Moral Hazard with Credit Default Swaps
Charlie Munger in the August 31, 2008 issue of Outstanding Investor Digest:
Let’s say you’re insuring against the outcome that people will lose money on a $100 million bond issue, and the credit default swaps, instead of amounting to $100 million, amount to $3 billion. Now you’ve got people with $3 billion worth of contracts that really have a big incentive in having somebody fail. And they may manipulate in some fraudulent or extreme way to cause a default in order to make the big collection.
There doesn’t seem to be enough transparency in financial systems to figure out whether this concern is relevant to this week’s panic.