We read in numerous publications a misconception about CDS (credit-default-swaps). Typically, they are viewed as insurance, but there is subtle aspect of insurance that makes the insurance industry protect itself from abuse and fraud. Let us explain the point a bit further.

Insurers only insure insurable interests. CDS insure bonds, which would mean in this case the buyer of the CDS needs to have an interest in the bond. Insurers who pay a claim are subrogated to the interests of the insured, which would mean they have a right to collect if the loss does not turn out as badly as the original claim.

In the case of CDS, the person who actually bought the swap as "insurance" ends up with a payout determined by a market process that assumes the CDS holders were just speculators who suffered no actual loss. Speculators are then asked how small of a windfall they are willing to take in settlement.

The second problem is that when there are defaults, the defaults are correlated in the sense any one insurer and all insurers are exposed to the same risk, and the risk rises because two different CDS are in fact not two independent trials from a random distribution.

To understand this, consider the auto insurance industry:

1. An insurance company will insure your car only if your have an interest in the car.

2. In addition, the business model of a car insurance, assumes that any two cars they insure are not statistically dependent in the sense of the probability of car accident involving these cars.

The CDS industry violate condition 1, because it allows speculators who do not have bonds in the first place to own CDS, and second when there is a financial credit crisis like what is happening now, the fundamental idea of risk reduction via diversification does not hold. Essentially a large number of claims happen all at the same time, and this will make insurance companies swallowed by the claims.
Insurance companies can not hedge this risk.

The business model is flawed.

The only way for the issuers of CDS to cover their obligations is to use cash. It is the reason why they are hoarding it, as they know that claims will start coming in due to mortgage defaults, and/or prices of mortgage portfolios which fell even if there is no actual default in payments.


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