http://dealbook.blogs.nytimes.com/2009/0 6/12/soros-says-default-swaps-should-be- outlawed/?ref=business

“The more I’ve heard about them, the more I’ve realized they’re truly toxic,” Mr. Soros said Friday, according to Reuters. Later, he added: “It’s like buying life insurance on someone else’s life, and owning a license to kill.”

“If I were the governor of the world, I would eliminate it entirely — 100 percent,” Munger said in a Bloomberg Television interview today. “That’s the best solution. 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.”

“The national policy that allowed the derivative markets to develop as they did was a stupid policy and we think the derivative markets as they evolved have done more public damage than public benefit,” Munger said. “That said, if they exist and they are legal and some opportunity therein is presented to us that we think makes sense to the shareholders of Berkshire, we would seize that opportunity.”

“The whole mass of incentives created is quite counterproductive,” Munger said. Buyers of the swaps get a “vested interest in the destruction of some business.”

So, as a result, where workouts in a business would normally be found, now we are almost certain to always enter into bankruptcy. In addition, the prices in bankruptcy are likely to represent severe conflicts of interest and potentially fraud.

“Banning CDS’s because they enabled the current crisis would be akin to banning stocks because they enabled the 1929 crash.”

Huh?

Stock – A fractional ownership in a business. Businesses need owners.

CDS – The financial utility is quite clear to me. Warren Buffett explained it nicely (referring to derivatives generally) as did Nicholas Weaver above. Buyer and seller both book a nice profit today and go on their merry way, leaving losses for the future. This is great; lets meet again tomorrow and do it again!

No, Nate, we really do need to put our feet on solid ground and ask whether what we do serves a helpful purpose. The credo “first do no harm” doesn’t apply only to doctors but all professionals including financial ones. That is what it means to be a professional. Contrary to our recent experience, banking and finance as properly practiced can and ought to bring good benefit generally.

Wall Street has done a fine job convincing the world that it has no professional ethics. Questions of “what net benefit does instrument X bring” are now more relevant than ever.

What has not been properly thought out and need a serious fix is the ramification of Credit Event Clause in Derivatives contract. I am not talking here only about CDS’s but ALL derivatives under ISDA. It is not the CDS’s written on Citigroup that causes systemic risk. The real source of systemic risk is the fact that all derivatives contract (fx, bonds, equities,commodities) would have to be unwound in a short amount of time together with their hedges. The only way to make derivatives safe and indeed useful for the economy is to tame them through exchange cleared contract,like financial futures, with robust enforcement of position limits. Exchange cleared CDSs, or even better, exchange cleared futures and options on liquid pari passu bonds have a place in a sound financial environment

Credit Default Swaps are financial crack, and I see that Felix is hooked. If you could put down the crackpipe for a minute (and there are very very few who, once hooked, can)and listen to that very rare commodity these days called REASON you can easily see that CDS is a piece of financial engineering that adds absolutely NOTHING to the economy. It’s brilliance is the sheer vertical market it creates in allowing financial institutions to skirt capital requirements in order to be able to participate in for what is now essentially a worldwide floating casino. Probably even more brilliant is how many crackheads it has created. The CDS market is not defensible under ANY circumstances but there are far too many glazed over eyes in smoked filled rooms full of drooling mouths thinking about how that new risk model is gonna make millions…..

Would you like anyone being able to take out a fire insurance against your house? Having plenty of people paying a small fee and …. throwing a burning candle in your house?

I have read estimates of 80% of CDS’s being naked (no underlying bonds). Congress apparently knew what would happen, because the “Futures modernization act” (heavily lobbied by Greedscam, Rubin, Summers, Levitt et al) explained that all the gambling laws would not be applicable to (the gambling with) CDS.

How convenient that lobbying by wall street resulted in removal of the uptick rule (June/July 2007; a few months later the stock markets would peak): now they could buy CDS AND shorts of firms they knew were heavily loaded with subprime toxins, or gas guzzling SUV manufacturers, etc. And then they prevent an orderly restructuring as they get more profit by letting the firms go fully belly-up.

And what about the rumored side letters? Both parties knew there would not be any payment, but one party could bamboozle the sleep-at-the-wheel regulators.

Regulation of CDS should take account of the correlation risks inherent in writing a large net exposure (to say nothing of the various counterparty risks involved in the netting process itself).

1. Do CDS help illuminate the price of credit?
2. If so, why is such “price discovery” a societal good?

A month ago, when I was a vocal defender of CDS, I would have argued that because CDS are so liquid and so simple, they must contribute to price discovery; as to why that is a good thing, I would have touted reductions in asymmetric information.

I’ve since retreated into a cocoon to re-evaluate my views on CDS. Question 1 is critical and may well determine whether I emerge again as a CDS defender, detractor, or mere skeptic.

That said, I still think that CDS have garnered a mountain of undeserved criticism, much of it evident in some of the comments above.

It is stunning to me that folks still praise the merits of CDSs *after* they have reached their disasterous culmination. It’s like a friend I know who clings to the notion that communism is a fine ideology that just hasn’t been implemented properly. Well that’s just terrific. Hasn’t the world suffered enough?

This discussion of credit default swaps reminds me a lot about discussions I had with friends about Napster and its ilk. There was absolutely nothing wrong with the technology we agreed, and it was none of Napster’s fault that it was being used for bad purposes. We confidently decided that Napster should not be restricted because legal files could certainly be shared through it. During the dotcom bubble, I help found a startup aimed at peer-to-peer filesharing so I relished these justifications.

Of course the reality is that anonymous P2P filesharing was used almost entirely for piracy, and its kind have catastrophically harmed the music industry. I say this with regret because my own involvement a decade ago in such technology.

Felix, it is very intellectually satisfying to think of credit default swaps as a kind of technologically pure system that was contaminated by evil users but can be valuable in the hands of good users.

In reality, as we have seen, credit default swaps have had overwhelmingly destructive effects (hiding of massive risk, allowing almost unimaginable leverage, causing huge systemic instability, and allowing enormous fraud by major financial players against each other and ultimately against taxpayers) balanced by very few actual positive ones. I don’t care how many theoretical positive uses there are, Felix. These past few years have shown these instruments to be on the balance so harmful that they ought not to exist. We did just fine (better even) before CDS’s and we will do fine again if and when we do the right thing and get rid of them.

1) There can be substantially more CDS written against a companies debt than there is debt outstanding. This leads can lead to rampant speculation and adverse price movements.

2) There is no capital assigned against this insurance since it is off-balance sheet. Whe things go wrong there is no cushion.

3) iven the size of the markets, the counterparty risk can cause systemic risk in the marketplace.

4) Who controls the concentration of risk (ie. AIG.)

5) It is black or white risk. Most of the time the writer of the CDS collects the premium; but when things go wrong the writer doesn’t have the funds to pay the insurance (AIG, Fannie, Freddie, and Citi and numerous hedge funds that are undocumented).

In concept the ability to hedge credit risk is sound, but in practice it has been shown to be a dangerous systemic risk to the entire financial world.