Tom A's Stock Picks

Lets Parse a few Sentences from the WSJ on ABK

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This morning's WSJ has an article on two of my favorite topics, ABK and gambling. It will be instructive to review a few quotes:

"It (the plan to divide Ambac) would pit policyholders and shareholders against both each other and regulators, and rankle investors, some of whom have been wagering through the credit-derivatives market that bond insurers would fail and default on debt."

Isn't there an oxymoron here? Investors who wager? Gamblers wager, investors invest.

Lets go on:

"Any split could imperil billions of dollars in play by banks, hedge funds and other debt investors who have been betting on the demise of the bond insurers."

More investors, now they are betting, not wagering. Gamblers bet, Investors invest.

Yet once more:

"The increases mean that hedge funds and other investors that bought these swaps to bet on the detioration in AMbac's finaancial health have profited as fears over the bond insurers' solvency have grown."

Hedge funds and other investors? Isn't that an oxymoron too?

This is too amazing, how many ways can they say it?

Finally, I will be deeply saddened if this ends in a way that rankles "investors" who have been wagering (and betting) (and gambling) that fear (spread by whom?) could continue to inflate the value of credit default swaps on the debt of triple A rated companies. That would be horrible, an affront to our system, to "rankle" that group.

I sent these comments, together with the following, to the authors of the article:

Re: Moral Hazard created by Credit Default Swaps

I am a private investor, retired after a career in insurance and accounting. I am writing to draw your attention to a situation which I believe has contributed to the recent credit market difficulties, and will continue to do so unless the underlying issues are addressed and resolved.

Moral hazard is created by a financial system which permits the use of insurance-like mechanisms to make leveraged bets in favor of negative outcomes by persons who have no other stake in the matter. Specifically, the practice of permitting the purchase of Credit Default Swaps by persons who have no interest in the debt involved has been a major contributor to the recent turmoil and stress in financial markets.

To provide a little background: the term "moral hazard" originated in the insurance business, to describe a situation in which the presence of insurance would create an active desire for a loss to occur. An example would be if someone were able to buy insurance on a house he didn't own, or to purchase life insurance on an enemy or a complete stranger. Moral hazard is created by the lack of an insurable interest in the life or property insured.

What does that have to do with investments? Credit default swaps are insurance-like mechanisms, created to permit hedging or protection by those who are exposed to loss because of an interest in the subject matter. An organization holding notes of ABC Company is exposed to loss caused by default on the notes, and a credit default swap will provide insurance.

Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea for those who actually own the security.

But I would submit that these mechanisms create moral hazard when used for speculative purposes. A determined group of short-sellers can short a companies stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors. That is the true moral hazard. CDSs, when they are not called for by an interest in the referenced debt, are an invitation to the financial equivalent of arson. I believe that this has happened in the bond insurance industry, where a determined attack by a small and extremely vocal cadre of short-sellers, motivated and driven by a desire to create Events of Default on the debt of MBIA and Ambac, has exacerbated an already serious problem.

As a fix to the system, I would suggest that the SEC establish some sort of a watchdog unit to monitor and suppress speculative activity in credit default markets. Perhaps anyone buying such instruments should be required to file a statement of insurable interest. If you would like to buy credit defaults on ABC Company, just list the bonds you own. Free markets are one thing, moral hazard is another. Alternatively, Credit Default Swaps can be regulated by the states as insurance, which in point of fact is what they are. The regulations would include a requirement of insurable interest.

Leaving aside my opinions on the possible solutions, I am suggesting that research into the scope of trading in Credit Default Swaps, particularly those that are not supported by an insurable interest as described above, will provide useful information on the causes of the current market turmoil.

As a shareholder who invests in Ambac and MBIA, I am "rankled" to say the least to read articles which matter of factly address the concerns of investors who "wager," bet," and "gamble" as if they needed to be considered.

I also have written my congressman, the SEC, the Federal Reserve, and the Editors of Barron's expressing my concerns. If you are troubled by "Investors" who wager, bet and gamble against legitimate businesses and then attempt to influence the outcome by acting as fear-mongers, I would suggest you do likewise. If you are frightened at the potential harm they may cause our financial system, then do it today.

Tom