Thursday, September 24, 2009

On credit default swaps, the Fool has it right

At a "Motley Fool" roundtable, the following question was asked -- "What financial regulation would you like to see implemented?"

Fool staffer Morgan Housel answered as follows.

"My Foolish colleague Ilan Moscovitz and I have discussed that if we can't find the will to regulate something as absurd as credit default swaps -- with which derivatives investors can insure debt they don't even own -- then the odds of passing any meaningful financial reform are nil. Simple talk of reforming the credit default swap market has been met with fierce opposition. That worries us about the prospect of overhauling more sensitive areas of the industry."

Over a year ago here, ENS became obsessed with the credit default swap issue. When the dust began to settle in early 2009 and we learned that there were by some estimates $60 trillion* of credit default swaps written against no more than $2 trillion of subprime mortgage backed securities, it seemed obvious that this was a starting point of reform to prevent hair trigger panics in the financial system for the benefit of a few. The only rationale for the roadblocks set up against reform on this important issue seems to be that many Republicans are dedicated to unfettered free markets while many Democrats are dedicated to uninterrupted free money. Is that the same thing?

Those at the pinnacle of the trading based segment of the hedge fund industry are powerful and well connected.

*The estimated $60 trillion is notional value, meaning the value of the instruments being insured versus the actual exposure of a swap. In the case of most derivatives notional value is a meaningless exposure number. Unfortunatately in the case of credit default swaps on subprime mortgages the ride down was so abrupt that notional is not completely irrelevant. Also it should be noted that there is no information on at what points in the collapse process many of the swaps were written. This is important as a swap written when a security was already trading at 40% of original value represents much less negative value to the writer of the swap than one written when the security was originally issued at par. The important point remains. CDS's were written on multiples of the securities that existed.


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