I Hate to Say “I told you so,” but…

Here’s an excerpt from my very first blog post:

Credit Default Swaps violate every relevant principle of underwriting and public policy. Why, then, are they legal? I can only guess that insurance people were not asked to think about them, or if they were asked, that their answers were ignored. (Insurance is such an arcane thing and all.) Instead, in what can most charitably be called an act of boneheaded stupidity, Congress tried in the Commodities Futures Modernization Act of 2000 to put CDS contracts outside the reach of state insurance laws.

John Paulson bought a CDS on bonds he did not own. Not only that, he created the bond pool himself from assets he thought would crater. Yes, he and Goldman Sachs had to fool some folks into thinking that Paulson had not suggested mortgages that he thought were undervalued, but that’s the point: if it weren’t possible for Paulson to buy a CDS on assets he did not own, the assets in question never would have existed, and no one would have had any reason to defraud anyone else into buying them.

The preventable causes of the Goldman case are the massive trade deficit that put so much money on Wall Street and the deregulation of derivatives, which made it possible to cheat people out of that money. Bill Clinton says that Rubin and Summers, who argued against regulation of derivatives, underestimated how much money they would involve. Maybe they didn’t grasp the importance of our growing trade deficit. But, in any event, an insurance contract without an insurable interest is a prescription for trouble, and trouble is what we got.

It did not occur to me that players would be able to invent their own assets to short, but there is no point in trying to guess what form of mischief a stupid rule will enable. Insurance people speak of “perils known and unknown.” I know that if you can insure something you don’t care about, trouble follows. The shape of the trouble is really irrelevant. Just give the worst and the brightest a financial regulation that makes no damn sense. They’ll figure out the rest.

(A follow-up: Roger Lowenstein joins the call on April 20, 2010: "Congress should take up the question of whether parties with no stake in the underlying instrument should be allowed to buy credit default swaps." Lowenstein also calls for transparency in trading derivatives, but that seems wholly unnecessary once the ones with no skin in the game are banned.)