Following Barry K comment on my previous post I went and read what the FT blog had to say about the debate. The only thing bone-headed here is the coverage and the knee-jerk reaction to anything legislative.
Let me see if I can give a 10 sec crash course on CDS. A credit default swap is a protection against a default of debt. If you hold a bond, you can buy "protection" against default. You pay a premium, and if the bond defaults you get the principal back. If you don't hold the bond then it is called a naked CDS. You pay the premium on a fictitious bond (you never paid the principal) but if it defaults you get paid the principal, pooof! out of bad debt, comes more bad debt.
CDS are good, good in the theoretical economic value sense as it moves risk around from a party unwilling or unable to assume the risk to a party that is willing and ,again in theory, able to assume the risk (AIG anyone?). When the bond defaults, the system remains strong. This is good from a systemic standpoint.
A naked CDS, however, will create a leverage on the default. People never really lent the money but if the bond goes bad they get the principal back. Multiply this by the number of people taking naked bets, 4 to 1 according to the article.
The effect of 'real' debt going bad is bad enough, sub-prime was responsible for this crisis, but the idea of turning 'virtual' debt into real debt only on default is really scary. Bad debt gets multiplied.
When all is said and done, the added value of naked CDS, if the bond does not default is marginal (better pricing of CDS, lots of money for the traders taking undue risks), but when the bonds default, they become weapons of mass destruction.
The call to ban naked CDS is right on. Don't be too quick to throw the 'bone-headed' moniker just because it is legislation and it comes from a elected representative. This ideology is partially to blame for the situation we are in today. So here is to you, Collin Peterson, chairman of the agriculture committee of the US House of Representatives: godspeed.