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Can we flush CDS contracts already?

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November 12, 2009 – Comments (5)

Today on Fool.com I took on credit default swaps. I seems to me that the whole thing is little more than a big game of musical chairs, passing risk around and just hoping not to get caught in the cold when the music stops. And while it could be argued that it does spread out risk, I think its also up for question whether it actually creates more risk in the end.

Anyone care to cheer me on? Or tell me why I'm wrong?

Matt

5 Comments – Post Your Own

#1) On November 12, 2009 at 5:32 PM, Teacherman1 (53.06) wrote:

Sounds like "Ghost Bonds".

I guess it really depends on how well you weigh the risk of a default for what you are taking on, and how likely it is that the one you buy coverage from will be able to cover it.

In a normal, stable environment (whatever that is), it is profitable business.

When the "S***T" hits the fan, as we saw, it can quickly become a house of cards.

If they are going to do it, there should be some sort of limit and a clearing house "referee" in place.

For the economy as a whole, it is probably not a good idea, only because Wall Street seems to have the idea that if one of something is good, two is even better, and three etc, etc, etc, is great.

They don't seem to be able to resist the "candy".

I guess overall, I tend to agree with you. It is something better left undone. 

JMO and worth exactly what I am charging for it. 

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#2) On November 12, 2009 at 6:00 PM, TMFKopp (98.13) wrote:

@Teacherman1

I like the idea of clearinghouse, but if we have to have these instruments out there, I like the idea of collateral even more. A CDS contract is basically insurance against default and if there's X% chance that any given bond will default then it stands to reason that any bank, insurance company, or other type of institution that's writing CDS coverage should have to reserve for the inevitable default payouts that they'll face. 

I've seen the notional value of the CDS market quoted at around $35 trillion, so even a 5% collateral requirement would require current CDS writers to retain $1.75 trillion in collateral. Is that possible currently? Probably not, so I would see collateral requirements putting a definite lid on the total size of the CDS market.

Matt

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#3) On November 12, 2009 at 6:56 PM, chk999 (99.97) wrote:

CDS are not inherently evil. For people that own corporate bonds, it is reasonable to be able to buy an insurance policy on default by the bond issuer. Where they have been misused is by punters betting on corporate defaults. The companies that write CDS have compounded the problem by not reserving adequately.

The obvious solution is to require that someone have an insurable interest to be able to own a CDS and that the writers of the insurance must reserve at some percentage of the potential liability. At that point the problem will be self correcting.

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#4) On November 12, 2009 at 6:57 PM, rd80 (98.21) wrote:

I would argue that CDS should not be eliminated, but be regulated as insurance products since that's essentially what they are.

Treating them as insurance products allows institutions to spread risk by buying protection, but eliminates most, if not all, of the pitfalls we learned about last year.

But don't worry.  I'm sure that at this very moment some financial engineer somewhere is creating another new swap, contract, or derivative that's every bit as dangerous as CDS and no one will know about it until it blows up.

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#5) On November 18, 2009 at 12:56 PM, abrandrew (< 20) wrote:

It's said there are negotiations in the works for Apple to drop its exclusive contract with AT&T ijn early 2010 and switch to the 3G superior VERIZON  (tick: VZ) network.  This means all thoose new Iphones not including the steadily increasing Motorola Droid smart phones will substantially increase  VERIZON's bottom line!   Indications sugguest that this may be the last week to pick up Verizon at  a low price target beow $32.

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