Naked CDSes

The brilliant Cenk Uygur says taxpayers are nuts to pay off AIG’s “naked” CDS losses:

How could the CDS [credit default swap] market be larger than the world GDP combined? That doesn’t make any sense…

CDS are basically supposed to be insurance on a group of assets. So, if you have a collection of mortgages, loans and other assets, and you would like to insure their value, you get a CDS. This makes sense since some of these underlying assets turned out to be quite risky.

What doesn’t make sense is for the insurance market to be many times larger than the value of all of the underlying assets combined. Well, it turns out there is a reason for that. It’s called the “naked” CDS. These deals are not attached to any underlying asset. They are not collateralized. They are not attached to anything of real value. They are simply bets. As in wagers. As in gambling…

Here comes the really crazy part — the American taxpayer is now paying off these bets. The people who bet that the housing bubble wouldn’t burst or that the assets would retain their value, well, they lost — but they don’t have the money to pay off all of these theoretical bets since they never put any collateral down on them. So, they’re turning to the government and saying they’re out of money. And we’re paying them. That’s insane.

It’s one thing to pay off mortgages that went bad. It’s another to pay off insurance for a collection of bad debts. But it’s another thing all together just to pay off gambling debts that otherwise have nothing to do with the economy. We, as the taxpayers, would have to be utter fools to provide the money for these inane bets. And, of course, that’s exactly what we’re doing…

I’ve never heard Tim Geithner or Ben Bernanke or any congressman or senator talk about what we should do with the naked CDS. They talk about all of the assets and obligations as if they are all the same.

Because most politicians serve their special interest paymasters rather than the American people, government refused to regulate the CDS market. Given that, I’m not sure the government could fairly just declare all naked CDSes null-and-void. But why are taxpayers paying off AIG’s gambling losses at 100 cents on the dollar (esp. on bets that are not total losses)? Taxpayers aren’t liable for AIG’s gambling losses. The government could have seized the insolvent financial institutions and imposed a solution. Or it could have used its leverage — before paying insolvent AIG’s gambling debts — to negotiate compensation of, say, 50 cents on the dollar. Instead, it screwed taxpayers to the maximum while sparing gambling losers, like AIG, from the normal and fair consequence (bankruptcy) of their actions and allowing gambling winners to collect all their winnings after gambling at a casino they must have known couldn’t pay its gambling debts in full if the economy sank.

Posted by James on Friday, March 27, 2009