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October 06, 2008

Comments

David Merkel

If a credit derivative is insurance, then so is every event-driven contract. Yes, they are like insurance, but many contracts have insurance-like features to them. That doesn't make them insurance.

All of the insurance regulators deemed CDS to not be insurance. There is revisionist history going on now in the face of failure.

Been there

Hi. I’m a relatively new reader to your blog. Thanks, I enjoy reading your thoughts and ideas.

I’m a partner in a CPA firm and have been active in my state society in various ways, including as member of the Ethics Committee for the past few years- and- soon to be serving in a similar capacity at the AICPA level. I generally agree with most of what’s been written here, but unfortunately, I’m not in agreement with parts of this post.

FYI- you can find the 60 Minutes clip in question at the following website:

http://calculatedrisk.blogspot.com/

I watched the clip and thought it explained the environment and evolution of “credit default swaps” (CDS’s) in a straight forward fashion. While our small business clients haven’t utilized CDS’s, I’ve read a great deal about them. We also have various individual clients who hold senior level positions at large financial institutions- so I’m not completely clueless on this topic.

IMHO the problem with CDS’s, the problem was not poorly written financial reporting standards, but rather, it was due to legal and regulatory shortcomings. Credit default swaps are insurance (or should have been treated as such). There is a protection seller, a protection buyer and an underlying asset, just like with regular insurance. Also similar to insurance, the buyer pays the seller for protection against a future event that would negatively impact the value of the underlying asset.

Unfortunately, since the market for CDS’s was not regulated (and that seems to be the only significant difference it has with insurance products), protection sellers were not being monitored to verify that they had the financial wherewithal to pay potential future claims (as we’re now finding out the hard way). Nor were protection buyers (sans regulation) precluded from buying protection on underlying assets in which they had no direct financial interest (speculation). Some knowledgeable folks have noted how funny things would start to happen if people, in general, were allowed to buy insurance against the possibility of their neighbor’s house burning down.

To conclude, I don’t disagree with your comments about offsetting, they seem to make a great deal of since. Rather, the problem with writing financial reporting standards for CDS’s was flawed because the CDS market was a flawed unsustainable (non-viable) system, and even the most well written standards could not make up for that deficiency.

I continue to look forward to your comments.

Jason

Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and selling them as a credit default swaps (CDS). They do this in order to protect themselves by large payment to mortgage providers such as insurers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com

Chris

I'm not sure CDS are really a posterchild for this approach, which works rather better with conventional, non-contingent fixed-floating swaps (essentially returning them to their 1970s origins as "exchanges of borrowings").

A protection seller on the asset side has a fixed-term annuity under which payments are contingent on the reference credit not defaulting and on the liability side has a payment whose occurrence is contingent on default of the reference credit and whose amount is contingent on trading levels of reference credit debt at the time of default. (Given recent trends in the CDS market, I'm assuming cash settlement.)

How is it clearer to decouple those two payments rather than showing the MTM value of the package? Assuming the goal is to inform, rather than terrify and confuse, investors, how is showing a gross notional exposure without reference to the likelihood that payment will be made (or will cease) going to help? Or worse, would the liabilities be accounted for as for normal contingent liabilities so that investors would see no liability until some remoteness threshhold was crossed at which point they'd magically appear on the balance sheet?

I have my differences with mark-to-market (not least selectively booking one's credit spread blowing out as "gain"), but in this context I feel about MTM as Churchill felt about democracy.

David

>All of the insurance regulators deemed CDS to not be insurance. There is revisionist history going on now in the face of failure.

I disagree with the contention of revisionism - in fact, the CDS was designed to avoid regulation by the very way it was worded in its design, (by a team from JP Morgan).

http://www.guardian.co.uk/business/2008/sep/20/wallstreet.banking?gusrc=rss&feed=business

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