In Defense of Speculators, Part III: Credit-Default Swaps

Not so long ago, AIG was the world’s largest insurer. In the year 2000, its value peaked at over $265 billion, and just one year ago, the insurance giant was worth nearly $170 billion. But last month, facing bankruptcy, the once-proud AIG—now worth a mere $2.65 billion—became the largest welfare recipient in U.S. history, receiving a then-unprecedented $85 billion “rescue package” in money created out of thin air by the Federal Reserve.

All financial crises are either directly or indirectly caused by the Federal Reserve’s anti-market monetary manipulations. But the government can never blame itself or its central bank—it has to find scapegoats. And who better to blame than people and institutions who deal in private and voluntary financial exchanges outside of the government’s domineering and prosperity-killing regulatory scope?

It was the “speculators” who caused AIG to fail—or at least that’s the official government story. More specifically, it was the roguish brigands who deal in the unregulated market for credit-default swaps (CDS).

The Coming Political Shakedown

Credit-default what? The official story is all the more plausible since 99% of Americans (to be generous) have absolutely no idea what a credit-default swap is. And why would they? Most of them went to government-funded schools that teach statist myths about the cause of the Great Depression and the need for strong anti-trust regulation to thwart potential “robber barons.” The real robber barons, of course, have always been the men behind the curtain writing the very regulations allegedly intended to rein them in!

With this in mind, one has to wonder what financial interests are backing Senator Tom Harkin, the Iowa Democrat who has threatened that his party might not just increase regulation of CDSs but prohibit the market altogether. On October 14, Harkin—who is chairman of the Senate Agriculture Committee, which has authority over derivatives regulation—said that CDSs “increase the risk, the systemic risk, of the whole society.” Global warming, Islamic terrorism, and CDSs: mankind’s greatest threats.

CDSs: Among the Last Vestiges of the Free Market

What anti-capitalist congressmen hate most about credit-default swaps is that they’re completely unregulated. In the wake of the Great Depression, FDR’s New Deal added a backbreaking amount of new market regulations that have served to do nothing but provide investors with a false sense of security and, in some cases, discriminate against the non-affluent by making certain asset classes off limits for them.

Even if you believe we need an SEC and “Blue Skies” regulations to “protect the public,” a similar argument cannot be made for CDSs, which are private transactions between large financial institutions. The public only assumes liability for CDSs when the government steps in to bail out firms that made bad financial decisions. No bailout; no liability.

AIG made some bad bets in the CDS market. As a result, their stockholders were decimated and some of their CDS trading partners were left in the lurch too. That’s the way things work in a capitalist economy: every transaction carries its own risk. And financial markets cannot function when the government steps in to remove the element of risk—or more accurately, to socialize it.

How do Credit-Default Swaps Work?

A credit-default swap is a pseudo-insurance agreement made between two counterbalancing traders. The reason CDSs are considered “pseudo-insurance” instead of actual insurance—something AIG might have actually known something about—is in effort to avoid the onerous regulations the government puts on official insurance products. Regardless, anything that two consenting adults do behind closed doors is their business, and the same philosophy should apply to financial institutions.

An example of a typical CDS agreement would involve one firm (Company A) with a lot of money invested in the bonds of a third party (say, GM). Company B would offer to sell Company A insurance protection against GM’s default. Perhaps Company A would agree to pay $265,000 a year to insure its $10 million in GM bonds. The terms of the agreement would spell the circumstances under which Company B would have to pay Company A and how much, but typically, payment is triggered by formal bankruptcy or failure to pay bond interest. In such a case, Company B would buy the bonds from Company A at a premium or pay Company A the difference between the bonds’ current market value and their par value.

That’s not so confusing, is it?

How CDSs Make the Financial Markets Safer

What is so sinister about such an arrangement? Nothing. Credit-default swaps let companies shift risk and efficiently allocate capital. What’s more, they work to keep the credit markets honest and to expose fraud or negligence on the part of bond rating firms like Moody’s.

For example, if a company’s credit-default swaps are trading at a high yield, and yet the firm is still rated as being credit-worthy by Moody’s, there may be a problem. Typically, the market can better assess a company’s financial health than credit-rating firms. Banning the CDS market, as some Democrats would like to do, would be a lot like the recent short-sale ban—it would merely shield unsound companies from having the reality of their situation exposed to the average investor.

Credit-default swaps emerged from the free market to meet a demand. Banning them would, like all financial regulations, only punish the honest and responsible participants in the market. Let the fraudsters go bankrupt and let the responsible parties pick up the pieces. This is the system of capitalism that served us so well for so many years—now is no time to turn our backs on that which made us great.

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