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.
“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 pretty close to the argument advanced for banning short-selling.
It is not the same. I have no objections to borrowing existing bonds and selling them. The borrow enforces a limit on the amount of shorting that can be done. So it should be with stocks. Borrows should be regulated.
Soros is on your side (today’s FT), I am a bit skeptical, on the same argument you could ban put options.
Hi David,
Following up on the previous comment – even if the borrows are regulated, the short does not have an economic interest in the company he is shorting. Sounds like there are two pieces:
1) Who is doing the CDS buying / short selling
2) The amount of short-selling/CDS buying.
It sounds to me like you are objecting to the amount of short-selling/CDS buying, not to the identity of the short-seller / CDS buyer (i.e. whether or not they have an economic interest in the underlying).
David:
Can you please justify this statement “gambling should be opposed on public policy grounds.”
What next? You have to own stock in order to buy a put?
Those of us who do not believe in “morals” have suffered too long at the tyranny of the smugly self-righteous, this is going too far. The only difference between gambling and investing is self delusion. Next we’ll be banning bonds “on public policy grounds” because its immoral to make money off of money. And soon sharia law. This is just like a long nightmare that won’t end.
P.S. Don’t the aforementioned stake holders deserve the ability to hedge their exposure? Why shouldn’t a pensioner be able to buy a credit default swap on his employer? Or municipality on a major corporation headquartered in its jurisdiction or a supplier on its major customer?
80% of CDS are owned by “investors” (speculators) that don’t own the underlying bonds. This has been a recipe for disaster. I am all for insurable interest in the CDS market, with a tranparent exchange.
?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?
How do you kill a corporation? A low stock price or high CDS should not kill a company (at least a non-financial). Isn’t the problem with CDS that companies like AIG thought they could get free lunch by writing a lot of CDS at too low premium leading to a _systemic_ effect (effectively killing AIG et al and not the companies the CDS were written on). It seems to me you have it backwards on who is getting killed by the CDS. If I am wrong, name me one non-financial that was “murdered” because of AIG, JPM etc CDS bets.
I agree that a prohibition on OTC CDS is excessive: they should simply be made unenforceable in a court of law. I think a distinction needs to be made between the right of contract (which does not need to be limited) and the right to have the power of the State applied in enforcing your contract (which is needless-to-say a legislative/judicial decision).
The first thing I think of in insurable interest is puts — how are equity puts different here than CDSs?
Second, ?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? — sounds a lot like everyday competition to me.
Everyday competition (unfortunately) has to be defined. Insurable interest was the result of insurance companies (correctly) understanding that if you insure your neighbor’s home or life it would eventually cripple/end the industry and insuranc does serve a general social good of stability. Notice the exclusion of nuclear war, terrorism, etc. Some things the nation has to collectively insure (eg FDIC) for stability purposes. Insurable interest for lives is obvious; but if it wasn’t enough companies would have failed quickly that the idea would not have lasted. Now for CDS; not have capital requirements and nothing massively disruptive happening (until now) allowed the mess to get bigger and bigger. But people underestimate what that market can do in a fear sense; bid up the CDS contracts (which it appears can be done easily as they are not overly liquid) can cause fear to rollover debt; that happened and the highly leveraged nature of our system started imploding. These tools can be used to destroy a company; shorting not so easily if done with the uptick rule and the borrow rules (not enforced). Puts and Calls have time expiration; it appeasr CDS really do not (I am no expert; i rely on people like Dave). There is no “free market”; all markets have rules of conduct. Contract Law is basic to all commerce as a man’s word is not good enough when it comes to money.
WE can all debate on “social good”; gambling a great example. Remember; the markets real purpose is capital formation; excessive speculation can turn it into a bankruptcy liquidation pricing market. The turn of the 20th century probably is a good example of what those markets would look like; If our markets must be that way so be it; but be prepared to live in a world of limited credit. I wouldn’t mind living init necessarily; but who wants to go into a transition of that magnitude; look at Russia 1998 and 1999 and see what happens. One man’s opinion.
Wouldn’t setting up a counterparty exchange eliminate the problems with CDS in general? As margin calls surge, the CDS would get closed out.
Of course, it doesn’t seem like many of the entities supporting exchanges want to take on CDS risk, which is telling, and self regulating.
At least, regulated entites such as banks and insurance companies should be required to conduct CDS business only with counterparty exchanges.
‘Those of us who do not believe in ?morals? have suffered too long at the tyranny of the smugly self-righteous’
Sociopaths mostly inflict suffering on those around them, which is what makes for the peculiar culture of prisons, where high concentrations of such individuals tend to occur.
Perhaps the best resolution for this unhappy population would be to define boundaries for a large reserve area, staffing the boundaries with a suitably trained and motivated border guard, and encouraging such non-believers in morals to emigrate to this territory of their own, where they can prey on each other rather than their “moralistic” neighbors, and thereby escape incarceration at a great savings to the non-sociopath public.
This is about as close to a “win-win” solution as one might achieve with those who refuse to recognize the legitimacy of social constraints on their behavior. Life would likely be turbulent and short in this territory, but at least the residents would not have to put up with any pesky “morals” to cramp their style.
http://en.wikipedia.org/wiki/Antisocial_personality_disorder