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How To Reform Credit Default Swaps

Geithner was asked today if he believed in naked credit default swaps.  Apparently he does, but it was both the wrong question and answer.  Reform of credit default swaps needs to be thorough, and though through from basic principles.  Here’s how to fix credit default swaps.

The first step is a name change.  Call them insurance, because that’s what they are.  The insure against the possibility that you won’t get paid money someone owes you.  Once they’re called insurance, regulate them like insurance.

  1. Require an insurable interest.  That is, if Joe owes Fred money, Emma can’t buy insurance on Joe not paying Fred.  This is a fundamental rule in most insurance, you can’t insure someone else’s house against fire, because then you have a reason to want that house to wind up on fire, and no reason not to want it to burn down.
  2. Don’t allow over-insurance.  No debt can be insured for more than it’s worth.  If Joe owes Fred $100, then Fred can’t buy more than $100 worth of insurance.  In fact, better, he can’t buy more than $90 worth of insurance.  Again, we don’t want anyone better off if the debtor defaults than if they make the payments.  In life insurance there are many studies which show that people who are worth more dead than alive tend to die a lot more than people who aren’t over insured.  Imagine that.
  3. The mathematical models and actuarial tables used to figure out how much must be paid for insurance, the premiums, are set by government actuaries, just like they are in most other insurance businesses.  Current credit default models tended to assume things like “this housing bubble will last forever” and “there will never be another recession” and “defaults don’t cluster”.  Those assumptions were so wrong that building them into models amounted to fraud.
  4. No product which insures against credit default can be put on the market without actuaries from government regulatory bodies reviewing it.
  5. Proper reserves.  The party issuing the credit default swaps must have enough money to back them up, based on the governments actuarial charts and reserve requirements.  Life insurers and property insurers have to, so should credit insurers.  These reserves cannot be the debts the insurer is insuring.

There are other methods one could use to regulate and fix the default market, like having open exchange traded contracts, which could be made to work as well, but this is the simplest model and one that has worked well in the rest of the insurance industry.

The larger rule is simpler: no unregulated financial markets or entities without sufficient capital to cover their bets, so the taxpayer winds up stuck with the bill.  If you want to gamble, go to Las Vegas.  If you want to sell insurance, be a nice old fashioned stody insurance company who pays your executives low six figure salaries.


Reinstituting Glass-Steagall: the only way to fix financial markets


Chuck “AIG should commit suicide” Grassley voted to repeal Glass-Steagall


  1. Mark Bagdonq

    You are too meek in your recommendations for credit default swaps. The G20 should get together and call them all void as of a certain date, April 15 would be a good date. The seller just returns the unused portion of the premium and we start from ground zero. $25 trillion of liabilities evaporate just like that – poof.

    Lots of financial institutions balance sheets improve overnight.
    The decrease in liabilities has got to greatly exceed the loss of assets.

  2. Ian Welsh

    I could live with that, I’ve even suggested it on occasion. I meant that if we want credit insurance going forward (as opposed to looking back at ones that were fraudulent in essence) this is what needs to be done.

  3. pat

    Or simply

    “Any entity that wrote a CDS they couldn’t cover shall have the signing officials
    and the supervisory managers all the way to the Board of Directors convicted
    of Commercial Fraud and serve 2-5 years in jail”

    writing contracts you can’t cover is Fraud, let’s treat it as fraud,
    and punish the people who did that

  4. wesgpc

    I like your plan. If you are still looking at comments, here’s my two cents. Your post doesn’t directly address the naked CDS issue. I found Geithner’s comments confused on CDS’s. When he spoke at the hearing, he seemed to be conflating the straight insurance function of a regular CDS (I forget its jargon name) with a naked CDS as a derivative to hedge and speculate. I think regular CDS contracts should be called insurance, as you suggest.

    Any hedging or speculation done with naked CDSs don’t go well at all with insurance, so if naked CDS contracts are to exist, they should strictly separated from the insurance function, and be standardized and only traded on formal exchanges, with added public clearinghouse information in addition to what you see in similar existing risk derivative exchanges.

    But better than that, is to dump them and go to Robert Shiller’s proposals for markets in credit and macroeconomic risk, which would be highly regulated and work with standard contracts on formal exchanges, with clearinghouse info. If some sort of general economic risk derivative is needed, do that.

    I saw a talk where Shiller claimed that a mortgage market risk contract following his ideas, that serves a similar function as a naked CDS, is in operation on an orderly formal exchange and has been working well throughout this crisis.

    So, why do Geithner and Summers not know, or pretend to not know about Shiller’s work? Why are they trying to fix a unfixable broken wheel, when better thought out ideas are out there? Why are they sticking with half-baked improvisation when they don’t need to? Because the financial industry wants to keep their toys?

  5. wesgpc

    Shiller’s book on risk markets

    Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks (Clarendon Lectures in Economics)
    by Robert J. Shiller
    Oxford University Press, 1998

  6. Ian Welsh

    Under my proposal you have to have a direct insurable interest, so naked swaps would be out. The question of hedging is an interesting one, will have to look at Shiller and see what he suggests. I don’t like the idea of using CDSs to hedge.

    I sometimes wonder just how good a thing hedging is. People who think they’re hedged get stupid and careless.

  7. wesgpc

    I agree with you about hedging -it has an insurance aspect to it. The party wanting to sell the risk has to rely on the soundness of the party that wants to buy it. So, thanks for your clarification, I understand your point better now.

    I used to think that Shiller’s ideas for risk markets had potential for unintended consequences of creating undetected systemic risk unless they were carefully designed, though I haven’t looked at the book in several years. I am changing my mind because at least Shiller had a clear idea about what he was proposing, where Geithner seems confused on this point. Every hedge requires too parties: one that wants to get rid of risk and another that is willing to accept it for a higher risk adjusted return (that is assuming you believe the usual theories). So what was all that confused mumbo jumbo about separating legitimate hedging function and risk taking? I did not understand that at all.

    Whatever problems with Shiller’s proposals, they pale in comparison with a continued OTC market in naked one-off CDS contracts, no matter what opaque, discretionary, ‘wise-man’ (or perhaps ‘wise-guy’) regulatory system Geithner wants to put in place.

    I grew up on a farm, and I know even small ones do hedging transactions on various markets all the time. So, while I agree with you, I think people will try to find ways to hedge, and it is a complicating unavoidable fact of market life.

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