Thursday, March 11, 2010

Credit Default Swaps Worry Me

Typically, in a normal transaction where you are betting on the direction of a stock, you can buy a call, which means that you think the price of the stock will go up. Conversely, someone on the other side will buy a put, because they think the stock will go down. One of them will be right and the other will be wrong.

What if you wanted to make a bet against Greece's Sovereign Debt? For example, you would buy a Credit Default Swap that you think Greece's Sovereign Debt is going to default. If you are right, then you get paid by a counterparty, like AIG.

The problem arises when you do not have to own any of Greece's Sovereign Debt. You can speculate all day long that Greece may default. If you have a ton of money, theorectically, you could buy tons of Credit Default Swaps and by doing so, you are in effect putting undue pressure on Greece's Sovereign Debt. As a result, speculation could in effect destroy the credit rating of Greece's Sovereign Debt.

Personally, I do not think that anyone should be allowed to speculate in this manner. This is exactly what got AIG in trouble. All these speculators bought Credit Default Swaps and AIG was the one selling them. There were so many speculators with tons of money who bought tons of Credit Default Swaps, that there was no way for AIG to pay them all their speculative gains. Therefore, the U.S. Government came to the rescue.

As of today, nothing has changed in regard to this type of Credit Default Swap speculation. As a result, I expect to see history repeat itself.

This is like if I wanted to short a stock, I could do so and not have to find someone who will allow me to bet against their stock. If I can go "naked," then I could speculate wildly on just about any stock. You are supposed to only be able to short stock if you can borrow it. The problem with the Credit Default Swaps is that they are going "naked." They do not have to borrow or own, for example, any of Greece's Sovereign Debt. Therefore, in my opinion, they could take down Greece's Sovereign Debt with a ton of speculative bets.

I do not know about you, but I do not like this situation at all.

Stay tuned.