Credit default swaps

Among the other exotic financial derivatives swimming around in the current fiscal morass are “credit default swaps”. A credit default swap is an insurance policy on some financial instrument, say a loan (or a bond or a mortgage, or a package of mortgages, all of which are forms of loans). If that instrument defaults, I get paid. Originally this was created as a way, for a small price, to pass off (swap) to the insurer the risk of default on a mortgage or loan or bond that I owned.

But in fact I don’t even have to own the financial instrument I buy the insurance on, so speculators quickly saw an opportunity for profit. They could insure someone else’s financial instrument – one they didn’t even own. That makes it really a sort of legalized gambling. In fact speculators typically don’t own the instruments they insure. (it’s sort of like buying life insurance on a stranger you don’t even know, just to bet that he/she will die in the next year).

If I am a speculator and the financial instrument I have insured defaults I win big (the insurance pays off at the full face value of the insured instrument) and lose nothing, since I didn’t own the loan in the first place. If it doesn’t default I don’t lose anything except my insurance premium. For a while it was a nice deal for everyone, especially the insurance companies that sold these credit default swaps (like AIG). They collected the insurance premiums, and only occasionally had to pay off, so they made billions.

But then the housing market crashed, lots of mortgages and loans and bonds began to default, and suddenly the insurance companies (like AIG) didn’t have enough money to pay off on the credit default swaps they had sold – hence the gigantic government bailouts to try to keep the system afloat.

Now here is the crux of the problem. If there were just a few of these credit default swaps around, a trillion or two might pay them off. But since they are unregulated, no one really knows how many are out there. Estimates are that there might be as many as $40 trillion dollars worth of them out there. By comparison, the entire world’s annual gross product is about $60 trillion dollars. There is no way the U.S. government can print enough paper money to pay them all off, let alone borrow enough real money to do the job.

Clearly the administration’s current approach is useless in the face of the magnitude of this problem.

Here is a suggestion that has appeared here and there in blogs, but ought to be seriously considered. The government should simply arbitrarily cancel all credit default swaps held by people who don’t actually own the insured instrument. That means the pure speculators lose their premiums, but don’t lose anything else. Meanwhile, those who insured instruments they actually own are still insured. And at the stroke of a pen you have wiped out much, perhaps most, of the huge liability that is nothing but pure gambling by speculators, but is sinking the system.