The problem with Credit Default Swaps is that there is no requirement to set aside an adequate amount of capital at the time the vehicle is sold, to ensure that the money is there to pay out on the loss if the 'insured' instrument goes into default. Words matter. By calling it a Credit Default Swap, rather than a Credit Default Insurance [Policy], the clever people on Wall Street were able to keep these products from being regulated as insurance products are, which would have required adequate capital reserves be set aside to cover losses.
These CDS are nothing more than illegal insurance. It's similar to an illegal lottery or gambling ring. When authorities step in and shut down an illegal lottery, the ticket holders lose their money. Authorities need to declare the CDS illegal and the problem goes away. I don't think it's all that complicated as they make it out to be.
Sorry for the tangent but since you brought it up....If you could buy life insurance on everyone in Denver would you? Unless you were planning on going on a mass-murder spree I'm pretty sure that you would spend far more in insurance premiums then you will collect from the few people that croak each month.
I would! Because then every time someone dies in Denver, you get paid. There is a 100 percent chance that everyone in Denver will die. The argument becomes even more compelling if you knew that everyone in Denver was going to die very soon (e.g. your mass murdering spree). The analogy to the CDS market is that you know the system is flawed, counter parties won't be able to pay and will go under (die).
On average, the monthly cost of the insurance premiums will exceed the payout you get each month from folks dying. Insurance companies are in the business of making money - this is no different than playing slots in Vegas, there is always the chance you might hit it big and walk away a winner but the game is stacked against you and once the law of large numbers kicks in you will be a net loser. Unless you go on a killing spree (and don't get caught)
Your right...except it doesn't need to be a killing spree. It could be just that you thought everyone was deathly ill (or overburdened with debt in the case).
Its funny that no products have been offered to normal ever day traders or investors. Would any of you be interested in insuring bonds that you are holding?
Another allure for CDS was that since there are no regulations it was perfectly legal to use insider info and buy sell these instruments to bet on companies future.