01/27/2009 05:12 am ET Updated May 25, 2011

Defending and Fixing Wall Street, Part II Credit Default Swaps

In the first article of this series I discussed how to reform the mortgage underwriting market. This article will focus on credit default swaps, or CDS'.

The most common argument against CDS' is to quote Warren Buffet's statement from the Berkshire Hathaway 2002 annual report where he called derivatives "time bombs." This is a particularly interesting statement considering the latest Berkshire Hathaway 10-Q states:

Berkshire utilizes derivative contracts in order to manage certain economic business risks as well as to assume specified amounts of market risk from others. The contracts summarized in the following table, with limited exceptions, are not designated as hedges for financial reporting purposes. Changes in the fair values of derivative assets and derivative liabilities that do not qualify as hedges are reported in the Consolidated Statements of Earnings as derivative gains/losses. Master netting agreements are utilized to manage counterparty credit risk, where gains and losses are netted across other contracts with that counterparty.

In other words, Buffet's investment firm uses derivatives to manage risks - just like every other investment manager on the planet. That makes the 2002 annual report's statement moot.

First - what is a credit default swap?

The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the credit worthiness of the product. By doing this, the risk of default is transferred from the holder of the fixed income security to the seller of the swap.

Let's flesh out this definition with an illustration that compares two situations. First, suppose an investment manager buys 100 shares of a company. He is doing this because he is convinced the stock price will go up. But he wants some insurance in case the price goes down below a certain level. To mitigate downside risk he can sell an option - a contract where he agrees to sell his stock to somebody at a certain price. He will sell the contract at a price below the level where he purchased the stock. This is one of the primary ways options are used and is standard practice with all investment managers. If you invest in a mutual fund your fund will use this strategy (look at the prospectus). This type of trading has occurred on a formal market since 1973.

Now, let's suppose an investment manager buys bonds instead of stock. He also wants protection in case the price of the bond drops below a certain level. Can't he just sell an option as well? No - at least not until 1997 when the first credit default swaps came into existence. The manager was simply out of luck. Now with a credit default swap the manager makes periodic payments to the insurer; and the insurer guarantees the manager will get his entire principal back in case the bond defaults. In other words - credit default swaps are simply options on bonds that allow bond managers the same degree of flexibility as equity managers.

So - why all of the terror talk about "financial weapons of mass destruction?" The central reason is there is no formal market where CDS' are traded. Instead they exist in what some people have called the shadow world of finance. As a result it is difficult to get a handle on the exact size of the CDS market. A Time magazine article in March 2008 placed the market at $45 trillion which is almost three times the size of the US economy. That total also assumes there is a CDS contract on literally every bond ever issued by a US financial entity - a fact which seems incredibly difficult to fathom.

And therein lies the central problem with CDS: there is no formal market. As a result, individual players are allowed to participate in the market to any degree they deem appropriate. This theory hasn't worked out very well as the failure of AIG demonstrates. They were heavily involved with the CDS market and it cost them - and the US taxpayer - big time. AIG loved the premiums they were getting from underwriting CDS but they were unable to pay in the event a large number of the bonds they wrote policies on might go belly-up.

CDS are very beneficial investments to the right player -- specifically large institutional bond managers. For these investors CDS offer the same protection long afforded to equity managers -- the ability to mitigate downside risk. CDS are also helpful to all investors because the provide information: when the premium on a bond increases we know that investors are concerned about the underlying credit.

As a result, the logical step to take is to form a formal CDS market. This would require a combination of options and futures knowledge. The key would be to write the underwriting rules in such a way as to insure people/companies that wrote the contracts would have the ability to pay for the underlying contract if the buyer wanted to exercise the contract. That is the central problem we've been dealing with lately thanks to an unregulated, shadow market.

So -- keep CDS just put them on a formal market. It's really that simple.