More on credit default swaps

A house insured for more than its value is always considered a fire risk. But home insurance is regulated and arson is a criminal offence. That keeps most people honest, most of the time. The same cannot be said of the credit default swap industry. The private, over-the-counter market allowing two parties to bet on the likelihood of a company defaulting on its debt had, by the end of 2007, grown to at least $62,000bn in notional amounts insured – more than all the credit outstanding worldwide. Contracts, however, are registered nowhere but in the books of the partners. Nobody really knows the real volume of trading, the method(s) of prices discovery or, in President George W. Bush’s phrase, the “interlinks” of risk.

CDS, of course, cannot be blamed for the excessive leverage in the system, or for the lack of visibility into the quality of credits bundled up into complex structured products. But the pressure to hedge has led the most liquid contracts to overshoot, in effect pricing in absurd default risks and recovery rates. These same prices are then used as supposedly objective indicators to value the securities the CDS contracts were designed to hedge – hence the spiral of over-hedging and overstated marked-to-market losses. David Paterson, governor of New York, seems convinced that bringing parts of the sector under the control of insurance supervisors will make things better. He is wrong. They are not up to the task. These were the same people that allowed AIG, the largest insurer in the US, to dice with death with CDS. The priority, rather, should be to move trades on to already regulated exchanges. That would mean buyers and sellers of protection were matched more efficiently and transparently. A central clearing house would reduce counterparty risk and enforce bigger margin requirements. This would also price out some of the chancers.

Standardising decades-long bespoke contracts would not be easy. But the great deleveraging and asset price correction is already painful enough. That this vast, opaque market underpins everything is not helping.
http://www.ft.com/cms/s/2/0041100c-8949-11dd-8371-0000779fd18c.html