New Dangers of Credit-Default Swaps

11/11/2011 8:45 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Credit-default swaps are not working for Greece the way they were intended, says MoneyShow’s Jim Jubak, and he is concerned that if markets lose faith in these instruments, it could turn into a long-term crisis.

I’m not a real big fan of derivatives—not because I think there’s anything wrong with creating instruments piled on top of instruments, but because the markets are so opaque.

I think that this particular thing going on in derivatives right now is a result of the Euro crisis. Really it doesn’t make any sense, and it’s really dangerous, and it’s being engineered into a kind of short-term fix, and I think it’s likely to create a long-term crisis.

Credit-default swaps are used as a kind of insurance policy. You get somebody to say, "Oh, well, Italy’s bonds are going to go down, and I’d like to buy some insurance against that," and you find somebody on the other end who says, "Well, I don’t think they’re going to go down that much, and therefore I’ll write you a series of derivatives that basically pay you if they go down, and if not, I collect some kind of fee."

The problem with this is that you’d think that in the case of Greece—where the issue is maybe Greece is going to default, and you’re talking about a writedown of 50% or so of the face value of Greek bonds—you’d think this is exactly what credit-default swaps are designed for. So there should be money flowing back and forth as people get paid out.

Well…no, because this has been written in very precise, legalistic terms so that it doesn’t trigger a credit event. So you’ve got all of these things out there—you’ve got a de facto default—but because of sort of technical things written into it, it’s not going to trigger these insurance policies.

Now you say, "Oh, well, that’s fine because it’d be good not to have these things triggered, and we can’t really tell what the effect of that is." But if you think about it going forward, this was a major way to distribute risk around the world to insure against risk.

You say, "Well, that’s a bad thing," because it encourages people to take more risk, but it’s also a good thing, because it encourages people to take risk they might not have otherwise taken. That lubricates financial markets.

If there were no credit-default swaps, would people lend money to Greece at all? Is that a good thing? If Greece had defaulted earlier, before anybody was really prepared—because there was no way to insure against that—would that have been good or bad?

I think you can make an argument on either side, but we’re really heading into uncharted territory. We’re basically saying this market is trillions and trillions of dollars, and this market doesn’t work the way that people thought it did. And the bets that you put out there, the insurance you bought, won’t work the way you thought it worked. Really, we can rewrite the terms of this any time we want.

If I were somebody buying bonds that were slightly risky, I would certainly not count on being paid, even if I had insurance. That’s not good for the financial system.

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