Knowing and Making

There's been a movement - reminiscent of the anti-short-selling campaign - against buying "naked credit default swaps". The idea of a CDS is to provide insurance against default on a corporate or national bond; and a naked CDS is one which is bought by someone who doesn't own the original bond. The objection to this is based on a kind of moral hazard argument - the idea that if I buy insurance against your house burning down, I'll have an incentive to leave piles of leaves and open cans of petrol near it. So one proposal, according to this article in the FT , is to prohibit people from buying a CDS if they don't own the underlying bond. ( Update : Felix Salmon points out Wolfgang Munchau's more in-depth article proposing the same thing) Sounds like it makes sense at first glance. But one big question arises: what if I want to sell the bond afterwards? Do you prohibit me from selling it without also selling the CDS? If so, I am suddenly left with...

In defence of Greece, I pointed out to a colleague the other day that the cost of a Greek CDS is only 4% for a five year period - meaning that you only need a 0.8% interest premium to make a Greek bond worthwhile, or that the market only gives Greece a 1/125 chance of defaulting each year. He responded with the valid observation that this is all very well, but who's offering this insurance policy and will they be around to pay it if Greece does default? After all, AIG wasn't. In fact, the 4% is not  the spread between the chances of Greece defaulting and a risk-free bond, as it's commonly presented. It is actually the spread between the chances of a Greek default and an  insurance company  default. It's a lot easier for an insurance company to go bust than it was two years ago. Not only have risk conditions deteriorated, but after AIG, Citi and the rest, it would be immensely tough politically to bail out another big insurance company or bank which had issued CDS...

Robert Peston raises the interesting issue of whether European banks (and Goldman Sachs) were taking high risks in dealing with AIG. Goldman, Barclays, Society Generale and Deutsche Bank have each received between $8bn and $13bn since the US government's AIG bailout. Peston takes this as some indication that these banks were not being managed prudently - their reliance on AIG being a risky one. But the main complaint against AIG is that it was selling credit default swaps and other financial insurance products while not having enough capital to cover them, and underpricing the risk of default. If this is the case, then it might have been perfectly legitimate for these banks to buy the insurance, even factoring in the risk that AIG would default. A large proportion of the payments received by Goldman (Peston doesn't break down the payments to the other banks) are CDS-related - indicating that their insurance policy paid off. Even if it hadn't, they would not have "lost...