Geithner was asked today if he believed in naked credit default swaps. Apparently he does, but it was both the wrong question and answer. Reform of credit default swaps needs to be thorough, and though through from basic principles. Here's how to fix credit default swaps.
The first step is a name change. Call them insurance, because that's what they are. The insure against the possibility that you won't get paid money someone owes you. Once they're called insurance, regulate them like insurance.
- Require an insurable interest. That is, if Joe owes Fred money, Emma can't buy insurance on Joe not paying Fred. This is a fundamental rule in most insurance, you can't insure someone else's house against fire, because then you have a reason to want that house to wind up on fire, and no reason not to want it to burn down.
- Don't allow over-insurance. No debt can be insured for more than it's worth. If Joe owes Fred $100, then Fred can't buy more than $100 worth of insurance. In fact, better, he can't buy more than $90 worth of insurance. Again, we don't want anyone better off if the debtor defaults than if they make the payments. In life insurance there are many studies which show that people who are worth more dead than alive tend to die a lot more than people who aren't over insured. Imagine that.
- The mathematical models and actuarial tables used to figure out how much must be paid for insurance, the premiums, are set by government actuaries, just like they are in most other insurance businesses. Current credit default models tended to assume things like "this housing bubble will last forever" and "there will never be another recession" and "defaults don't cluster". Those assumptions were so wrong that building them into models amounted to fraud.
- No product which insures against credit default can be put on the market without actuaries from government regulatory bodies reviewing it.
- Proper reserves. The party issuing the credit default swaps must have enough money to back them up, based on the governments actuarial charts and reserve requirements. Life insurers and property insurers have to, so should credit insurers. These reserves cannot be the debts the insurer is insuring.
There are other methods one could use to regulate and fix the default market, like having open exchange traded contracts, which could be made to work as well, but this is the simplest model and one that has worked well in the rest of the insurance industry.
The larger rule is simpler: no unregulated financial markets or entities without sufficient capital to cover their bets, so the taxpayer winds up stuck with the bill. If you want to gamble, go to Las Vegas. If you want to sell insurance, be a nice old fashioned stody insurance company who pays your executives low six figure salaries.