Turning from risk to a gamble

Lou Dubose of the Washington Spectator (alas, no link) supplies a bit of background on the financial regulation package that just passed the Senate. A big part of the financial mess of the last two years is because of credit default swaps (CDS). I'll try to summarize his explanation. Suppose you bought GM bonds. It begins to look like GM may not be able to make the payments on those bonds, so you take out insurance in case GM defaults. If GM does just fine you lose the price of the insurance (but get the bond payments). If GM goes into bankruptcy the insurer loses the price of the bond payments and you don't lose out. In this case the insurance is called a credit default swap because one person is swapping the risk of default on some type of credit (the bonds) with someone else. The company that issued the insurance is supposed to make sure it has a way to pay the claim if GM can't pay it's bonds, which is called reserves.

So far, so good. But a CDS could also be a gamble. You could buy a CDS on GM bonds even if you don't own GM bonds. Then it isn't transferring risk, it is simply a bet on the future of GM. And a lot of people made a lot of those kinds of bets.

And here's where it went wrong. In 2008 before the crash, the entire world economy was about $60 trillion. But there was $600 trillion in outstanding CDS claims. There was no way all those claims could be paid.

So the new regulatory laws fixed that problem. Right?

There are five institutions that do 80% of all CDS trades. These five have combined assets of over $8 trillion. Would that much financial power let a silly little law get in the way of their feed trough?

There is some actual good in that new law. There is a new consumer protection agency now a part of the Federal Reserve. Real progress. If they don't get too cozy with the companies they regulate.