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Originally Posted by Soriak  We have a weekly show here that goes into finance/economic issues, explains the basics of them and does reports on innovative businesses and managers. This week, they had an interesting part on Credit Default Swaps and possibly fraudulent actions involving them.
The premise of a CDS is fairly simple: it's insurance against someone's debt defaulting. Unlike normal insurance, you can insure things you don't actually have - and you can insure them more than once. The scenario then floated was that large investors could buy CDSes on (for example) Lehmann Brothers, then conspire to drive down the stock price. As the price dropped, it'd become impossibly difficult for the firm to raise additional capital. They go down and the investors earn billions and billions.
I liked the analogy, which makes it very easy to explain: an arsonist insures a house he doesn't own with multiple insurance policies, then burns it down and walks away with the payout.
Of course doing this would be illegal (burning down the house, that is), but it's not something that can be ruled out at this time. While CDSes certainly have their purpose, I wonder if they shouldn't be considered insurance for regulatory purposes. You only get to insure the stuff you actually have and you only get to do so once. Or maybe that's not going to be necessary anymore?
edit: at the very least, there needs to be more transparency on them. They're currently traded over-the-counter, which means as a private deal between two parties that doesn't go through an exchange. (like the NYSE) |
The New York governor wants to make CDSs handled the same way as insurance contracts (regarding oversight), however this is just silly because I'll just trade them in some other market without those regulations (London, Frankfurt, wherever). The Fed was also pushing for a clearing house so that they could give CDSs more transparency and a way to sort out all of the CDSs if a company such as Lehman goes bust (because if they market maker isn't there anymore who is going to settle all the contracts?)
