“The great benefit of the admittedly inconvenient, pre-global and more localized world is that it was compartmented into nations. Parts of it could be sealed off and rest of it still function.”

Speaking of compartmentalization. The thing that has been driving me crazy is the idea of the credit default swap. As is understand it, this instrument is essentially credit default insurance purchased by the buyer of bonds to provide extra protection against credit risk. It isn’t actually called insurance because that might make it subject to insurance regulations.

What makes me want to scream is the idea than an institutional investor can pass on making a rigorous evaluation of credit risk because the purchase of the default swap takes the place of critical analysis at the cost of a slight decrease in net yield after the price of the derivative contract is factored in. Does this sound like moral hazard to anybody? How many of us have heard from a broker on the phone that a bond has a AAA rating or some such, and that therefore it is a suitable addition to one’s portfolio?

Investors got too comfortable with rating agencies and big investors got to comfortable with credit risk hedges. All of the business and academic defenders of derivatives talk about the benefit to society of the ability to hedge risk. Is this really a benefit or is it a mortal danger when investors turn off their bullshit detectors and get comfy with credit risk when it is hedged through counterparties with credit risk issues of their own.

I think compartmentalization is a good, simple concept and I think it is clear that derivative contracts have been a primary means of defeating compartmentalization.