Regarding the Pope and Credit Default Swaps

Sarah Rudolph

Sarah Rudolph

Managing Editor & Head of Editorial Operations

By James M. Falvey, Contributing Editor, John Lothian News

I once made the mistake of asking a Jesuit Priest what university he attended. The Jesuit, Father Phil, put down his pen and pad of paper, rubbed his hand over his forehead and back over his shiny scalp, grabbing onto the few grey strands left. 

“Do you really want to know?” Phil asked me.

“Yes, absolutely,” I said.

“Okay. Which one?”

“You went to more than one school?” I asked, sensing that there was not a quick and easy answer to my question.

“Yep. Around ten.”

Father Phil had a couple of doctorates, a law degree and an MBA. Jesuits like education. A lot. It is key to their mission as priests.

I thought back on my experience with Father Phil when I recently read that Pope Francis, the first Jesuit to ever serve as the Holy Father, spoke out against credit default swaps or “CDSs.” I did a double take when I saw the headline. “The Pope has an opinion on credit default swaps?” I asked no one in particular. As a derivatives attorney and part-time financial journalist, I was shocked that he even knew what they were; most people in the world don’t know what a CDS is. Then I remembered the Jesuit adoration of education. Of course, he knows and understands the ins and outs of a credit default swap, I thought. He was probably shorting housing stock in 2008 because he knows everything! He’s a Jesuit!

Credit default swaps are a type of a derivative investment that allows the buyer of the contract to protect against the risk that a particular company in the CDS goes bankrupt. A CDS is, essentially, an insurance policy to protect investors against the risk of extreme financial distress with the company at issue. CDSs received much notoriety in the aftermath of the Great Recession of 2008 and were blamed, in part, for the severity of the crisis.

The Pope isn’t the first prominent individual to speak out against derivatives. Billionaire Warren Buffett notoriously called them “financial weapons of mass destruction,” despite routinely investing in derivatives (including CDSs) himself on behalf of his company, Berkshire Hathaway.

Nor is the Pope’s issuance of critical commentary on derivatives the first time the Catholic Church has waded into the water of “justice” and “fairness” around the economy, especially in the U.S. In the mid-1980s, the U.S. Bishops issued a Pastoral Letter exploring and commenting on “economic justice” in the U.S. They stated that the United States had a moral responsibility to see that no one is hungry, homeless or unemployed. It was required reading for me as a liberal arts major at Notre Dame.  In his current criticism, Pope Francis calls speculation via derivatives – especially CDS contracts – equivalent to gambling. The particular concern with CDSs is that, according to the Pope via a document issued by the Vatican last week, investors are betting on “the failure of others, which is unacceptable from the ethical point of view.”

The Pope’s negative comments about CDS contracts are misplaced. While it is indisputable that derivatives have been used at times for inappropriate, unethical and even illegal activities, they are not in and of themselves immoral. Quite the opposite. The primary purpose of these financial instruments is to provide protection for investors. They were invented as a hedging tool. Without their existence, many businesses – from bulge bracket banks to farmers in Michigan – would not be able to manage their financial risk effectively. The value of derivatives as a risk management instrument in a firm’s basket of tools to deal with uncertainties in the investment world is not just language that you would find on a glossy brochure. It’s true.

I doubt the Pope would argue that property insurance (or any type of insurance) is “unacceptable from the ethical point of view.” But the mechanics and substance of a property insurance contract is similar to a CDS contract. The homeowner buys an insurance contract to gain protection in case something bad happens to the property. To use the Pope’s logic regarding CDSs, the property policy owner is gambling on the destruction of the property in order to collect on the contract. But, as is the case with both CDSs and property insurance, except in rare cases of fraud, neither party wants to collect the proceeds of the insurance – property or the CDS contract. Instead, they want their asset to grow in value, be it real property or the stock/company in the CDS.  

Derivatives also allow funds and other investors to more effectively allocate their assets. For example, derivatives provide access to a wide range of securities and markets at lower transaction costs. As such, funds can create a diversified portfolio by investing in derivatives, such as “going long” or buying oil derivatives, rather than purchasing oil directly in the commodities market.

Father Phil, Pope Francis and the Jesuits throughout the world are very well educated. They offer well-reasoned arguments on most topics. But, on the criticism of CDSs, Pope Francis has missed the mark.

 

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