warning: this post will require you to be able to intelligently ponder philosophical concepts and theories, and perhaps try to forget some assumptions you may already have. I failed in my attempt to explain the concepts below in a comment thread on NakedCapitalism, so here's the full thought process:
Let's have a quick CDS tutorial: Credit Default Swaps are insurance on the credit of an underlying company. An investor who buys CDS on company XYZ will pay a fixed fee (ie, 1% of the notional he is purchasing) every year, and in exchange, the seller of the CDS will owe the buyer money if there is a default event at the company.
The biggest problem with the CDS market was that sellers of CDS - ie, sellers of insurance, wrote checks their bodies couldn't cash. They ended up with liabilities they couldn't possibly make good on, and you know the rest of the story - government bailout to avoid Armageddon.
There is another problem with CDS, though, and that's the fact that there are many more CDS outstanding on some companies than the actual underlying debt that the CDS are supposed to be insuring. Let's consider a hypothetical example: Company XYZ has $100MM in debt outstanding. JoeHedgeFund owns it all. JoeHedgeFund goes out to the Street - the sell side broker dealers, AIG, etc, and purchases protection - CDS - for his bonds. However, JoeHedgeFund takes it one step further - he manages to buy $500MM worth of CDS - because when you buy CDS, no one asks you how much of the underlying bond you own. Why is this a problem? Because, when company XYZ runs into trouble, and goes to negotiate a restructuring, a prepackaged bankruptcy, or a reorganization, JoeHedgeFund now has no incentive to negotiate in favor of the debt he owns - in fact, he's DIS-incented from helping XYZ restructure their debt, because he's essentially overhedged by a ratio of 5-1. He doesn't care if he takes a loss on the $100MM in bonds by refusing to compromise on any sort of restructuring and forces the company into bankrutpcy, because he gets paid on $500MM of CDS.
This is what's known as "perverse incentive." Opponents of CDS sometimes say that we shouldn't allow people to buy "naked" CDS, because they don't have an "insurable interest," and thus are exposed to perverse incentives. A commonly cited example is that you can't buy insurance on your neighbor's house, because you could then burn the house down and collect on the insurance policy. You also can't buy life insurance on your neighbor, because you'd have perverse incentive to murder him to collect the payout.
Now, here's why it's fallacious logic to apply this reasoning to CDS. If I buy CDS on a company without owning any of the underlying debt, I cannot effect the health of the company. Note that I don't have an insurable interest, but it doesn't matter - the "perverse incentive" is a pipe dream, because I can't act on it. It doesn't matter how much CDS I buy - I could own a gazillion dollars worth of insurance on the debt of a given company - but that still doesn't give me any say, any seat at the table in a restructuring negotiation scenario. There is a similar analogy with short selling stocks, and it's the reason why people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company. Similarly, CDS levels do not effect the health of a company - they REFLECT the health of a company, or at least the market's interpretation of that health. Some companies will see the value of their CDS widen when people fear for the company's financial health. The CDS is a reflection of the fear, and not the cause of the company's problems. To suggest that panic from widening CDS levels causes companies to collapse is like saying that avoiding marking assets to market makes them worth whatever we want them to be worth - limiting CDS trading would not alter the underlying health of the company, it would only mask it.
So, since one cannot effect the health of the company by owning CDS - since one cannot murder the company (or burn it down) via a CDS position, the "burning down your neighbor's house" analogy goes up in smoke as a straw man fallacy. If you're philosophically inclined, you can imagine a world where I could buy life insurance on my neighbor's house, but the insurance company would give me a magic pill that would prevent me from being able to harm the house in any way - it would essentially eliminate the perverse incentive I had. In this scenario, obviously, there is no reason why I can't buy insurance on my neighbor's house. Similarly, with CDS, I can't effect default events by owning CDS alone, so the perverse incentive is a straw man.
However - once one DOES own some of the underlying bonds in a company, like JoeHedgeFund in our example, he certainly can effect the outcomes, and thus we need to propose some rules for how much CDS one can own. Now, these rules are theoretical - I don't have a suggestion for how to enforce them, so if you don't have the capacity for regulatory philosophy, you can click away now. Also note, that these rules address ONLY the "perverse incentive" concept - they don't cure the problem of the AIG's of the world writing too much insurance (CDS).
It's actually simple, and it's actually only one rule: SINCE a debtholder can effect the future health of a company, IF you own debt in a company, you cannot own CDS notional greater than your debt position. Following logically from that, if you own CDS in a company, you cannot buy debt in the company unless the notional value of the debt is at least at large as the notional value of the CDS.
That's it - just one rule. Note that under this rule, there is no prohibition on buying "naked" CDS in a company whose debt I don't own - because naked CDS buying does not cause the collapse of companies.
The real problem with CDS, apart from the perverse incentive effects which we've now solved with a simple rule, are not with the buyers of CDS - but with the sellers. Sellers of CDS historically underestimate the likelihood of default, and issued much more insurance than they could cover if things went sour. Regulating exposure of the sellers of CDS is a topic for another post - but one that will be covered amply in the news over the next 12 months, I'm sure.