How Not to Fix Anything

First, this absolutely absurd headline of a NY Times article – I swear – it’s NOT from The Onion: “California Pension Fund Hopes Riskier Bets Will Restore Its Health.” Oh jeez – what can you even say about that? Marty Up!

Then, this article about banning “naked” credit default swaps. A refresher course – CDS is a way for investors to protect themselves against default. However, you don’t have to actually own bonds in the underlying entity on which you’re buying protection (CDS). Some say this is akin to “buying insurance on a house you don’t own.” It’s no different from an equity put option – you seek to profit if the underlying decreases in value. There is nothing nefarious about buying insurance on a house you don’t own, provided you don’t burn the house down. Of course, others who don’t understand will suggest that speculators buy CDS, short the underlying company’s stock, create panic, and destroy the company. Those who understand know that you cannot destroy a company by shorting its stock or taking a protective position against its risk of default. Lehman brothers blew up not because people were short selling its stock, but because their liabilities greatly exceeded their assets. AIG blew up not because they bought massive amounts of naked CDS – but because they SOLD massive amounts of CDS.

I don’t know why it’s so hard for people to understand that the problems we had were not related to investors/speculators/traders buying credit default swaps. Not ONE hedge fund, mutual fund, sovereign nation, insurance fund or bank blew up from buying credit default swaps. The problem was not people buying put options / credit protection. The problem was people SELLING CDS without sufficient collateral. This is a very very simple concept, and it shocks me greatly that authorities don’t get it.

-KD

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