Burning Down the House

The best description of the whole Credit Default Swaps problem I have heard so far is an analogy to Insurance on your house. Unfortunately I can’t remember who said it. That said, it is a very good explanation of how this whole CDS’s scheme works.

So, say you insure your house against fire. Then say many of your neighbors also buy insurance against your house burning down. How well are you going to sleep at night knowing that hundreds of your neighbors are betting that your house is going to burn down and betting that it will (Goldman Sachs, et. al., that means you?) It is frightening that your neighbors’ financial benefit is based on your house immolating, right? That is what Credit Default Swaps are all about. The counterparties are betting on the bet that your house is going to immolate. Now how legit is that? Now if there is no connection to the underlying asset there should be no bet just like your neighbor’s bet on your house burning to the ground.

Wipe those bets out and stop payments to the counterparty’s bets on those bets. Bets are a risk, just like at the track. The Counterparties need to pay for their risk: it is called Moral Hazard.

Simplistic, maybe, but it is a thought.

JMHO!