CDS as a regulatory instrument!

Warren Buffet may have described Credit Default Swaps (CDS) as "financial weapons of mass destruction", but Luigi Zingales and Oliver Hart see an important role for CDS in preventing the failure of large financial institutions (LFIs).

They draw parallels for regulating LFIs with margin accounts, whose holder (an investor) buys stock with only part of the cost but has to post new collateral if the value of his stock holdings drops or liquidate his holding by paying the full amount due. They write, "an LFI will have to post enough collateral (equity) to insure that its liabilities are always paid in full. When the fluctuation in the value of the underlying assets puts creditors at risk, the LFI's equity holders will be faced with a margin call: They will either have to inject new capital or lose their equity. In both cases the creditors will be protected."

However, unlike conventional margin calls, there is need to have alternative mechanisms to trigger off margin calls on LFIs since their creditors are often dispersed and therefore unable to coordinate to make a margin call, and since most LFI assets (commercial loans and home equity lines) are non-standardized and not frequently traded, their value is hard to assess. Instead of a regulator setting off the margin call, Zingales and Hart prefer a market-based trigger, through a CDS.

A CDS on an LFI is an insurance claim that pays off if that institution fails and creditors are not paid in full, and therefore its price naturally reflects the probability that the LFI debt will not be repaid or the credit risk inherent in the LFI at any point of time. They write, "When the CDS price rises above a critical value (indicating that the institution has reached an unacceptable threshold of weakness), the regulator would force the LFI to issue equity until the CDS price and risk of failure back down. If the LFI fails to do this within a predetermined period of time, the regulator will take over."

The devil, as always, is in the detail, especially since the authors are silent on a couple of important issues. Who will issue these CDS? And given the limited market in them, how accurate will be the price discovery? Who determines the critical value beyond which the regulatory trigger is set-off and how is it arrived at? And how cost-effective is this in comparison to the other insurance mechanisms like collateralized insurance or even plain vanilla capital requirements (debt or reserves-based)? And like what happened with all the CDS, like those issued by AIG, what is the guarantee that they will be honoured when times comes?