Tuesday, November 15, 2011

A few WSJ words about Credit Default Swaps

For those who tuned in late, a credit default swap (CDS) is paper insurance, if the financial paper you hold defaults, the credit default swapper will pay you off. For a slight fee of course. The swapper will charge a percent or two to cover his expenses. So eager beaver young hi-roller can buy Greek bonds that pay 28% and tell his supervisor "It's OK, I bought a credit default swap on them, so when the Greeks default, we get paid off."
Only, the Greeks or the ECB or somebody worked some kind of evil magic and the Greek CDS's won't pay off after the bondholders took a 50% haircut. Woe is me.
"investors concluded that the CDS's of other EU countries weren't to be trusted either. So when fears mounted over Italy's solvency last week, investors bailed out of euro-zone debt."
Oh the horror of it. Investors will stop pouring money down an Italian drain. The world will end on Tuesday. Francesco Guerrera, a Wall St Journal editor, thinks this is terrible.
Actually, it's a good thing. Capital ought to be invested in economic development, factories, mines, off-shore oil platforms, sea going ships, roads, bridges, airliners, you know, stuff that employs people and makes money. Money loaned to EU governments just goes to pay pensions of retired bureaucrats. The bad part about CDS's, is that they encourage investors to invest in loser government bonds instead of useful things.
Far as I am concerned, anything we can do to stamp out CDS's is a good thing. Investors ought to look at the risk involved in any investment. CDS's (when they work) shuffle the risk off on the third party, and allow the investor to put his money into really risky stuff but without assuming the risk himself.
Society's capital will be better directed, resulting in greater economic growth and more employment, if the investors have to face up to risk.

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