Correct, but doesnt limiting it to just the security holder limit its liquidity and defeat the purpose?
What is the core purpose of a CDS? To me, it should be insurance to the security holder and only that. AIG got burned because they failed to realize the back-end underwriting risks they were amassing by selling swaps to so many folks who didn't own the underlying security. And AIG was smart in other areas of insurance underwriting. Do you think they would have sold homeowner's insurance to someone who didn't own the home in question? Of course not. Yet they rushed pell-mell into selling swaps, blinded by the money they were making.
And liquidity? Last I checked, our problem over the last decade became too much liquidity - too much money sloshing around the globe looking for any place to make a buck, smart or not.
What we need is less liquidity and more fiscal castor oil - for those who failed to recognize risk to assume the consequences of such instead of having governments bail them out. I'm sure we have some other festering high-risk derivatives being sold as we speak for wonderous profits, with the assumption that governments and central banks will bail out the eventual downside.
I have no problem with wonderous profits - as long as you are prepared to assume the underlying risk yourself. That moral hazard is long gone.
posted on 05/17/2012 6:36:56 AM PDT
To me, it should be insurance to the security holder and only that. AIG got burned because they failed to realize the back-end underwriting risks they were amassing by selling swaps to so many folks who didn't own the underlying security.
If AIG executives had their personal fortunes seized, and were forced to work in hard labor camps to pay off their debts, then you could say they got burned. But that didn't happen.
Honest people benefit from minimizing correlation of risk. Those who are in a position to welsh on bad bets, however, benefit from maximizing the correlation of risk. Consider the following two weekly lottery schemes:
- Scheme #1: Bob prints 10,000 lottery tickets numbered 0000 to 9999, which he sells for $100 each. The holder of the ticket whose number appears on Illinois Pick-4 drawing the next Friday evening will win a $950,000 prize. To help assure that he actually will pay the prize, he has $950,000 in escrow.
- Scheme #2: Larry prints 10,000 tickets, all with the number 1138, which he sells for $100 each. Unlike Bob, however, offers a $1,500,000 prize (again using the Illinois Pick-4 drawing). Because of the bigger prize, he has $1,500,000 in escrow.
Who stands to profit more--Bob or Larry? Bob will sell $1,000,000 worth of tickets for his game, and pay out a $950,000 prize, making a net profit of $50,000. Larry will sell $1,000,000 worth of tickets for his game, and most likely (99.99% odds) not have to pay out anything, making a net profit of $1,000,000. If the Illinois Pick-4 drawing comes up 1138, Larry will have to flee the country and abandon the $1,500,000 escrow fund, but unless he got unlucky within the first few weeks of running his game, he will have pocketed enough money to set up a safe haven for himself.
posted on 05/17/2012 3:16:15 PM PDT
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