I found this one article on Yves Smith's Naked Capitalism. She is coming out with a book March 2010 called "ECONNED; How The Myth of Free Markets Wrecked Our Economy." She has been called the crisis queen by Goldman Sachs defenders which endears her to my heart and mind and builds greater credibility in my eyes as she must be striking home with her words. She is a former Sachs Account Executive.

This particular post was written by George Washington . . . spare me the wise cracks . . . and is titled: Credit Default Swaps; "Love Em, Ban Em, or Tax Em?" <link>

"I have repeatedly argued that over-the-counter credit default swaps (CDS) - or at least at least 'naked' CDS - should be banned ('naked CDS' is the term I coined to describe the situation where the buyer is not the referenced entity. I will not comment on whether or not there is a real economic benefit when the referenced company buys CDS concerning itself or its suppliers as an insurance policy; I will leave that analysis to the CDS experts.

Says who?:

• A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown
• Warren Buffet called them "weapons of mass destruction" in 2003
• Charles Munger has called the CDS prohibition the best solution, and said "it isn't as though the economic world didn't function quite well without it, and it isn't as though what has happened has been so wonderfully desirable that we should logically want more of it"
• Former Federal Reserve Chairman Alan Greenpin - after being one of their biggest cheerleaders - now says CDS are dangerous
• Former SEC chairman Christopher Cox said "The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis"
• Newsweek called CDS "The Monster that Ate Wall Street"
• President Obama said in a June 17 speech on his plans for finance industry regulatory reform that credit swaps and other derivatives "have threatened the entire financial system"
• George Soros says the market is still unsafe, and that credit- default swaps are "toxic" and "a very dangerous derivative" because it's easier and potentially more profitable for investors to bet against companies using them than through so-called short sales.
• US Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees.
• Nobel Prize winning economist Myron Scholes - who developed much of the pricing structure used in CDS - said that existing over-the-counter CDS were so dangerous that they should be "blown up or burned", and we should start fresh
• In perhaps the most anti-derivatives statement of all, Nassim Nicholas Taleb said this month, "To curb volatility in financial markets some financial products 'should not trade,' including complex derivatives."

A recent article in Bloombergs seems to think so . . . "A year after the bankruptcy of Lehman Brothers Holdings Inc., credit-default swaps have lost their stigma for disaster."

"Satyajit Das, a leading credit default swap expert - the commonly-accepted figures for the CDS losses suffered due to Lehman's bankruptcy have been understated." He goes on to state: "the new credit default swap regulations not only won't help stabilize the economy, they might actually help to destabilize it."

Supporting the CDS safety proposal are the too big to fail banks or the five banks the FED an the Treasury bailed out with loans, etc. These banks hold the majority of CDS. Why would they push this view so soon after they were bailed out? One reason is they know we, the taxpayer will always be there to bail them out again under the "Too big to fail." The other reason is the ability to leverage using CDS in a deleveraging scenario. It is F*cking profitable for them to sell CDS under the current scenario with no regs. The market for CDS was larger than the entire world market. The problem with the CDS is they increase the reliance on the other banks. If one fails, it takes the others down with it. And who can forget that CDS are paid before all creditors, bondholders, and holders of stock by law as passed by "Gramm."

Two ways of controlling CDS includes taxing them as Yves Smith suggests and as Paul Volcker suggest to limit big bank exposure to them if the bank was bailed out. The former would cut into profitability for creating "nothing."

Anyhoo, I thought this article by Washington was a good read and worthwhile. I hope you visis the site and read the detailed version which I boiled down.

I'd suggest an outright ban on your "naked" CDS and taxes on the remainder. Technically their could be an economic benefit on the more vanilla variety as they can can and should be used to more broadly distribute risk. Unfortunately, they seem to have done the exact opposite with a few firms *cough* AIG being the counterparty to a sizable fraction of all CDS, thereby concentrating the risk.

As I posted some time ago concerning the spreading of risk: It is probably better that a few die than that everybody gets sick. If risk cannot be laid off on some other party, then the originator is forced to assume all of the risk and, with rational people making the decisions (ha, ha), they will see that they need to rechart their course to reduce the risk.

As I noted, CDS didn't actually work to distribute the risk. The risk was actually concentrated on (and off) the balance sheets of a handful of institutions, with AIG being the notable example. Of course things went south and AIG very nearly became financial roadkill, in which case all its counterparties would have come down with fairly serious, and conceivably lethal illnesses. In the end the ultimate risk spreaders also know as the Federal Government and Federal Reserve intervened, distributing the risk to all tax payers present and future and anyone that holds US currency.

Phil, do you have a savings account? If so, you're a collaborator in the effort to spread risk. In the case of a savings account, you give the bank access to your cash and recieve an interest payment. In order to pay you interest the bank loans your money and that of the other depositors. This provides you with the benefit of diversification. Instead of going out and making sizable loans to a single or handful of entities, the banks makes loans to thousands. The consequence is that if any one of these loans goes bad everyone takes a little hit (gets a little sick) instead of a single individual being left destitute (dying). I guess what I'm saying is that the risk of each individual loan going bad is spread among all the bank's depositors.

The same thing goes for owning individual shares of stock. Instead of a single or handful of owners being subject to the entire risk of business failure all shareholders shoulder a chunk of it.

Actually, no: I do not have a savings account. I have three checking accounts, including two in commercial banks and one municipal bond fund which allows check-writing. The annual rates are: 0.00%, 0.05%, and 0.07% per annum. That obviously reflects the very low risk of those accounts. I understand that the first two are insured (risk spreading) by the FDIC and the third isn't. I would have to state, given the rates of return, that I have no sense of participation in the earning activities of the three entities. Commercial banks are a practical irreducible minimum in finance.

As far as the stock market goes, I do have my capital spread. I just counted and I have an investment in 66 different entities, several of which are funds so the actual number of entities I hold is probably in the thousands. I don't think of it as reducing risk but rather as reducing volatility. If there were no speculators manipulating what would otherwise be very boring properties, I would probably be spread somewhat less. I think the level of risk I have is pretty low. I think the risks that we are really talking about were suicidal. I think it would have been much more satisfying to let them dangle and ripen at the end of their ropes. The real problem we had was that we allowed these entities to grow too large (too big to fail) and to engage in practices that were not at all necessary to maintain a healthy real economy.

If I was in control, the economy would be arranged far differently.

TR:

Comparing a regulated industry to a non-regulated industry is an apples to oranges comparison.

The example of AIG and the amount of CDS they had written was not transparent to the government, traders, or investors. This truly was a Ponzi scheme with less than 1% of the risk in reserve to protect against calls. This was the problem with CDS and is not the problem with stocks, banks, etc. We all know who has a portion of the later and we knew nothing or little about who held or holds portions of the former. If properly regulated through the CFTC as Brooksley Born wanted, the build up at AIG, Lehman, etc. (the loss here was under-rated). Citi, BofA, Chase are actively fighting regulation so they can leverage once again and spread that very same risk to us, the taxpayers.

I wasn't commenting favorably on CDS, but rather disputing the contention that spreading risk was necessarily a bad thing. There were two separate thoughts in my response to Phil.

...hope that happens more and often.