Rein in the Frankenstein financing…
We argued earlier that credit default swaps are not intrinsically bad, but they are used in a perverse way because of lack of regulation. Regulation should include that parties have skin in the game. Now, anyone can trade these CDS’s, which produces incentives for bad outcomes:

• This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.
• When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

It’s Time for Swaps to Lose Their Swagger
By GRETCHEN MORGENSON

“USING these instruments in a way that intentionally destabilizes a company or a country is — is counterproductive, and I’m sure the S.E.C. will be looking into that.”

That’s what Ben S. Bernanke, chairman of the Federal Reserve, said last week when lawmakers asked him about credit default swaps during his Congressional testimony. Concerns are growing about such swaps — securities that offer insurance-like protection and helped tip over the American International Group in 2008 when it couldn’t pay mounting claims on the contracts.

Now, there are fears that the use of these swaps may also help propel entire countries — think Greece — to the precipice.

First, Greece employed swaps to mask its true debt picture, with the help of Wall Street bankers, of course. And now it appears that some traders are using swaps to bet that Greece won’t be able to meet its debt payments and will face a possible default.

Mr. Bernanke is undoubtedly an intelligent man. But his view that it’s “counterproductive” to use credit default swaps to crash an institution or a nation exhibits a certain naïveté about how the titans of finance operate now.

High-octane trading may be counterproductive to taxpayers, for sure. But not to the speculators who win big when such transactions pay off. And in the case of A.I.G., the speculators got their winnings from the taxpayers.

The certainty that Mr. Bernanke expressed about the S.E.C.’s inquiry into credit default swaps is quaint as well. If the past is prologue, we might see a case or two emerge from that inquiry five years from now. The fact is that credit default swaps and other complex derivatives that have proved to be instruments of mass destruction still remain entrenched in our financial system three years after our economy was almost brought to its knees.

DERIVATIVES are responsible for much of the interconnectedness between banks and other institutions that made the financial collapse accelerate in the way that it did, costing taxpayers hundreds of billions in bailouts. Yet credit default swaps have been largely untouched by financial reform efforts.

This is not surprising. Given how much money is generated by the big institutions trading these instruments, these entities are showering money on Washington to protect their profits. The Office of the Comptroller of the Currency reported that revenue generated by United States banks in their credit derivatives trading totaled $1.2 billion in the third quarter of 2009.

Congressional “reform” plans for credit default swaps are full of loopholes, guaranteeing that another derivatives-fueled financial crisis awaits us. According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009, the most recent figures available.

Credit default swaps are “a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent,” said Martin Mayer, a guest scholar at the Brookings Institution and author of 37 books, many of them on banking. “They were not well-motivated.”

Mr. Mayer has been critical of credit default swaps almost since they arrived on the scene. In 1999, for example, he wrote an opinion piece for The Wall Street Journal entitled “The Dangers of Derivatives.”

“These ‘over the counter’ derivatives — created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing — are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall,” he wrote, referring to the market turmoil of 1998. “The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions.”

Calling credit derivatives “the most dangerous instrument yet,” Mr. Mayer concluded in his article that neither banks nor bank examiners have any idea how to handle them. “The system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries — their knowledge of their borrowers, and their incentive to police the status of the loan,” he wrote.

Pointing to a study by the Federal Reserve Bank of New York, he said: “In the presence of moral hazard — the likelihood that sloughing the bad loans into a swap will be profitable — the growth of a market for default risks could lead to bank insolvencies.”

How’s that for prescient?

His predictions having come true, I asked Mr. Mayer for solutions to the problems that credit default swaps have created. He had several.

First, he said, those trading in swaps must be forced to put up more capital to back them so that if a client asks for payment, the issuer actually has the funds on hand to do so.

“This is an insurance instrument and it must be regulated on an insurance basis with minimum reserves, instead of making deals that don’t even have maintenance margin on them,” he said. “And I think it is an instrument that insured depositories ought not to be allowed to hold or trade.”

And yet United States commercial banks, those with insured deposits, held $13 trillion in notional value of credit derivatives at the end of the third quarter last year, according to the Office of the Comptroller of the Currency. The biggest players in this world are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs.

All of those firms fall squarely into the category of institutions that are too politically connected to fail. Because of the implicit taxpayer backing that accompanies such lofty status, derivatives become exceedingly dangerous, said Robert Arvanitis, chief executive of Risk Finance Advisors, a corporate advisory firm specializing in insurance.

“If companies were not implicitly backed by the taxpayers, then managements would get very reluctant to go out after that next billion of notional on swaps,” he said. “They’d look over their shoulder and say, ‘This is getting dangerous.’”

But taxpayers remain decidedly on the hook for future bailouts because Congress has done nothing to eliminate the once-implied but now explicit government guarantees backing large and interconnected companies. And on derivatives trading, lawmakers’ moves have been depressingly incremental.

Mr. Mayer, for one, believes that credit default swaps must be exchange-traded so that their risks would be more evident. He dismisses the contention of big institutions in this arena that many credit default swaps cannot be traded on an exchange because they are tailor-made for particular customers.

“These are generic risks and can be traded generically,” Mr. Mayer said. “You are not insuring against a very individual risk.”

AND what of the argument that increased regulatory oversight of credit default swaps will crimp financial innovation?

“This insistence that you mustn’t slow the pace of innovation is just childish,” Mr. Mayer said. “Innovation has now cost us $7 trillion,” he added, referring to the loss in household wealth that has resulted from the crisis. “That’s a pretty high price to pay for innovation.”

Couldn’t agree more. Too bad Washington doesn’t see it that way.