Luigi Zingales was kind enough to reply to my jokey post about him below.  He directed me to an op-ed of his, with Oliver Hart.  They present an extremely cleaver idea of how to use Credit Default Swaps to prevent large financial institutions (LFIs) from taking on too much risk and not having enough money on hand to pay their debts.

The idea is something like the following.  Suppose a Credit Default Swap CDS pays off if Citibank, say, fails.  Different traders of the Citibank CDS has different information about the chance that Citibank may fail.  The price of the Citibank CDS aggregates that information.  The price will be high if the chance of failure are high.  Hence, a regulator can monitor the Citibank CDS price and step in to force the LFI to cover it loans or be taken over. For details, see their op-ed.

I guess the only issue is that CDSs got a bad name because they were chopped up, traded and re-traded till the final object was so complex and mixed-up that no-one could evaluate its risk.  I suppose this is avoided in the Hart-Zingales plan as a CDS would have a verifiable name to correspond to the institution that it insures.

About these ads