Are Naked Credit Default Swaps A Case of Too Much Information?

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Credit default swaps are an insurance-like derivative that pays off if someone defaults on their debt. But with conventional insurance, you’re normally not allowed to buy unless you have an “insurable interest” in the thing being insured. I can buy fire insurance on my house, but not on my neighbor’s house, in part out of fear that this would create a profit-making opportunity in the arson sector. Many people criticize CDS on this grounds, for reasons that don’t strike me as particularly persuasive.

But in an interesting paper (PDF) published a year ago that I read last night, Gary Gorton looks at a different potential problem here. The idea of complete financial markets is that they’re more efficient, and the idea of efficient financial markets is that they disclose information. Specifically, naked CDS mean that corporate debt prices now reflect specific information about the firm in question and not just general credit conditions:

Expressing a negative view was next to impossible because it is hard to find the bonds and short them for a longer period. Even expressing a positive view would usually require finding off‐the‐run bonds to buy, not easy in size. But, more importantly, it simply would not pay to investigate, or analyze, and find information that was so important that it would affect a reference entity’s bond prices. Information always impacts the equity because that is the residual claim, but information has to be fairly important to affect bond prices. That’s why, prior to the introduction of CDS, changes in the spreads on investment grade corporate debt were functions of U.S. Treasury rates, but not of firm‐specific information.

Now thanks to the possibility of buying CDS, that’s not true any more. So we know more. But is that a good thing? Well as Gorton observes, information-insensitive assets play an important role in the economy:

Information‐insensitive debt plays an important role in the economy because it can be sold fairly easily without fear of losing to better informed traders (because it is not profitable for them to become informed). So, it is held, for example, by insurance companies which have to sell to payoff claims at random times. It can be used as collateral for repo, clearing and settlement. The reason that Treasuries were scarce before the crisis is because they are information‐insensitive.

In the long-run, the availability of naked CDS and therefore more information about firms could be a good thing that enhances the operation of the economy. But in the specific moment, it contributed to a shortage of Treasuries that exacerbated the crisis. And it also means that going forward we need to do something—like maintain the existence of a large pool of federal debt—to make sure that the world has the quantity of information-insensitive debt it needs to continue routine operation.