Credit Default Swaps: Securities, Insurance or Just Gambling?

Tom Armistead argues that credit default swaps are insurance transactions that should be regulated as such; some suggest that "deregulation" of credit default swaps was a major cause of the financial crisis of the late 2000s.
In a recent article, Tom Armistead suggests that credit default swaps are actually insurance transactions that should be regulated according to insurance regulatory principles.
Credit default swaps are insurance, and should be regulated as such, with a requirement of insurable interest for the buyer and adequate capital for the seller.[1]
In his analysis, Armistead defines insurance as "the transfer of risk for a consideration" and explains that purchasers of insurance are generally required to have an insurable interest in the subject of the insurance because: "otherwise, the transaction would create a moral hazard."[2]
Lack of an insurable interest in fire insurance would lead to arson for profit. Similarly, lack of an insurable interest in life insurance would lead to murder for profit. Moral hazard is created when the buyer of insurance is motivated to desire a loss.[3]
With respect to credit default swaps, however, savvy speculators and clever hedge funds have no true interests in the credit default swaps but can create profit by actively driving losses with respect to the swaps, according to Armistead.[4]

Armistead also equates credit default swaps with gambling, especially when there is no insurance interest involved.[5]
In simpler times our forbears noted that gambling in the financial markets creates economic turmoil, recessions and depressions, and outlawed it. Our elected servants in Congress have more and better wisdom, it seems, and have placed gambling in financial markets beyond the reach of the law.[6]
Credit default swaps were exempted from regulation as insurance (or gambling) under the Commodity Futures Modernization Act of 2000 (CFM Act). Credit default swaps are generally regulated by the United States Securities Exchange Committee, although some argument exists that regulation of credit default swaps was reduced by financial deregulation efforts linked to the Gramm-Leach-Bliley Act and the CFM Act.[7]

Eric Dinallo, the former New York Superintendent of Insurance, discussed how credit default swaps stepped outside of the realm of insurance regulation in an article from 2009:
Credit default swaps started out as essentially an insurance policy. If you owned a bond in a company and were concerned it might default, you bought the swap to protect yourself. Literally, the buyer swaps the risk of default with someone else. Banks bought them to reduce the amount of capital they were required to hold against investments – in other words, to avoid regulation. Because they owned the swap, banks claimed they no longer had the risk of a default of the bond. Others bought swaps without owning the bond to place a bet on a company’s future.

But there was serious concern that swaps violated the old bucket shop laws. Thus, the Commodity Futures Modernization Act of 2000 exempted credit default swaps from these laws. The act also exempted them from regulation by the Commodities and Futures Trading Commission and the Securities and Exchange Commission. Unregulated, the market grew enormously.[8]

"...one of the major causes of the financial crisis was not how lax our regulation, or how hard we enforced, but what we chose not to regulate."
Dinallo's article, written during the height of the Great Recession, concluded that "we modernized ourselves into this ice age." The "old fashioned" rules and regulations that the CFM Act sought to modernize were actually effective prohibitions against activities that had been illegal for almost a century for good reason. This "modernization" was a major cause of the financial crisis, according to Dinallo. "Thus, one of the major causes of the financial crisis was not how lax our regulation, or how hard we enforced, but what we chose not to regulate."[9]

Armistead defines credit default as "cash settled upon the occurrence of an event of default" and "the obligations are supported by the exchange of collateral as the values involved fluctuate prior to loss." Thus, Armistead characterizes credit default swaps, as currently written, as insuring market values "which do not correspond with actual economic loss."[10]

Insurance contracts, in contrast, are generally designed to make the insured whole, but not necessarily place him or her in a better position that he or she would have been had no loss occurred, according to Armistead.[11]

Armistead's simple solution: credit default swaps should be regulated as insurance, including the requirement that the seller have adequate capital and that the buyer have an insurance interest.[12]
The insurance business has been in existence for centuries, and its underlying principles are clearly understood. It is a business affected with the public interest, and effective methods of regulation have been developed and are in place globally, with certain exceptions.[13]

Thus, Armistead urges the repeal of the CFM Act's regulatory exception for credit default swaps, and concludes that such transactions should be "explicitly defined as insurance when backed by an insurable interest, and as gambling when naked."[14]

Read the full article:
1JPMorgan: Another Reason CDS Should Be Regulated As Insurance, Tom Armistead, Seeking Alpha, May 21, 2012
2 JPMorgan: Another Reason..., id.
3 JPMorgan: Another Reason..., id.
4 JPMorgan: Another Reason..., id.
5 JPMorgan: Another Reason..., id.
6 JPMorgan: Another Reason..., id.
7. See, for example: Deregulation and the Financial Panic, Phil Gramm, Wall Street Journal, Opinion, February 20, 2009; 8We Modernised Ourselves into this Ice Age, Eric Dinallo, Financial Times, March 30, 2009.
8We Modernised Ourselves into this Ice Age, Eric Dinallo, Financial Times, March 30, 2009.
9 We Modernised..., id.
10 JPMorgan: Another Reason..., id.
11 JPMorgan: Another Reason..., id.
12 JPMorgan: Another Reason..., id.
13 JPMorgan: Another Reason..., id.
14 JPMorgan: Another Reason..., id.

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