Finance 101 tells us that the credit default swaps debacle should not have happened, and private equity groups should not have been able to leverage their acquisitions to the max.

Let me start with credit default swaps (CDS). Finance 101 claims that investors in debt instruments should receive a risk premium to compensate them for expected losses stemming from defaults by the issuers. On a portfolio of debt with similar credit risks, the actual default losses should equal the aggregate value of the risk premiums on the portfolio (on a present value basis).

CDS were marketed as insurance against expected default losses. If the debt markets priced these risks correctly, then the sellers of CDS should have charged premiums equal to the  market risk premiums in order to almost break even. If they had done so, there would have been no incentive for investors to buy the insurance. So the sellers of CDS charged premiums below the market determined risk premiums. This made CDS attractive for investors since they potentially could receive something (additional yield over government bonds) for nothing (no additional default loss risk). While Dire Straits did sing about getting something for nothing, in the real world there is no free lunch.

The sellers of CDS might have believed that they could generate a sufficiently large return investing the premiums they received to more than compensate for their expected underwriting losses and operating costs. If so, they should have kept substantial reserves in place to cover their future losses. However, this would have diminished the likelihood that they could generate the sufficiently large returns.

But alas, the rocket scientists employed by the sellers of CDS created their black boxes to measure the expected losses, and inserted their assumptions to show that the expected losses would be much smaller than what the debt markets were indicating. Thus, there was no need to hold much in the way of reserves. The premiums were treated largely as income which flowed to the bottom line, warranting enormous bonuses.

The buyers of CDS were able to record capital gains equal to the present value of the differences between the risk premiums they received on their investments and the premiums they paid for the CDS. Everyone seemed to win. But Finance 101 should have raised red flags because there was no basis for any gains to be generated in the CDS market.

Turning to private equity and leverage. Finance 101 tells us that the cost of debt increases with leverage. The more debt a company takes on relative to the equity invested, the greater the expected default losses and the higher the risk premiums a company must pay for additional debt. The higher the cost of debt, the less attractive it is for a company to take on more debt.

Private equity firms should not have been able or have been willing to leverage their acquisitions to the hilt. But, curiously, interest rates did not appear to rise with the degree of leverage, and debt seemed to be readily and relatively cheaply available.

Is Finance 101 wrong? No, but Finance 101 does not consider the possibility that providers of debt had strong incentives to support the private equity firms (can you say “fees”), and also ignored that there is a significant “greater fool” mentality in the capital markets.

Why do I bother with Finance 101? Because there are important lessons for regulations and regulators. When the markets ignore the basic principles of Finance 101, there is likely a problem!