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In his novel, “The Great Gatsby,” F. Scott Fitzgerald wrote that “traders are different from you & me.” Yes they are. Some say that traders are compulsive gamblers who use any opportunity to place a wager. Nowhere in the history of financial products has one form of gambling had such an adverse impact on the world economy. That form is Credit Default Swaps (CDS).
The CDSs were designed to allow holders of government or corporate debt to insure themselves against the borrower (debtor) going bust, much the same way you buy home insurance to protect your investment against the risk of fire. For instance, a large amount of Lehman Brothers’ debt was sold to Asian customers. Even though Lehman had a high credit rating, the Asian lenders felt it was prudent to buy CDSs as protection against the tiny risk that Lehman could go bankrupt. As with insurance premiums, the cost of the CDS was a very small percentage of the value of the debt.
At this stage, CDSs were fulfilling a beneficial function. Insurance against unforeseen events creates stability & gives us the ability to weather those events. Where it started to go wrong was when traders (being the compulsive gamblers they are) decided to create a market for CDSs. From then on, it was not just a case of insurance companies deciding how much they would insure a particular asset for & negotiating premiums with the company that owned the asset. Instead, anyone could start making bets & booking bets on whether various companies would go bankrupt, even if they had no interest or relationship with the companies involved.
To understand how this worked, imagine that, in addition to you buying house insurance from your broker, your next-door-neighbor also takes out insurance against your house burning down. And then he buys a policy from your neighbor down the street, who doesn’t have the financial wherewithal to pay up if your house ever did burn down (he just wants the premiums). Now imagine that all your neighbors, & in fact people all over the world, are allowed to jump in on the act, buying & selling policies & making bets on the survival of your home. Those who sold the most insurance might grow quite wealthy collecting premiums from thousands of people. Everything continues just fine, until the tragic day your house actually does burn down. Now, not only will you be collecting on your insurance, but a lot of other people will also be looking to collect from another lot of people who can’t pay up.
This doesn’t happen in real life because there are laws & regulations governing who can offer insurance products. However, thanks to the regulatory loophole that was created in 2000, the market for CDSs came to resemble a frontier casino. CDSs didn’t trade under the auspices of the SEC, the CFTC or any other regulatory body. They were in a deregulated wilderness where there was no accurate way to measure the risk involved, & no independent House making sure that all parties could cover their losses if a bet went against them. It is estimated that there are trillions of dollars tied up in unpaid CDS claims. This mess needs to be resolved along with the home mortgage defaults & financial institution failures.
That's what unregulated gamblers did.
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