Ban Naked CDS

John Paulson made CDS famous as he built a fortune buying CDS on subprime bonds. CDS are essentially a side bet that a certain bond will fail. Investors are buying cheap CDS in a similar fashion to the way they buy lottery tickets.  Everybody wants to make the next Greatest Trade Ever. And they are doing so on European sovereign debt and banks.

This is all well and good except that these CDS can effect the markets that are being bet on. For instance, as investors buy CDS on Societe Generale the banks that sell them have to hedge by either shorting SocGen's bonds or their stock. This causes the price to go down and can lead to a vicious spiral. Not to mention it creates incentives to spread rumors and cause a run on the bank.

There is no economic need for these instruments, when they are not being used a s a hedge on a long position in the corresponding bond. Quite frankly, I don't even understand why they are needed as a hedge. Just sell the bond if you don't want the risk.

The EU put out the fire in Spain and Italy but it seems that new fires will arise everyday as long as naked CDS are allowed. I say ban them.

3 comments:

Onlooker from Troy said...

Hear, hear!  But the banks call the shots, for now.  And they make a bunch of money on them, so...

Tsachy Mishal said...

It will end up destroying them if this is allowed to continue.

Anonymous said...

Why is that such a bad thing.