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How to solve the credit crisis

how to solve the credit crisis

October 06, 2008

How to Solve the Credit Crisis

Congress abolished gold clauses in contracts in 1933.  Should it do the same with speculative credit default swap contracts?

Blawgletter just finished reading an article on credit default swaps from our source for all facts whose accuracy doesn't matter -- Wikipedia .  And, boy, did it throw a scare into us.

It says:

A credit default swap (CDS ) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if a credit instrument goes into default or on the occurence of a specified credit event (such as bankruptcy or restructuring). The associated instrument does not need to be associated with the buyer or the seller of this contract.

Originally used as a form of insurance against bad debts, these instruments became a tool for financial speculation when the US Commodity Futures Modernization Act of 2000 specifically barred regulation of these trades.

The part that gave us a fright notes that "[t]he associated [credit] instrument does not need to be associated with the buyer or seller of this contract."  The "not need to be associated" means that anybody

-- anybody -- could gamble that just about any debt obligation would go south and reap a big bonus from the swap seller if it, in fact, does.

We guess the most tempting morsels must have taken the form of credit default swaps on the riskiest kinds of debt.  Subprime mortgages, say.  Or the murkiest, scariest, double-dog-dare-dangerousest tranches of subprime mortgage securitizations.

As the folks at Investopedia gently note. "it is obvious that speculation has grown to be the most common function for a CDS contract." 

Bloomberg puts the size of the swaps market at $54.6 trillion.  For those of you keeping track, that amounts to about 5.5 times the size of the U.S. national debt .

All that sounds to us like pure gambling.

But this isn't Las Vegas.  And all those speculators who had no business with the credit default swaps except gambling should receive, at most, a refund of their money.  But neither would we mind seeing them get bupkes.

Congress voided contract clauses that required payment in gold or gold equivalent dollars during the Great Depression.  Credit default swaps, anyone?

Posted by Barry Barnett on October 06, 2008 at 09:44 PM | Permalink

Category: Credit

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