I didn’t think I’d see a proposal like this one which would (seemingly) bar investors from purchasing default protection via the credit default swaps [CDS] on corporations without owning the underlying bonds. But here it is. (It would also force the creation of a clearinghouse for CDS, something I have been more dubious about — it will work for large liquid exposures, but not others.) This is more restrictive than I would recommend; consider my earlier piece, Rethinking Insurable Interest.
My basic idea is that people, even artificial people like corporations have a right to restrict who takes life insurance out on them, aside from those that already have a financial interest in the well being of the company. Also, gambling should be opposed on public policy grounds. Most of the CDS market is just a series of side bets, with little or no true hedging going on.
Now, what I am suggesting is controversial, though less so than the proposed bill. There is a very good blog called Derivative Dribble, that took issue with what I wrote in my piece. The author, Charles Davi, asked me to comment on it, and I ran short of time, and never did. This proposed bill gives me a chance to comment on his piece, and for you to read his logic. It is a clear statement of what those that have an economic interest in the size of the CDS business will say.
My argument with Derivative Dribble is this: he brushes past my moral arguments and focuses on the right of two parties to be able to contract freely. (Also, his argument about incentivizing illness is just weird, and does not apply to the discussion at hand.) Merely because a life insurance company has an economic interest in not selling insurance to someone who might harm the insured, does not mean that the insurable interest argument relies on the self-interest of the insurer. It is a statement of public policy that we don’t allow parties with no insurable interest to make bets on the lives of others. It arose out of many incidents where insured parties got murdered. Innocent people have a right to not be concerned that someone has an incentive to kill them.
In the same way, corporations have a right to not have to worry about being harmed by those that might have an economic interest in their demise. This is not just for the good of the management, many laborers, suppliers, pensioners, and other stakeholders lose when a firm goes bust. There are situations where parties controlling the financing of a firm in trouble have acquired CDS protection greater than that of their likely economic loss. Given that the ability of the firm to refinance in such a situation is limited, this virtually guarantees the demise of the firm.
The right to free contract is limited in our culture, and in most cultures. Even an economic libertarian like me knows that. This is one of the areas where the right to contract should be limited, so that corporations do not have to be looking over their back to see if someone has an interest in their demise.