In the early years of the London insurance market, it was possible to buy a life insurance policy on a complete stranger. Then insurance companies noticed the high incidence of unexpected homicides among their lives assured, and the concept of insurable interest was devised, codified by the Life Assurance Act of 1774. Today, you can’t buy a life insurance policy unless you can demonstrate some loss by the assured party’s death. The business is safer that way!
The same consideration must surely apply to the CDS market. The legitimate hedging purpose of CDS today represents only a tiny proportion of contracts outstanding.... With multiple bankruptcies and huge market instability owing at least part of their provenance to CDS, the public policy consideration for closing or at least sharply restricting the CDS market is even clearer than that promoting the restriction of the insurance market in 18th century London (at least taxpayers weren’t expected to pick up the tab for insurance policies on murder victims!)
As a minimum, therefore, CDS writing should be restricted to those holding bond, loan or swap obligations against which CDS might reasonably hedge. CDS should be distinguished from stock short positions and stock options (which have similar theoretical possibilities) because their greater leverage and higher outstanding volume make them uniquely dangerous. Such a market would be highly illiquid, but it would fulfill CDS’s essential function of enabling credit risk transfer. CDS’s other advantages, of demonstrating credit spreads over a public marketplace, allowing the hedging of baskets of similar credits, providing an instrument for hedge fund “investment” and making huge returns for the major dealers, would be lost. However, CDS’s destabilizing effect on global financial markets would also be lost, and the cost to taxpayers of rescues for those major institutions which had either got the CDS market wrong or were victims of CDS “bear raids” would be eliminated.
The free market is a wonderful thing. However, allowing unrestricted free markets in everything, without regard to the real-world economic effect of those markets, is a Whig shibboleth similar to the “Repeal the Corn Laws” unilateral free trade policies that destroyed Britain’s economic strength in the 19th century. The great and economically highly sophisticated Tory Prime Minister Robert Lord Liverpool, a generation prior to the mid-century free traders, also believed in free markets, but was a realist in their application to the world in which he lived.
The real world is messy and does not conform to simplistic equations either mathematical or moral. The wise policymaker will legislate accordingly, providing the maximum market freedom but inserting restrictions where the temptations to malfeasance are too great. The CDS market forms an open and shut case for restrictive regulation.
Thursday, March 05, 2009
Objectivism & Economics, Part 22
Ayn Rand's insistence on the separation of the economy and the state means that she opposes all regulations, even those that would prevent serious market failures with widespread externalities. Indeed, there is a tendency among Objectivists to deny that regulations can ever have a positive effect. The implicit argument is that, because regulations infringe on individual rights, they are immoral; and since Objectivists insist on equating the moral with the practical, this suggests that any infringement of "individual rights" must lead to bad results (such as aversely affecting millions of people). But if this isn't true, if certain types of financial instruments produced by the market lead to extreme financial dysfunction which harms millions of people, shouldn't the government seek to regulate those financial instrumen? Martin Hutchinson over at prudentbear.com presents a convincing argument for regulating the CDS (Credit Default Swaps) market: