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Are Credit Default Swaps Casinos in Disguise?

Photo of the inside of the Venetian hotel and casino in Las Vegas by Flickr user kris.hoet.

Update | 1:50 p.m. ET This post has been edited to include the reference to the CDS explainer and Jon Stewart.

Paul Solman frequently answers questions from the NewsHour audience on business and economic news on his Making Sen$e page. Here is Tuesday’s query:

Name: Hugh Stringer

Question: If an insurance company has sold multiple credit default swaps on the same bond and the bond is in default, who is insured?

Making Sense

Paul Solman: Is this a trick question, Hugh? If you mean “who supposedly gets paid?” the answer is obvious: the party that bought the credit default swap (CDS) — the “insurance.” I throw in the “supposedly” because there may well be arguments and even litigation as to what constitutes a “default,” defined in CDS contracts as a “credit event.” Would a failure of the U.S. debt ceiling have constituted a default, for example? Probably not, but we have yet to find out. Will the Greek debt deal, which lowers both the principal and interest on its old loans, be an official default that triggers CDS contracts? Not to this point, but the issue is being hotly contested, and fear of triggering is one explanation for today’s market downturn.

(For an explanation of credit default swaps, see our 2008 video primer,
Risky Credit Default Swaps Linked to Financial Troubles. and, if you can’t resist Jon Stewart, his send-up of our primer on The Daily Show: Financial Crisis Cartoons.)

But my suspicious journalist mind thinks your question may be a touch rhetorical, as in: “How can they call this insurance if they’re selling ‘protection’ that extends beyond the scope of the actual risk?”

If that’s your question, the answer is equally simple. The CDS market takes the form of insurance; you pay an annual premium, you get paid a lump sum if the negative event takes place. But it has become a market for making bets, not just for hedging them. To what extent is the CDS market a casino? You’d have to know if CDS buyers owned the underlying bonds they were insuring against. We don’t.

It’s safe to assume that a lot of CDS buyers are speculating, not protecting prior investments. On the other hand, some CDS buyers are hedging. Ask yourself this: Without the CDS protection, might they not unload the bonds they’ve “insured,” thus raising the interest rate for the bond issuers? Might CDS, by that logic, serve some legitimate purpose? Just wondering aloud.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions

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