Fortune ‘s Steve Gandel: Ban credit default swaps.
The reason to get rid of CDS is that it doesn’t work. Reuters recently reported that trading by the London Whale, and the hedge funds that were looking to make money off of the unwinding of JPMorgan’s outsized trades, caused the price of certain CDS contracts to jump and fall, even though the actual credit worthiness of the companies the contracts were based on hadn’t changed. Bank analyst Dick Bove for Rochdale Securities says the London Whale trades show that the CDS market is manipulated. “There’s something wrong with this market,” says Bove.
Earlier this year, CDS contracts tied to McDonald’s (MCD), for instance, rose 19%, during a period when there was almost no news about the restaurant company, and certainly no reason to suspect McDonald’s would have a harder time paying back its debt. In the same time, McDonald’s stock price barely moved, down 1.1%. Markets can become out of touch with reality for some time. That’s how we get bubbles. But the problem with the CDS market is that it’s so thinly traded that the actions of one player can cause market distortions. That’s supposed to be left to the idiocy of crowds. [Emph. added]
What’s more, CDS holders needn’t have an insurable interest in the paper the contract covers. The potential for mischief is-and already has been-vast. . . .