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In defence of sovereign (and other CDS) - or, why it’s market forces and not regulation that prohibits you from buying fire insurance on your neighbor’s house.

Greece’s Prime Minister, Mr Papandreou and other critics of the CDS market are mistaken  when comparing the CDS market with the market for fire insurance.

 

Referring to the market for sovereign CDS, Mr Papandreou yesterday said, “It is common sense, enforced by insurance regulators, that a person is not allowed to buy fire insurance on his neighbor's house and then burn it down to collect on that insurance. Yet, that is exactly what is done in the market for credit default swaps.” 

 

Mr Papandreou is correct on the common sense part but incorrect on assuming that it’s the enforced regulation that prohibits you from purchasing fire insurance on your neighbor’s house. The fact that an insurance company will not allow you to purchase this insurance has everything to do with price and incentives, and assessment of the risk/reward in the transaction. Like any politician with a good socialist worldview, Mr Papandreou has failed to grasp how a free market works.

 

An insurance company will assess the probability that they would have to make a payout - i.e. in the case that your neighbor’s house would burn down, they would take into account your motivation in wanting to purchase this insurance and hence be suspicious of your motivations as they would no doubt assess that you could have an “incentive”, and be capable of, burning down the house. They would thus either price the premium to be 100% of the payout value (in which case it would not make sense for you economically to pay the premium), or report you to the police, perhaps most likely both. Hence a transaction does not happen here and it has nothing to do with a regulator.

 

On the other hand, in the CDS market, every time some “unprincipled speculator” purchases protection on Greece, or any other sovereign/corporate entity, and expresses a negative view on that entity, there must be another counterparty to that transaction that must make an opposite, positive assessment. All these counterparties that take a positive view on the entity must in their calculations of having to make a payout, assess whether the “speculative” negative guys are capable of influencing the outcome of the event - in this case the default of Greece. They must thus conclude that it is a risk worth taking and are been adequately compensated for that risk. Hence a transaction occurs here between two counterparties who we should assume are equally smart enough to assess the degrees of risk involved and are free to enter the transaction. 

 

Perhaps Mr Papandreou has not realized this yet, but for each of the “unprincipled speculators” out there with a negative view on Greece, there are exactly as many “investors” with a positive one.  

Disclosure: No CDS positions.