Credit default swaps in China

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Credit default swaps in China insurance

Usually, I would not select such an exotic topic as credit default swaps in this column for a general audience. I am doing it today because China is playing the financial game that may affect many who have invested or will invest in China. Let me first tell you what a default swap is.You may have a life insurance policy that pays your surviving family if you die. Sometimes, a husband or a wife buys a large sum of life insurance on his or her spouse. Sometimes when their relation sours, the person who holds the insurance wants the spouse to die so that he or she can keep the money. The intention of default swap is not that bad, however.Can we buy a life insurance policy, not on human life, but on business life? Can we buy an insurance policy on the possible default on money that I loaned to a company? Yes, we can. That is called a credit default swap or default swap.Insurance on human life, at least in principle, is based on one’s care of another human being to make sure that they will not suffer too much when, say, I die. Insurance on a business’ life involves no such humanity, and pays me as a bondholder when the business dies or defaults on loan. The bondholder is the one who lends money to the company by buying bonds issued by the company.Readers may wonder why they trade default swaps. Why would I buy bonds of a company if I feel that I may need insurance for the payment of interest or principal, to begin with? Does the interest paid on bonds not take such a risk into account by paying higher interest on riskier loans?As I explain below, a default swap is one of many gimmicks that society would be better off without.Default swaps were created in the mid-1990s by Wall Street giant, J.P. Morgan. They allow a party to buy or sell insurance that will cover payments if a company fails to pay interest or principal. Just like personal life insurance, the party buying the swap pays premiums, while the party selling the swap receives the premiums. When the company defaults on loans, the seller of default swaps pays the buyer an amount specified in the swap contract.What did China do on default swaps?In September this year, I happened to be in Houston and picked up a newspaper called Epoch Times in the hotel lobby. One article in the business section caught my eye titled "China Calls on Credit Default Swaps to Spread the Pain," written by Fan Yu of the newspaper.According to the story, on September 23, this year, Chinese regulators approved the trading of credit default swaps in China that would provide investors insurance against defaults. Default swaps will cover many Chinese companies, including state-owned enterprises that may have debt problems.When state-owned enterprises defaulted on loans in the past, the state or the local government had been responsible for paying off the loan. According to Yu, many analysts believe that "the decision [of adopting default swaps] is a sign that the Chinese communist regime may allow more bond defaults." The Chinese government is transferring financial risk from it to investors.Why should I care as an investor? Do I not get my money back through the insurance company, if state-owned enterprises default on my loan? It is not that simple.There is a problem of information asymmetry in that people who lend money to the company by buying the company’s bonds do not know as much as people who are running the company. Bondholders are likely to hear more good news than bad news about the company, making the risk assessment an adventure.Consequence is an adverse selection, meaning that bondholders are likely to buy bonds that effectively pay lower interest rates, and buy default swap insurance that costs higher premiums, than they merit. There will also be all kinds of transaction costs such as a delay in payment, legal fees, and more.There is another problem with default swaps by incurring costs to society. Because of the default swap arrangement, companies may undertake riskier projects than they otherwise would. This is a classic case of moral hazard. Moral hazard describes a situation in which insurance changes human behavior in such way to generate a loss usually to the party not directly responsible for the loss.If you think this is all in my imagination, think about what led to the Great Recession of 2008.Sellers and brokers of mortgage-backed securities sold the securities to buyers who had little knowledge of how risky these securities were. These sellers made money through commissions and bonuses. When borrowers of money could not make the payments, the burden of risk ultimately fell on the buyers of these securities. When the default spread widely, even the sellers of these securities as well as default swap insurers faced bankruptcy, leading to the Great Recession.