Credit Default Swaps: Yes, You Have to Think About Them

Yes, ev'rybody's talkin' 'bout bagism, dragism, thisism, thatism, ism ism ism. And, of course, credit default swaps.

Arnold Kling over at Econlog has an interesting little exposition on why you should care, and connects them with some genuine fears about the possible effects of runaway short-selling (for more on which, see this piece from me from last month).

The key, from Kling:

A credit default swap is like insurance against default. If you want to buy a municipal bond or a corporate bond but not take default risk, you try to buy a credit default swap. You pay a fee, and in exchange for that fee the seller of the swap will make you whole if the city or corporation defaults.

The seller of swaps collects nice fees, and most of the time the borrowers don't default. But if borrowers do default, then the seller is like an insurance company in a town that was hit by a hurricane.

Sounds grim. How can the seller of such a swap hope to survive?

Suppose I have sold a credit default swap on Sallie Mae. That means that if Sallie Mae defaults on its bonds, I will have to pay some of the bondholders a big chunk of money. One way I can hedge that risk is to sell short Sallie Mae securities….. However, the more short-selling takes place, the closer they get to default. It is a vicious cycle. Ordinarily, I do not believe that short-selling affects the price, but when there is massive short-selling that is driven by dynamic hedging, I can see where the short selling would drive down prices.

So, does this mean that even the formerly soft on short selling Kling thinks there is a sensible place for short-sell bans or restrictions? It's a little more complicated than that, as are most things in the world of contemporary high-flyin' high finance. Short selling, after all, is a big way** the sellers of the swaps can hope to ride out the storm. Thus:

….if the government tries to curb short-selling, all that does is cripple the credit default swap market. It becomes costly to sell default swaps, so now creditors cannot get them at affordable prices. The only way they can reduce exposure is to sell their munis and their corporates and flee to Treasuries. I'm not saying that the curbs on short selling make things worse, but such regulations certainly don't solve the problem–at best, they shift it.

If my theory is correct, then the credit default swap protection is somewhat of a delusion….It is too late to undo the delusion. In the aggregate, markets under-estimated the risk of the bonds they were buying. The risk premium needs to adjust upward. That upward adjustment is not a credit squeeze–it's a return to reality.

See Kling talking general bailout horrors in this reason.tv clip.

**Amended from "only way" thanks to the totally justified comment from Gilmore.