How to Think About Credit Default Swaps

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I missed this article when it came out, but Philipp Bagus deals clearly and to my mind persuasively with the vexed question of credit default swaps.

Frank M

Outstanding, Professor Bagus.
Max Hylander

Great article, but how do you come about when the government is subsidising the behaviour? JP Morgan Chase is rigging the gold market with naked credit default swaps. And every time there is a lawsuit luming the US government comes out and saves JP Morgan.
BrunoT

CDS cannot be paid off on. AIG showed that. Therefore it becomes a casino, not insurance.
The problem comes where “we have to protect the financial system” comes in and governments print to “save” it. CDS encourage this, so in the REAL WORLD they are a danger. There is a distinction on their value to society based on the environment they operate in. (real vs theoretical) The current one makes them dangerous.
If you think you’re going to teach the world an economic lesson by letting it destroy itself, good luck. “next time you’ll be more careful” is no way to organize a society. Besides, they will just make up an excuse why it happened (dirty speculators) and nobody will learn anything. As long as government allows fiat money with no gold standard and the excessive credit it allows, these are toxic.
I say the credit risk should be reflected in the interest rate, not CDS rates, and that insuring against default is a poor substitute for proper diversification. CDS helped hide risk from investors as they relied on bogus “insurance” that could not be paid off on. “Gee, I wonder why these mortgages return 10%? They’re insured!”
This over-emphasis on “risk free” life is part of what has brought us to the ruin we’re in now. Pay $10 to see the doctor. Insurance covering birth control. Mortgage insurance instead of 20% down payments, bailouts for banks, subsidized flood insurance…etc, etc. Talk about the malinvestments this causes!