- by Stephen Gandel / @stephengandel
“Credit default swaps, or CDS, are contracts that allow investors and traders to bet on whether a company, a country or a group of companies, countries or individuals will pay back their loans. In theory, CDS work like insurance contracts. Sellers promise to cover the losses of the buyer of the contract if the loan the CDS is based on isn’t repaid. In fact, CDS aren’t really used that way. CDS are rarely held until a default occurs. Instead they are traded, in theory rising and falling based on the credit worthiness of a borrower or borrowers.
Of course, just because CDS have been at the heart of a number of recent blow-ups isn’t a reason to ban them. Stocks weren’t banished after 1987, or 2000. The reason to get rid of CDS is that it doesn’t work. Reuters recentlyreported that trading by the London Whale, and the hedge funds that were looking to make money off of the unwinding of JPMorgan’s outsized trades, caused the price of certain CDS contracts to jump and fall, even though the actual credit worthiness of the companies the contracts were based on hadn’t changed. Bank analyst Dick Bove for Rochdale Securities says the London Whale trades show that the CDS market is manipulated. “There’s something wrong with this market,” says Bove.
Earlier this year, CDS contracts tied to McDonald’s MCD 1.57% , for instance, rose 19%, during a period when there was almost no news about the restaurant company, and certainly no reason to suspect McDonald’s would have a harder time paying back its debt. In the same time, McDonald’s stock price barely moved, down 1.1%. Markets can become out of touch with reality for some time. That’s how we get bubbles. But the problem with the CDS market is that it’s so thinly traded that the actions of one player can cause market distortions. That’s supposed to be left to the idiocy of crowds.
The best question for proponents of the CDS market is when have the contracts actually worked. The CDS contracts sold by AIG only paid out because of Uncle Sam. And you can’t even count on bailouts. When Greece was “voluntarily” bailed out by the rest of Europe, the country’s government bonds were written down by 50%. Yet, the group that governs the CDS market ruled that CDS holders couldn’t collect on the insurance they had bought. Voluntary bailouts, as if Greece had a choice, were not covered by CDS. It was just another loophole in a Swiss cheese market.”