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Credit default swaps: RIP

GB Geo-Blog

Credit default swaps: RIP

Janet Tavakoli, the president of Tavakoli Structured Finance, was quoted in this past Sunday New York Times: “The problems that we’ve had since the inception of the credit derivative market have never been solved in any meaningful way. How many times do we want to live through this?”

The latest time being the debacle with Greek debt and whether accepting a “voluntary” cut of 50% of the value of this debt represents a a credit event for the credit derivatives markets.

Tavakoli added: “At this late date we still don’t know the risks that are out there. The market is opaque, bespoke and the regulators don’t know what they are doing.”

Ms. Tavakoli is absolutely right! For the reasons she has set out, the European Union and the European Central Bank have been terrified to tackle the Greek debt problem head-on from the beginning. No one in Europe knows what the financial fall-out might be – a very sad indictment of policy-making and regulation.

Let me suggest that policy-makers just kill the credit derivative markets altogether by not permitting any regulated financial institution from participating in any such market.

Whenever an investor buys a bond, there is a risk premium, over and above any risk premium on US Government bonds with the same duration to maturity, built into the interest rate for the bond. This premium is intended to compensate for the investor’s expected losses in case the issuer defaults. But we live in a 0-1 world, so there will be defaults in some cases and no defaults or losses in most cases. This is where diversification enters the picture. If an investor holds a diversified portfolio of bonds, on average, the realized losses ex post should equal the expected losses ex ante. Thus, diversification and the risk premiums should provide adequate insurance for investors.

If credit derivatives are priced properly; that is, their prices reflect the risk premiums built into each bond issue, there is no benefit for investors to buy credit default insurance. Only if the price is below the risk premium, a recipe for losses and ultimately disaster for the sellers of the credit derivatives, is there any benefit for investors. But in this case, investors have to be wary of the counter-party risk that the “insurer” will be able to cover the losses when a default occurs.

If the sellers of credit derivatives (the insurers) do not set aside ample reserves, they will not be able to honor their “commitments” when defaults do occur. Thus, we do not really have an insurance market. Rather it is a combination of a Ponzi scheme and a casino. These markets should be an easy target for organized crime.

Thus, let’s do away entirely with the charade and shut down these markets. This will make life easier for regulators, and eliminate some uncertainty from financial markets.

The opinions expressed in this blog are personal and do not reflect the views of either Global Brief or the Glendon School of Public and International Affairs.


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