Mark Wadsworth

This is a spare 'blog in case my main 'blog at markwadsworth.blogspot.com isn't working

On the infinite stupidity of European Parliament

From Europolitics:

The European Parliament is attempting to rid the EU of speculators betting on Greece going bankrupt, voting for a ban on the practice of naked short-selling of credit default swaps… CDSs are insurance-like contracts that pay the buyer if a country or company goes bust.

OK.

Buying a CDS is analogous to buying insurance.

If you own a house, you are “long” of a house and you can insure it against the risk of it burning down. The insurance company doesn’t own your house (the bank does, probably). It is gambling on your house not burning down (or fewer houses burning down).

If you own Greek bonds, you are “long” of Greek bonds. You can insure against default by buying a CDS. The seller of the CDS doesn’t own Greek bonds, and is gambling on Greece not defaulting.

The owner buys insurance, the insurance company sells insurance. You buy a CDS, the insurer sells a CDS.

If you own Greek bonds and buy a CDS, your risk is ‘covered’ and you are now indifferent whether Greece defaults. The insurance company has sold you a “naked” CDS and has every interest in Greece not defaulting.

The general rule in insurance (apart from life insurance) is that you can only insure something up to the lower of its value or replacement cost; if you over-insure, you have every incentive to burn down your own house and pocket the difference.

Now imagine, I could buy “naked” insurance, i.e. I don’t own Greek bonds (or your house) – then I have every incentive to trigger a Greek default (or to burn down your house). And as we know, setting fire to a house is easier than preventing other people from doing so – there is assymetry of risk here.

So it’s the BUYERS of “naked” CDSs who cause the problem (to the extent that there is one) and not the SELLERS – all insurers are by definition “naked” sellers. Greece (or its new rulers, the EU) ought to be rejoicing every time a major financial institution sells naked CDSs because this institution has just put itself in to bat for Greece.

Here endeth.

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