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One arguably good thing about the financial crisis is that it has broadened public understanding of the global financial system. One bit of exotica to grace the front pages of our newspapers is the credit default swap (CDS). These swaps brought insurance giant AIG to its knees, and precipitated a $100 billion U.S. government bailout of the company. More recently, it has been reported that hedge fund manager John Paulson made more than $3 billion using CDSs to bet against subprime mortgages. These things are obviously very powerful.
But what are they—and how should they be taxed?
A CDS is a contract between a “credit protection buyer” and a “credit protection seller.” The buyer pays a premium (typically quarterly) to the protection seller over the contract’s term (often five years). The seller must make a single payment to the buyer if and only if an issuer of debt (called a “reference entity”) defaults, declares bankruptcy, or suffers some other “credit event.” The contract designates a particular debt issuer as reference entity, but this entity is in no way a party to the contract. The contract also designates a “notional amount,” which is the base from which both parties’ payments are computed. For example, if the notional amount is $10 million (a common contract value), the buyer’s premium might be, say, 200 basis points, which is $200,000 per year (payable in four quarterly installments of $50,000 each), and if the reference entity’s debt is worth, say, 40 cents on the dollar after a credit event, the seller pays the buyer $6 million. If the reference entity does not have a credit event during the contract term, the seller pays nothing to the buyer.
These swaps may look like insurance but are not. A fundamental principle of insurance law is that a purchaser must have an interest in the thing being insured. I cannot, for example, purchase fire insurance on your house. But a purchaser of credit protection is not required to have an insurable interest. I can buy credit protection on the debt of IBM Corp., even if I do not own IBM bonds and would sustain no loss if IBM defaulted. Indeed, as John Paulson well knew, a CDS is a very efficient way of taking a short position on a bond. If I make a short sale of IBM stock, I gain if the value of the stock falls, but lose if the stock price rises. Similarly, if I buy credit protection on IBM bonds without owning any IBM debt, I gain if IBM’s credit standing goes in the tank; I either receive a payment following an IBM credit event, or, in the absence of such an event, the value of my position increases. If IBM’s credit remains strong, I get nothing in return for my premiums. A swap, in other words, is a derivative financial instrument, not insurance.
Quite amazingly, given the size and number of CDSs that have been written in recent years, it is not clear how these instruments are treated for tax purposes. The two most promising approaches for taxing them would be to treat them as put options or to apply regulations designed primarily for interest rate swaps. The most important issues are the timing and character of income and loss under CDSs and the application of withholding taxes to payments under cross-border swaps. The two competing approaches give somewhat different answers to these questions, but each has both advantages and disadvantages. If you’re interested in knowing more, look here (some PowerPoint slides) or look here (Taxation of Credit Derivatives paper). Given the amounts at stake, the Treasury, and perhaps Congress, needs to clarify the treatment of these swaps—soon.
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