What is a CDS? Hint: Credit Default Swap

This is quite a horrifying article from Fortune: The $55 trillion question

It’s pretty relevant to my previous post where I compared these instruments to gambling. This is from the article:

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world’s largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, “To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract.”

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. When you put $10 on black 22, you’re pretty sure the casino will pay off if you win.


Read this article, it’s very interesting. It makes me why no one has gotten up in arms screaming:

Make Credit Default Swaps (CDS) illegal!

It sounds like they are pretty shady to begin with. If some trader has the ability to write a contract via IM or over the phone that has millions or more of potential payouts in the event something happens that would seem to me to be a very substantial breakdown in corporate controls that would trickle all the way up to the CEO – via the Sarbanes-Oxley. Risk of this magnitude should be disclosed to shareholders and ignoring it seems pretty stupid – even if you think bad things are unlikely.

Another great quote from the article:

The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. “People have been insuring risks that they can’t insure,” says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. “Let’s say you’re writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there’s a huge fire and they all burn down. What do you do? You just close up shop.” (Emphasis added.)

So, what do you think ?