More Games People Play with Credit Default Swaps

Willem Buiter lays out the latest manipulations engineered in the credit default swap market. I was aware of various squeezes that the holders of CDS (those who are insured against default, in other words) would try to orchestrate, to send a company pitching into bankruptcy so they could collect on their bets. But, in a delicious irony, they're not the only ones who can play games in the CDS markets where, remember, you don't have to have any interest in the underlying asset (bond, security, whatever) to take a bet.

Check out his case study of Amherst Holdings. It turns out the writer of CDS policies can (legally) screw the holders. And so Amherst did.

So, to add to the list of offenses committed by the CDS market:

#77 -- high potential for unethical game playing (manipulating, screwing the other guy through a big-money muscle play, whatever you want to call it).

All of which reminds me: I talked to a former Morgan Stanley guy over the weekend. Quite bright, articulate. He passionately defended credit default swaps. He defended them on a level of granularity that I wasn't always able to follow. But again I noticed that CDS true believers tend to stake out a micro bit of turf. They tend to miss the forest for the trees. He was talking mostly about pricing information (as if there was no way to discover this before the advent of the credit default swap).

The big stuff he didn't go near: the high levels of leverage that CDS create, the fact that the swaps suck hard on spare liquidity in a crisis when credit is tight, the fact that CDS create the illusion of risk vanishing under a film of fairy dust (if the U.S. government had not bailed out AIG and thus its writing of CDS lottery tickets, a lot of banks that thought they had their butts covered on risky asset-backed securities would be in a world of hurt) ... and now, it looks like a large amount of game-playing is possible when you can take out multiple insurance policies, willy nilly, without having any interest in the underlying asset.

The credit default swap market needs to be brought to heel. Really really soon.