Bad for GM, Bad for America

That would be just about perfect if we could count on the credit-default-swap market to provide perfect insurance. A credit-default swap as insurance is only as good as the money of the investor on the other end of the deal.

If that investor pays off in a default, great. If the demand for payment, or the prospective demand for payment, creates a scramble to sell before the insurance bill comes due, then the cost of insurance can skyrocket.

That, in turn, would lead some investors to sell any credit-default swap contracts with lower "premiums" (assuming the market would allow this) and would send other investors back into the bond market, where they'd demand higher yields rather than paying higher premiums in the credit-default-swap market. And if a weak hand fails to pay up on that insurance, then pricing in the whole credit-default-swap market runs amok, with prices for contracts soaring or with supply collapsing -- or both.

Testing, Testing

No one knows, of course. This isn't an old market, and it's not well tested. Moreover, the derivatives market has failed some past tests as weak hands have proved unable to meet commitments.

And the risk in the credit-default-swap market rises as events get more uncertain. More uncertainty brings more investors to the market looking for insurance. And the growing demand increases the odds that one investor or another offering insurance will make a mistake or get overextended. That can lead to exactly the swings in price and supply that could lead to a collapse of liquidity in this market.

We've already seen clues to how volatile this market can be. The most actively traded credit-default swap in March was that of GMAC. In a matter of a few days, prices moved from lows of $300,000 for $10 million in insurance to highs of $485,000.

That's about a 62% swing. Without a strike at Delphi or a wildcat strike against GM. Without fears that the Cerberus-GMAC deal might collapse. Without another ratings drop on GM debt.

I don't have much faith in any of the parties to this mess. But I sure do hope they work it out. I can get along without another real-life test of the derivatives market.