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'Naked' Swaps on the Hot Seat

Rep. Collin Peterson (D-Minn.) is trying to outlaw "naked" credit default swaps -- swaps in which the holder has no risk of financial loss if the underlying security fails.

Peterson, chairman of the House Agriculture committee, has written language into the Derivatives Markets Transparency and Accountability Act of 2009 that is being considered by his committee, that reads: "It shall be unlawful for any person to enter into a credit default swap unless the person would experience financial loss if an event that is the subject of the credit default swap occurs."

Credit default swaps are insurance on debt, and their abuse has been pegged as one of the villains of the current financial crisis. They have been well-described like this: Imagine poker players sitting around a table. Now, imagine another circle of people sitting around the poker players who are not playing poker, but who are taking bets on which poker player will win the hand, which will fold, when that fold will occur and so forth.

Many holders of swaps carry risk; the swaps are, after all, insurance.

But swap holders are not required to own parts of the underlying security -- these are holders of the so-called "naked swaps." They win regardless of what happens to the underlying security because they have no stake in whether it defaults and hence to exposure to risk.

That's what Peterson and Sen. Tom Harkin (D-Iowa) want to change.

Proponents of the legislation would argue that it makes sense -- it should be wrong for a person to gain reward without risk, especially if that risk is shouldered heavily by others.

Opponents would counter that swaps serve an important role in a free market and may even go so far to say they should be under some kind of regulation or at least exposed to transparency -- they are not -- but outlawing them is anti-free market and even un-American.

-- Frank Ahrens
The Ticker is Twittering!

By Frank Ahrens  |  January 29, 2009; 5:37 PM ET
Categories:  The Ticker  | Tags: credit default swaps, naked swaps  
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