insurance and then having your insurer say, "Sorry, we're out of money, we only wanted your premiums ..."? This is essentially what has happened with the CDS market.
The problem with the CDS market is that it gave investors-speculators a false sense of confidence. It helped them believe that their products and portfolios were insured. This encouraged them to write and invent even more complex financial instruments, which only fed the cycle that led to market collapse.
Consdider this: The size of the CDS market grew from a "modest" $1 trillion in 2001 to an astounding $54.6 trillion (some estimates put the amount at $75 trillion) by 2008. This was more than double the size of the U.S. stock market.
If you're wondering where your trillions in bailout money has been going, wonder no more. Much of it is now going to pay off these insurance contracts - which insured bad bets and poorly vetted financial instruments. This explains why some of the financial conglomerates are now reporting "profits" this quarter. They're getting payout (and bonuses) for writing a bad product.
I agree with Rep. Maxine Waters. The practice of issuing CDS contracts in their current form should be banned. Still, I also think there are some merits to insurance markets for certain industries. But insuring market "bets" and other "derivative" contracts should not be part of the equation.
Read Hutchinson's article. It goes a long way in explaining why we will only end up doing our market meltdown all over again if we don't deal with (i.e. regulate) the CDS market now.
- Mark
UPDATE: For more information on credit default swaps click here and here.
So, just what are credit default swaps? In a few words they're supposed to be insurance contracts for the complex financial instruments that helped bring down the market. Why do they need to be banned? Because no one could pay out on the contracts when the market meltdown occurred. Here's a synopsis of the credit default swap market (which appeared in my book, p. 228), which helps explain why.
Credit default swaps (CDS) are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt, and mortgage securities. They are sold by banks, hedge funds, and other market players. Like anyone who purchases car insurance those who purchase CDS contracts make payments on a regular basis. In return they get peace of mind, knowing that losses will be covered if a default happens.
The process is supposed to work similarly to someone taking out car or home insurance to protect against losses from fire and theft. Except that it doesn’t. Banks and insurance companies are regulated; the CDS market is not. This explains why credit default swap contracts were traded — or swapped — from market player to market player without any oversight. Most market players simply wanted the income stream from the “premiums” paid.
Not surprisingly, many buyers did not have the resources to cover losses if the security that they insured failed. This is what happened in 2007 and 2008. Like small insurance companies who hoped they never would have to face claims from a regional earthquake or a Katrina-like event, market players who provided insurance for investment and derivative portfolios weren’t properly capitalized and could not pay out claims when their markets collapsed.
Can you imagine buying car insurance and then having your insurer say, "Sorry, we're out of money, we only wanted your premiums ..."? This is essentially what has happened with the CDS market.
The problem with the CDS market is that it gave investors-speculators a false sense of confidence. It helped them believe that their products and portfolios were insured. This encouraged them to write and invent even more complex financial instruments, which only fed the cycle that led to market collapse.
Consdider this: The size of the CDS market grew from a "modest" $1 trillion in 2001 to an astounding $54.6 trillion (some estimates put the amount at $75 trillion) by 2008. This was more than double the size of the U.S. stock market.
If you're wondering where your trillions in bailout money has been going, wonder no more. Much of it is now going to pay off these insurance contracts - which insured bad bets and poorly vetted financial instruments. This explains why some of the financial conglomerates are now reporting "profits" this quarter. They're getting payout (and bonuses) for writing a bad product.
I agree with Rep. Maxine Waters. The practice of issuing CDS contracts in their current form should be banned. Still, I also think there are some merits to insurance markets for certain industries. But insuring market "bets" and other "derivative" contracts should not be part of the equation.
Read Hutchinson's article. It goes a long way in explaining why we will only end up doing our market meltdown all over again if we don't deal with (i.e. regulate) the CDS market now.
- Mark
UPDATE: For more information on credit default swaps click here and here.
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