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CDS Investors Shouldn't Pay for Being Right

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Punishing them not part of the solution.

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I generally like the work of Gretchen Morgenson, financial columnist for the New York Times. But in recommending the cancellation of all credit-default swap (CDS) contracts in Sunday's edition, she has gone wrong.

Indeed, her argument is inconsistent. She rightly blames institutions that sold these insurance policies on corporate debt too cheaply for much of the trouble that followed.

I will take it one step further. The asset allocators who bought into those hedge funds which were selling cheap CDSs were often doing so with borrowed money, creating multiple layers of leverage on an intrinsically flawed premise. Two or 3 years ago, these asset allocators were pulling money out of investors who saw that insurance was too cheap and were buying it, sustaining consistent but minor losses as time passed and bankruptcies didn't threaten.

The problem is Ms. Morgenson's solution: Penalizing those who were trying to sound the warning signal -- that credit risk was being priced too cheaply -- by buying the swaps. Had we paid more attention to these folks a few years ago, we might not be in this situation now. At the same time, Ms. Morgenson wants to tear up the losing trades made by those who were being most irresponsible throughout the credit bubble - in effect giving the culprits a huge do-over.

This is conceptually not unlike bailing out homeowners who overextended themselves with mortgages they would only be able to afford in the sunniest of circumstances. But from a policy perspective, it's much worse. Trying to keep people in their homes, and working with them to minimize past mistakes, is one thing. Telling a bunch of "investors" that we'll tear up their losing trades, inspired by momentum and crowd-following and a lack of independent thought, is far worse. It's more akin to the poorly reasoned and ill-fated ban on short-selling of financial stocks, which the SEC now readily admits was a big mistake (as many voices were shouting at the time it was implemented).

One of the worst parts of the idea of voiding CDS trades is that they may have been used for many kinds of hedges, not just the obvious ones involving the underlying debt. Ms. Morgenson's approach doesn't even begin to address this. Once again, those who may have been using the CDSs prudently will be punished.

The desire to make "the gamblers," as Ms. Morgenson describes investors who speculated on CDSs, pay for the nation's troubles. makes good populist reading. But it doesn't make financial sense.
No positions in stocks mentioned.

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