The nature of credit swaps explained:
The difference between insurance and speculation in CDSs.
“Anti-bucket shop” legislation as a precursor to the CDS debate.
The origins of the exemption for CDSs.
The role of the New York Insurance Department.
Steps to bring CDSs under control.
There is no doubt that credit default swaps (CDSs) have played a major role in the financial problems the world now faces. As the insurance regulator for New York, the New York Insurance Department had a role to play in the development of CDSs. As they developed, there was a question about whether or not they were insurance. As they initially were used by owners of bonds to seek protection or insurance in the case of a default by the issuer of the bonds, this was a reasonable question. In 2000, under a prior administration, the New York Insurance Department was asked to determine if swaps were insurance, and said no. That is a decision the department has since revisited and reversed as incomplete. We are now unambiguously in favor of the regulation of CDSs.
Since 2007, when the author took office, the impact of CDSs has been one of the major issues the department has had to confront. In the first instance, the department tackled the problems of financial guarantee companies, known as bond insurers. CDSs were a major factor in their difficulties. More recently, the department was involved in the rescue of AIG. Again, credit default swaps were the biggest source of that company’s problems.
What Is a Credit Default Swap and How Many Varieties Are There?
A CDS is a contract in which the seller, for a fee, agrees to make a payment to the protection buyer in the event that the referenced security, usually some kind of bond, experiences any number of various “credit events,” such as bankruptcy, default, or reorganization. If something goes wrong with the referenced entity, the protection buyer can put the bond to the protection seller and be made whole. Or a net payment can be made by the seller to the buyer. Originally, credit default swaps were used to transfer, and thus reduce risk, for the owners of bonds. If you owned a bond in company X and were concerned that the company might default, you bought the swap to protect yourself. The swaps could also be used by banks who loaned money to a company. This type of swap is still used for hedging purposes.
Over time, however, swaps came to be used not to reduce risk, but to assume it. Institutions that did not own the obligation bought and sold credit default swaps to place what Wall Street calls a directional bet on a company’s creditworthiness. Swaps bought by speculators are sometimes known as “naked credit default swaps” because the swap purchasers do not own the underlying obligation. The protection becomes more valuable as the company becomes less creditworthy. This is similar to naked shorting of stocks.
I have argued that these naked credit default swaps should not be called swaps, because there is no transfer or swap of risk. Instead, risk is created by the transaction. For example, you have no risk on the outcome of the third race until you place a bet on horse number five to win.
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