Lawrence J. Kramer

Exchange-Traded Derivatives: Why Stop at CDS?

CDS contracts should not be traded on an exchange. Quite the opposite - the transfer of CDS contracts, and all naked derivatives - should be banned.

The problem with CDS contracts is not transparency; it's moral hazard. A CDS on a company in which the holder has no significant stake is, in effect, a life insurance contract on that company, unsupported by an insurable interest. The holder benefits from the collapse of the company, and that's always bad public policy. Since the whole point of an exchange would be to make CDS contracts transferrable from those who need them as hedges to those who want them as speculations (or worse), an exchange for them is a terrible idea.

The law has long prohibited people from taking out life insurance policies on people in whose lives they have no insurable interest. Such a policy gives its buyer a motive for murder and provides no competing social benefit.

Imagine that John Doe wants to borrow $1,000,000 without collateral from XYZ Bank. The bank examines his credit and says "Ok, but you'll need to provide us with a life insurance contract that will pay off your debt to us if you die." Joe, who is in excellent health, easily obtains the contract from CDS Life Insurance Company. Then, unbeknownst to Joe, CDS puts this ad in the newspaper:

----------------------...
Life Insurance on John Doe

We have recently underwritten the life of John Doe and have found him to be in excellent health (depsite his severe peanut allergy). To amortize the cost of underwriting Joe's policy, we are offering identical policies on Joe's life to anyone who wants one, no questions asked. Joe lives at 10 Maple Lane, Somewhere, USA, and likes to buy his lunch from passing vendors.
----------------------...

Is that offer any different from what AIG FP proposed with respect to various American corporations? And if not, is there any reason to believe that transparent pricing of this toxic product would do anything to remove the moral hazard it creates?

Naked CDS contracts are a terrible idea, and better price discovery won't make them any less so.