Can it get worse?

Okay, here’s yet another reason why letting Paulson buy unrestricted derivatives in secret is a bad idea.

First: I know what credit default swaps (CDSs) are, and I know how they got used to amplify this current crisis. I also am quite aware that they can be used “legitimately” to hedge against risk, even including against non-asset based problems like changes in weather (screwing up airline flights, cancelling outdoor shows, etc). So yes, CDSs are valid tools for risk management; they shouldn’t be removed from the economy, but for heaven’s sake they should be more transparent and better regulated.

Then I listened to this episode of This American Life (you can download it this week for free). What I didn’t know (should I have?) is that people were writing CDSs against assets which they didn’t even hold. They’d bet against the drop of value of, for example, some debt Lehman entered; the insuring counterparty would bet (of course) that the value wouldn’t drop, and they’d collect the “premiums” for a promise to pay later. The insured counterparty would be betting they’d be able to gain the value of the underlying asset (or, more properly, the amount of the underlying loss) if it went down in value, and they were willing to pay for that privilege. This is like the “dead man’s” insurance WalMart was trying to get written against their (non-key) employees. It’s even worse than naked shorts, which of course have to be covered with a real asset at some point. This is trying to make something out of nothing.

There is no economic theory I can think of that can justify this behavior as enhancing the allocation of capital; this is gambling, pure and simple. The legislation enabling the bailout should have very explicitly prohibited the governmental purchase of such swaps; instead, the swaps should be invalidated immediately. Whether the insuring counterparty gets to keep or must refund the premium(s) is none of my concern; although the disposition should probably have been legislated as well, to avoid unnecessary judicial entanglement. Removing the uncertainty of whether insuring counterparties were on the hook for vast amounts of money on absurd gambles would probably go a long way to restoring short-term confidence in counterparty solvency. Long term, these things should be banned outright; a CDS against property (not an act of nature, etc) should require one of the counterparties to actually own the property; and when the property is disposed, the contract expires or goes with it.

We don’t insure office gambling pools; we don’t allow you to write gambling losses off your taxes (except against your winnings); why should we bail out these crooks at all?