The Death of the Credit Default Swap

LvMIC:

Warren Buffet must be crying tears of joy after last week’s announcement where The International Swaps and Derivatives basically destroyed the function of a credit default swap. Via the New York Times:

The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit-default swaps linked to the country’s bonds.

I concur wholeheartedly with Big Picture blogger Barry Ritholtz:

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

In order to get paid on a default, you need a committee to evaluate whether or not failing to make payments is a — WTF?!? — default?  Even more ridiculous, the committee is composed of biased, interested parties with positions in the aforementioned securities?

ISDA: After this ****show, why on earth would anyone EVER want to own an asset class that requires you to determine payout? Indeed, why should ANYONE ever buy a derivative again?

Indeed, who in their right mind would buy a CDS ever again after its sole purpose has now been relegated to the irrelevance due to the decision of one group?  It’s the equivalent of purchasing car insurance, being side swiped by another driver, and then having the insurance company renege on paying out.  Depending on the contract, such could be fraud punishable by legal arbitration; not to mention a good way to run a company into the ground.  This latest decision by the ISDA has most likely put a death nail in the CDS market as we know it.  Those who see the financial industry as the embodiment of all that is unholy and in dire need of divine regulation from those elected angels in the halls of Congress, such as George Soros, are ecstatic at this probability.

Yet credit default swaps are in no way shape or form an instrument to be demonized.  As Thorsten Polleit and Jonathan Mariano explain:

However, sound economic analysis reveals that CDS are fully compatible with the principles of the free market, and that CDS are not to blame for the disintegration of credit markets—with their tumbling banks, struggling private borrowers and increasingly overstretched government finances. The truth is that CDS provide investors with an efficient and effective instrument for exposing economically unsound and unsustainable fiat money regimes and the economic production structure it creates—which, in turn, provokes a (n intellectual) counterattack from government officials (and their “court intellectuals”), who argue for regulating or even banning CDS.

Credit default swaps, at their core, are a bet against the solvency of an institution.  If they are to be criticized and heavily regulated, than any game of chance involving monetary payments is to be as well.  The same goes for speculators who risk their own capital in trying to forecast future market signals in an efficient manner.  Basically, those who see credit default swaps and speculators as the enemies of mankind have their verbal knives pointed at entrepreneurs attempting to smooth out market fluctuations at a profit.

Since market information is widely dispersed between individuals, preventing the free flow of interaction between market participants cuts down on the efficient allocation of goods and resources.  From Freidrich Hayek’s invaluable The Use of Knowledge in Society:

It is with respect to this that practically every individual has some advantage over all others because he possesses unique information of which beneficial use might be made, but of which use can be made only if the decisions depending on it are left to him or are made with his active coöperation.

If investors purchase credit default swaps, they likely realize something is amiss on the functionality or solvency of the institution they are betting against.  In the world of fiat currency and fractional reserve banking, practically every bank in the world operates on the basis of insolvency as their liabilities far outweigh the real assets in their possession.  Since governments pursue a monetary policy of constant inflation, (the recent financial crisis only reinforced this notion with central banks around the globe, lead by the Federal Reserve, printing to kingdom come to keep their respective banking systems afloat) continual default is the norm as nominal payments on bonds are made but are worth less in real terms.  This may not constitute default by CDS standards (nothing does anymore apparently) but the promises of utopia made by politicians will inevitably bring government balance sheets to their knees the world over.  Greece and the rest of the PIIGS are just the beginning.

Since credit default swaps are a weapon against the bad habits of the political class and the special privileges granted to the banking industry, they continue to be regarded as a great evil by those who benefit from the state.  If banks refrained from engaging in the practice of extending unbacked credit or governments didn’t spend more than they take in, credit default swaps would not have been widely used to speculate on their solvency.

Now, the CDS market may have just met an early death despite the Greece government clearly defaulting on its debt.  One more tool to fight Leviathan’s growth might have been removed but no doubt others will develop as to ensure a market for betting on the solvency of over extended states and banks.  Capitalism, when not regulated into the ground, works in spontaneous and mysterious ways.  Silver linings exist in almost any situation if you look hard enough.  With the CDS market effectively rendered useless, perhaps government bonds will lose their appeal to the investor class.  This can only be a good thing as it means less money flowing into the coffers of unproductivity.

*Addendum- As Martin Sibileau points out, the ISDA’s controversial decision over a credit non-event was in regard to not the prospect of private bondholders being forced to absorb a loss on their holdings of Greece debt but on the ECB receiving preferential treatment due to a new swap deal with the Greece government.  Bloomberg explains:

The ECB will exchange its Greek debt for new bonds with an identical structure and nominal value, though they’ll be exempt from so-called collective action clauses the government is reportedly planning. That implies senior status for the ECB over other investors, according to UBS AG, and the use of CACs may lead to credit-default swaps protecting $3.2 billion of Greek bonds being tripped.