Tom Armistead

CDS Regulation: Just One Simple Rule

Kid,
BSC, LEH, AIG, MBI, ABK, MER, AIG etc. were all brought down or severely damaged by the buy CDS, naked short, and put out the word short and distort crew. Have you every looked at the threshold lists from that point in time? A situation was created where no financial instituion had any access to capital. Finally, the failure of the Federal Government to stop the carnage brought Lehman down and with it very nearly the entire economy and financial system. Panic ensued, everybody started cutting production, canceling orders, firing workers, etc. So we nearly had a Depression because of CDS and you don't see a problem?

Your argument that hedging exposure to counterparty risk shows there is a need for CDS not supported by an insurable interest doesn't hold water, for the simple reason that a counterparty exposure creates a chance of loss due to the insolvency of the counterpary which in turn creates an insurable interest.

To deny the moral hazard created by CDS in the absence of insurable interest is absolutely naive: you clearly do not understand human nature. Arson and murder for profit are a fact of life: that's how people behave; that's why fire and life insurance have requirements of insurable interest.

Obviously, some of the institutions taken down were fragile. However to justify perpetrating the financial equivalent of arson on those firms is similar to reasoning that anybody who lives in a frame dwelling has no reason to complain if someone buys eight insurance policies on his house and then burns it down. The victim of arson is not responsible for his loss becasuse he did not live in a concrete bunker.

For that matter, a person who murders for the life insurance proceeds can't justify himself by saying: "the victim had cancer, he was going to die anyway."

I am not sure why you wish to bring mark to market into a discussion of CDS. What I have observed is that many of the securities that were the issue in mark to market have recovered much of their value. Similarly, many CDS spreads have come back down into contact with reality. But the damage done to the firms involved and to their shareholders has not yet been repaired.

The whole effect of permitting the sale of naked CDS was to give an irresponsible band of financial manipulators access to a huge amount of leverage which they promptly applied to every financial instituion they could finger as a remote possiblity for take-down. Finally we had the Fed guaranteeing the credit of GE and GS, and others, with Warren Buffett putting his money on the line, for huge profits.

That was the high point of the CDS bear raids, when the spread for GE ballooned out and it looked like they were gonig to bring down the big one.

CFMA, carefully engineered as an end run around regulation for the likes of Enron, and the perpetrators of CDS, was one of the most egregious examples of our legislators selling out to financial interests who have destroyed free market capitalism as it had been established following the Depression. One by one the protections created in the wake of that horrible time in the life of this country were taken down, cumulating with CFMA which brought the curse of unregulated CDS down on the country, destroying trillions of dollars of wealth.

To summarize, CDS should be regulated as insurance, with a requirement of insurable interest for the buyer and adequate capital for the seller.