Is it possible to defend Credit Default Swaps?

On Reuters.com today, I see an attempt to defend Credit Default Swaps (CDS) titled "Demonization of CDS mis-states real role in crisis".

If I recollect aright, I have earlier explained on this Blog that CDS have two roles. First, they have an insurance function, and are used to protect against the risk of a company, government or other borrower not paying back their debt. When a borrower fails, the party that buys the protection is eligible to be paid the full amount insured.

Second, however, CDS can be used to gamble, in that one can speculate on the likelihood of a company or government or other borrower not paying back their debt.

The defence of CDS on Reuters needs to be seen in the context of the size of this market: currently CDS are worth $55 trillion (that is, more than all the real wealth in the world). What one thinks of CDS therefore has huge consequences.

Rising to the defence of CDS is Professor Roy Smith of the Stern School of Business at New York University who, according to Reuters, is reported to have said that CDS are "nothing more than an insurance contract .... You can't have a good or an evil insurance policy." He completely ignores the fact that CDS can be used, and indeed have largely been used, for the purpose of incredibly large-scale gambling.

That is why some people (rather more eminent people than myself, but including myself), consider CDS as "evil", "acts of Satan" and "financial weapons of mass destruction". CDS have played a key role in spreading the risks of immoral mortgage-lending decisions globally. CDS have also encouraged banks and insurers to take on more risk than they could handle, sometimes causing not only their collapse but also threatening systemic collapse, such as when they affected Lehman Brothers or Goldman Sachs. The latter had outstanding leveraged bets (such as CDS) worth more than $1Trillion, when its own capital base was "only" $43 billion.

Professor Smith, however, argues that the tool itself is not to blame for lax risk management.
"You could criticize demon rum, or anything that might serve some other purpose that which can be misused," NYU's Smith said. "There are lots of ways to abuse many things."

True. But we forbid juveniles from being able to buy rum and all other forms of alcohol, we don't have rum running free through the public water supply system, and we don't actually pay people to drink rum (don't forget that people were actually making huge sums of money from issuing CDS that they knew they could never honour).

If the abuse of some thing has huge global consequences, then it is right and proper to regulate who can buy or sell, how much they can buy or sell, and for what purpose they can and should buy or sell.

Like Professor Smith, I believe in free markets. But there is (or should be) a difference between a free market and a jungle.

You can have free markets that systematically ignore and subvert even existing safegaurds - as was the case in the global economy over the last decade and more. Or you can have free markets in line with rules and safeguards - like a football match or other sports or athletic event.

There is all the difference in the world between saying "May the better boxer win" and saying "Every murderer should be allowed to get away scot free". Sphere: Related Content