Nobel Economist: Ban Over-the-Counter Credit Default Swaps

Bloomberg notes:

Myron Scholes, the Nobel prize- winning economist who helped invent a model for pricing options, said regulators need to �blow up or burn� over-the-counter derivative trading markets to help solve the financial crisis.

The markets have stopped functioning and are failing to provide pricing signals, Scholes, 67, said today at a panel discussion at New York University�s Stern School of Business. Participants need a way to exit transactions and get a �fresh start,� he said.

The �solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over,� he said, referring to credit-default swaps and other complex securities that are traded off exchanges. �One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices.�

Scholes also recommended moving the trading of credit- default swaps, asset-backed securities and mortgage-backed securities to exchanges to allow for �a correct repricing� of the assets. The securities are currently traded between banks and investors, without any price disclosure on exchanges.

Time Magazine"s Justin Fox notes that:

What that means, he elaborated, is that regulators should "try to close all contracts at mid-market prices" and then start up the market anew with clearer rules and shorter-duration contracts.

(Fox also notes that this is especially dramatic given that Scholes is the "intellectual godfather of the credit default swap").

I agree with Scholes.

Legally, you can cancel CDS based upon fraud or mistake. Or you can reform (that is, modify) CDS if one party to the contract was mistaken about what he was getting into. The government must use its power to do so, or the economy will continue to go down the tubes.