Credit Default Swaps: Bad Enough to Ban?

Columbia University's Coffee says setting up a clearinghouse is critically important.

"Until we get a clearinghouse, there is the continuing possibility, maybe even more than a possibility, that sooner or later we'll have a major crisis in the over the counter derivatives market," he says. "It still could develop because AIG appears to be still several billion -- several dozen billion short of what it needs to remain as a going concern."

AIG spokesman Nick Ashooh says AIG is working on selling assets and still has access to several billion dollars worth of credit, but says he "will not speculate," on whether AIG might need to borrow more money from the government.

Despite the threat of a CDS-led market meltdown, Coffee says an outight ban is ludicrous.

"This would be the 21st century equivalent to the Luddites, who 200 years ago tried to destroy all the knitting mills because they were putting workers out of business," he says. "The credit default swap lacks transparency today, but in terms of what it does: it's basically a sophisticated insurance policy, and it makes every bit of sense that people who want insurance should be able to purchase it."

That way of thinking has led several observers to argue that the market should be restricted to creditors who want to insure themselves against a default by a debtor, as a ban on naked CDS would do. Michael Greenberger, law professor at University of Maryland and a former director of trading and markets at the Commodity Futures Trading Commission, favors that solution, which he estimates would shrink the market by 80%. Naked CDS should probably be banned, he says.