Three things are certain regarding credit default swaps (CDS's); and the first two certainties make the last all the more critical.
First, the world economy has developed a dependence on CDS's evidenced by the size of the CDS market and their use and importance as a marker of financial health as presented in the previous article.
Second, credit default swaps are so completely imbedded in the international economy that one major financial institutions CDS default adversely affects, to some degree, many (perhaps dozens of) institutions; even those not in a direct credit default swap relationship with the faltering institution.
Third, credit default swaps are unregulated. The previous article alluded to the SEC's lack of over site and the fact that there is no regulatory authority within the insurance industry to shoulder the burden. Based on the potential domino effect of bank and financial institution failures triggered by a CDS default, there is clear need for some form of regulation.
What and Who of CDS's
Credit default swaps have recently acquired the title of "insurance contracts," leading some to conclude that a CDS is, in fact, insurance. If these are insurance contracts, then are state departments of insurance best suited to regulate the trade of CDS's or is a federal or international insurance regulatory board necessary due to the world-wide reach of these financial derivatives?
The next several paragraphs will answer two questions: 1) whether these financial instruments are insurance; and 2) is a state department of insurance qualified to effectively regulate the contract and sale of a CDS.
Are Credit Default Swaps Insurance?
Certain risk characteristics are required before protection, in its classical sense, can be considered true "insurance." Each characteristic of insurance compared to the characteristics of credit default swaps produces a gap leading to the conclusion that these derivative products are not insurance in its most basic form.
Pure vs. Speculative Risk. Insurance was designed to insure against pure risk not a speculative risk.
Pure Risk: Only one of two things could happen, something bad or NOTING. The house could suffer a fire loss during the policy term or it could stand the entire period with nothing happening to it. The owner/insured pays a premium for a promise to pay if something bad happens. If nothing happens, the only out-of-pocket expense to the owner is the premium.
Speculative Risk: One of three possibilities exists in a speculative risk; something bad could happen, nothing could happen or the risk taker could realize a profit. Credit default swaps are based on speculative risks and are, themselves, a speculative risk.
The bond purchaser hopes to make a profit by speculating on the future of the company selling the bonds; but to protect itself against the potential default of the bond-issuing company, the purchasing company buys a credit default swap (hedging the default risk) from a second counterparty. The counterparty bases its premium/fee on the perceived quality of the bond-issuing company. Now, three things could happen to the company that bought the bond; it could be paid back as expected thus realizing the hoped-for profit (net the premium/fee for the CDS), interest rates could fall and the bond purchaser could end up even or worse; on the bond seller could go out of business causing the purchaser to lose its entire investment - against which they bought protection in the form of a CDS.
The counterparty, as detailed above, likely sold some or all of the risk to another party (the "reinsurance" scheme) to protect its exposure and to make a profit. Financial institutions "bought them [CDS's] not just to protect against a loss, but to hopefully make a profit. That transformed them from an insurance policy that covers pure risk into a gambling contract that is effectively a speculative risk," according to Brenda Wells, Ph.D., CPCU, AAI, associate professor of risk management and insurance at the University of North Texas.
Further evidence that these are speculative risk contracts is found in the numbers. At the end of 2007, the CDS notional value was $47 trillion; however, the total value of the assets on which CDS's are based (corporate bonds, municipal bonds, and structured investment vehicles) totaled only $25 trillion. This means that there was a minimum of $20 trillion in speculative "bets." (Taken from: Credit Default Swaps: From Protection To Speculation; September 2008; Published in the September 2008 issue of Pratt's Journal of Bankruptcy Law. Copyright ALEXeSOLUTIONS, INC. Written by Richard R. Zabel, CPA)
The seller of a credit default swap (rarely an insurance company, usually another financial institution) agrees to protect the buyer against poor speculation and bad investment decisions. That is not the purpose of insurance.
Insurable Interest: To purchase or collect on an insurance policy, in the classical meaning, statute requires insurable interest in the person or property being insured. For an insured to collect the proceeds from a property policy on a commercial building, for example, they must be financially harmed by its damage or destruction; same with insuring an individual's life. Credit default swaps do not require such interest. In fact, Chairman Cox stated in his testimony that CDS buyers do not have to own the bond or other debt instrument upon which the contract is based. This is known as a "naked short." This leads back to the speculative risk issue (the $20 trillion "bets" mentioned above).
Being able to bet (via a CDS) on the future of a company in which the better has no insurable interest removes credit default swaps from being considered insurance. Point of consideration; being able to speculate and bet on a company whose collapse would not financially harm the CDS buyer creates a moral hazard.
Credit default swaps meet neither requirement of insurability and thus do not truly qualify as insurance in its founding and classical sense.
Regulating Credit Default Swaps as Insurance
There is little to no regulation of CDS's. Trillions in notional value trade yearly without over site. Wells points out the results this past and current lack of over site and regulation causes insurance carriers such as AIG who invest and trade in CDS's, "A key problem here is that the insurance company balance sheet is supposed to reflect everything the insurer is risking, and everything it owes. For instance, regulators monitor the value of investments, requiring that they be marked to market for a truly accurate picture of what assets are available to pay policyholder claims. Regulators also require that a certain amount of premium from every product be held in reserve for future claims. Yet there (has been) no transparency with these products, since they were unregulated. There was no way for a commissioner to require a certain amount of premium be set aside to pay in the event of a massive wave of bond defaults."
New York State's Department of Insurance has been the only department, thus far, to step up and say that they are willing to regulate at least part of CDS contracts. Superintendent Eric Dinallo testified before the US Senate on October 14, 2008, that regulation for this exposure is necessary and that the state and the Federal government could jointly regulate these derivative contracts.
Dinallo went on to say, "It would optimal to have a central counterparty." Due to the press CDS's have received over the last several weeks, such a central counterparty may be forced upon the industry.
Wells concludes, "A fundamental problem with CDS's is the lack of transparency. The regulator cannot control or monitor what it cannot see, and these contracts were marketed as insurance policies just like any other, although the terms and conditions of each one were not readily available. These instruments were outside the regulator's purview, which will likely change. One solution to this problem is to make the contracts standardized, like commodities, and buy and sell them on an open exchange. There has been some movement towards this in the past, but it is not required. I suspect after the AIG bailout that we'll see people pushing for heavy regulation of this market, at least with respect to insurance companies. It may go the route of the junk bond, in terms of regulators setting limits on how many can be included in admitted assets."
Conclusion
Credit default swaps do not qualify as insurance in the classical sense because: 1) they protect against speculative losses; and 2) no insurable interest is required for their purchase. Essentially, they are an investment instrument used by all counterparties to protect against the loss of and to generate income.
Finally, a single institution's CDS default can place a financial strain on others in the chain of "retrocession" (as described in the previous article) by making the downstream institution(s) responsible for unexpected and unfunded costs (after all, the risk had been transferred). Unexpected CDS "loss" payments required of the downstream institution lowers the amount of capital it has available to satisfy debts owed to other financial institutions, perhaps even those outside the CDS agreement chain. As a result of being unable to pay the other institutions, those banks and financial institutions have lower-than-expected income and may default on their debts - on and on it may go, potentially involving banks in several countries.
One state or even many states in collective cooperation cannot effectively manage and regulate such a world-wide financial product that, upon analysis, ties the world's financial markets together (the default of which would have global fallout). Regulation of CDS's is best left to a federal authority, and since these are not classic insurance (mostly speculative bets), this does not serve to back up or support the argument for financial regulation of insurance.
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Given the international market for CDS's, I don't think State insurance regulators are approproiate to monitor it and refgulation should fall to some federal or international regulatory body.
Bottom line, there is a financial guarantee and the party providing that guarnatee needs to have the requisite capital and adequate reserves to fund the potential default. In that respect, it must be approached much like insurance or surety bonding.
'This is worse than a divorce... I've lost half of my net worth and I still have my wife..'
The bailout, a different perspective:
Back in 1990, the US Government seized the Mustang Ranch brothel in Nevada for tax evasion and, as required by law, tried to run it. They failed and it closed. Now we are trusting the economy of our country to a pack of nit-wits who couldn't make money running a wh**re house and selling booze?