Why it’s time to outlaw credit default swaps

June 19, 2012, 12:59 AM UTC

Fortune — In finance, there should be a three-strikes-and-you’re-out rule. If there were, credit default swaps would be headed for the graveyard.

Indeed, when JPMorgan Chase (JPM) announced its $2 billion and counting trading loss a month ago, there seemed to be little explanation of what exactly credit default swaps, the financial contracts the London Whale had been trading, were. Instead, many stories used this short-hand description for the financial contracts instead: the same things that caused AIG to go bust.

On Tuesday morning, Jamie Dimon will be in front of Congress again, this time to answer questions from the House Financial Services Committee. Dimon is expected to stick to the same script, literally. Save a few small changes, Dimon’s opening remarks are expected to be nearly word-for-word identical to those he delivered when he testified in front of the Senate’s banking committee last week. Like last time, there will be a lot of questions about financial regulation and whether banks should be allowed to place risky bets. But once again it’s unlikely there will be a lot of questions about credit default swaps and why they are allowed, mostly unregulated, to continue to exist.

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Credit default swaps, or CDS, are contracts that allow investors and traders to bet on whether a company, a country or a group of companies, countries or individuals will pay back their loans. In theory, CDS work like insurance contracts. Sellers promise to cover the losses of the buyer of the contract if the loan the CDS is based on isn’t repaid. In fact, CDS aren’t really used that way. CDS are rarely held until a default occurs. Instead they are traded, in theory rising and falling based on the credit worthiness of a borrower or borrowers.

Of course, just because CDS have been at the heart of a number of recent blow-ups isn’t a reason to ban them. Stocks weren’t banished after 1987, or 2000. The reason to get rid of CDS is that it doesn’t work. Reuters recently reported that trading by the London Whale, and the hedge funds that were looking to make money off of the unwinding of JPMorgan’s outsized trades, caused the price of certain CDS contracts to jump and fall, even though the actual credit worthiness of the companies the contracts were based on hadn’t changed. Bank analyst Dick Bove for Rochdale Securities says the London Whale trades show that the CDS market is manipulated. “There’s something wrong with this market,” says Bove.

MORE: How JPMorgan made its mult-billion dollar blunder

Earlier this year, CDS contracts tied to McDonald’s (MCD), for instance, rose 19%, during a period when there was almost no news about the restaurant company, and certainly no reason to suspect McDonald’s would have a harder time paying back its debt. In the same time, McDonald’s stock price barely moved, down 1.1%. Markets can become out of touch with reality for some time. That’s how we get bubbles. But the problem with the CDS market is that it’s so thinly traded that the actions of one player can cause market distortions. That’s supposed to be left to the idiocy of crowds.

The best question for proponents of the CDS market is when have the contracts actually worked. The CDS contracts sold by AIG only paid out because of Uncle Sam. And you can’t even count on bailouts. When Greece was “voluntarily” bailed out by the rest of Europe, the country’s government bonds were written down by 50%. Yet, the group that governs the CDS market ruled that CDS holders couldn’t collect on the insurance they had bought. Voluntary bailouts, as if Greece had a choice, were not covered by CDS. It was just another loophole in a Swiss cheese market.

What’s more, it’s not clear any of this would change under Dodd-Frank. The new financial regulations state that most CDS trades will have to be run through a clearinghouse. But much of the other investor protections that are supposed to rid stock and bond markets of manipulation and fraud still don’t apply when it comes to CDS.

The recent four-part Frontline PBS documentary on the financial crisis starts with a long description of the CDS market and how it got started. CDS contracts were created at JPMorgan. Frontline interviewed a number of JPMorgan bankers who were there at the start. The implication was that JPMorgan, which sidestepped much of the losses of the financial crisis, knew what they were doing. But when other less responsible and intelligent bankers started getting into the market, that’s when CDS got dangerous. The fact that it’s now JPMorgan getting stung by the CDS market would serve as a fitting bookend for this chapter in financial “innovation,” and a good example of why it should be closed.