Credit Default Swaps and Moral Hazard

In the insurance business,moral hazardis famously a problem. Evelyn Waugh describes in Scoop
how in his fictionalized version of 1930s Addis Ababa, a taxi ride revealed “numerous gutted sites, relics of an epidemic of arson some years ago back when an Insurance Company had imprudently set up shop in the city.”

Help me out here if I`m wrong, but don`t credit default swaps, a financial instrument invented in the 1990s, suffer from the usual insurance contract problem of “moral hazard?” If you can make a deal so that you get compensated if your mortgage-backed security defaults, aren`t you more likely to bring about a default?

If you are, say, Goldman Sachs and AIG offers to, in effect, insure for a modest price a no-doubt-fraudulent pile of mortgages you are thinking about buying from some dubious firm, why not go for it? AIG is rock solid! And if, perchance, AIG turns out not to be so solid, well, Goldman has friends in high places.

Credit default swaps have a second interesting moral hazard aspect. You don`t have to be the owner of the security to get paid if it goes bust. This is kind of like being able to take out a life insurance policy on a complete stranger or your own worst enemy. The murderous marital moral hazard implicit in life insurance is a common theme in crime stories (e.g., Double Indemnity). That`s an inevitable problem, but insurance companies have tightened up over the centuries on who can take out a life insurance policy on whom. Still, there was an Arsenic and Old Lace case in LA recently of two elderly women, who had murdered homeless men after taking out multiple life insurance policies on them. (They bribed the men into signing up for one, then forged their signatures on other policies).

It would certainly be interesting to learn more about the impact of both types of moral hazard.

I could see how the second kind (where third parties make bets against the financial health of firms in the securitized mortgage business) could be either bad or good for the economy, in that it could send signals that financial instruments are dubious.