Lehman Brothers CDS settles. Now the portfolios using using CDS to bet on a bailout will lose. But how many CDS are outstanding—no one knows—and how many will default on their default swaps? Buying a security is buying future contingent cash flows, and trusting that the other side of the transaction will honor their side of the bargain. That trust is now gone from many markets…

A centralized market with margin requirements would have been a good idea. There is an important tradeoff here–if you said no new securities unless you had set up a regulated market first, then you would have a lot less financial innovation. But it is not clear that we want that, either. The policy is not so obvious here, although a market the size of CDS surely should have been centralized and regulated, given that people were doing rating arbitrage.

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