Naked Truth on Default Swaps

In the end we have another round of sophistry hiding the fact that it is all about third parties taking bets on a horse.

Markets work well as a rule based game.  They fail miserably when rules are constantly changed out by the legal profession to satisfy the financial whims and greed of a client.  This is the creation of non reserve insurance and the losses have been horrific. 

Obviously a no interest bet opens the door wide to outright insurance fraud because there is no downside.  After all, the perp is hidden offshore.  It would have taken the criminals exactly one sales pitch to figure this one out.

Naked short selling, now naked insurance all have one thing in common.  The gambler can win if he is able to destroy the victim.  True stock manipulation begins with short selling and its ilk.  Gamblers are proactive in this regard however they cloud their actions.

The choicest irony was watching Lehman bros scream about the practice as they went down.

It is completely possible to reform the security trading industry but no one ever would let someone who had a clue near the game.  The victims continue to be citizens and the US economy in general because a huge amount of capital is simply diverted away from its intended destination.

If a thousand investors decide to support a new energy source with ten million dollars and this money is diverted into a short selling syndicates account and the company is then starved into a profoundly disadvantageous financing that provides only a fraction of the money, while the balance is appropriated by the syndicate, then by most natural measures, a fraud has taken place.

This is not clearly blocked by the SEC who only squawks once in a while.

Naked Truth on Default Swaps

On Thursday May 20, 2010,

Should people be able to bet on your death? How about your financial failure?

In the United States Senate, Wall Street won one this week when the Senate voted down a proposal to bar the so-called naked buying of credit-default swaps. If that were the law, you could not use swaps to bet a company would fail. The exception would be if you already had a stake in the company succeeding, such as owning a bond issued by the company.

On the other side of the Atlantic, Germany announced new rules to bar just such betting — but only if the creditors were euro area governments.

None of this argument would be taking place if regulators had done their jobs years ago and classified credit-default swaps as insurance.

As it happened, however, clever people on Wall Street followed the prescription laid down by Humpty Dumpty in Lewis Carroll’s “Through the Looking Glass:”

“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”

When Alice protested, Humpty Dumpty replied that the issue was “which is to be master — that’s all.”

The word here is “swap.” It used to mean, well, a swap. In a currency swap, one party will win if one currency rises against another and lose if the opposite happens.

Credit-default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of the swap cannot meet its obligations. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.

But the people who dreamed up credit-default swaps did not like the word insurance. It smacked of regulation and of reserves that insurance companies must set aside in case there were claims. So they called the new thing a swap.

In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decisions they wished.

That decision, perhaps more than anything else, enabled the American International Group to go broke — or, more precisely, to fail into the hands of the American government. Had it been forced to set aside reserves, A.I.G. would have stopped selling swaps a lot sooner than it did.

The decision that swaps were not insurance meant that anyone could buy or sell them — or at least anyone who could find a counterparty.

Had credit-default swaps been classified as insurance, the concept of “insurable interest” might have been applied. That concept says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest.

Gary Gensler, the chairman of the Commodities Future Trading Commission, recently laid out the history of that concept. It did not exist until the 18th century, when many people — not just owners of ships or cargos — began buying insurance against ships sinking.

More ships began sinking, and insurers cried foul.

The British Parliament outlawed such sales of ship insurance in 1746. Ever since, to buy that insurance you had to have an interest in the ship or its cargo. But it was another 28 years before Parliament extended the idea to life insurance.

So should it be illegal for me to buy credit-default swaps on companies even if I have no other interest in the company? And if I have an interest, should I be limited to buying only enough insurance to cover my exposure? That is, if I own $100 million in XYZ Corporation bonds, should I be able to buy $1 billion in insurance against an XYZ default?

To most on Wall Street, the answer is obvious: let markets function. My buying that insurance will probably drive up the price, and serve as a market indication that people are worried about the credit, which is good because it gives a warning to others.

In any case, it is legal to sell stocks short. That, too, is a way to bet that a company will fail. So what’s the difference?

One difference is that many people short stocks because they deem them overvalued, not because they think the company will go broke. They can profit even if the company does well, so long as the stock does turn out to have been overvalued.

Many who despise credit-default swaps argue that they can be used to force companies to fail. The swap market is thin, and even a relatively small purchase can drive up prices. That very movement may make lenders nervous, cause liquidity to dry up and bring on unnecessary bankruptcies.

There is another, little noticed, possible impact of credit-default swaps. They can undermine bankruptcy laws.

Normally, a creditor wants to keep a company out of bankruptcy if there is a decent chance it can survive. If it does go broke, the creditor wants to maximize the value of the company anyway, so that more will be available to pay creditors.

But what happens if a major creditor, who might even control one class of bonds, has a much larger position in credit-default swaps?

Will he not have interests directly at odds with those of other creditors, since he will do better if the company ends up with less to pay its creditors? Might that creditor seek to, and perhaps be able to, sabotage the company’s best hopes for revival?

At a minimum, such things should be disclosed, but that gets tricky when one part of a megabank (the one with the bonds) claims it is run independently from the other (the one with the swaps).

I don’t know whether it is necessary to treat credit-default swaps like insurance and require someone to have an insurable interest before swaps can be purchased.

The financial reform bill now being debated in the Senate has provisions intended to assure that many of the previous swap abuses are not repeated.

But I do think Germany’s decision was ill considered. First, it may have little effect if other countries do not join in. Buying a swap in New York or London, rather than Frankfurt, will not be difficult.

But the more important issue is one of limiting the targets of credit-default swap purchases. If Germany had simply required buyers of credit-default swaps to have an insurable interest, it would have been standing up for a principle.

By limiting the scope to swaps on debt of euro area governments, the German government sends two signals: it is acting in self-interest, and it is still worried that it may have to finance more bailouts.

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