This is in response to Josh's post on TMP reader MD, who took umbrage at reader RB selectively judging bondholders and derivative counterparties. 

I don't know if I'd go so far as to make a "moral distinction" between bondholders and derivative counterparties. (My capacity for outrage at this point at anyone who tried to make huge amounts of money by compounding systemic risk the rest of us now have to assume is pretty much exhausted.)  On the other hand, to claim, as TPM reader MD does, that "both were just playing by the rules as they were and pursuing their own financial interests" is deceptive and disingenuous.  It suggests a false equivalence where a key distinction needs to be made.

First, I want to be clear about who stands indicted as "derivative counterparties".  We're not concerned with holders of classic, publicly tradable derivatives - things like puts and calls that have been an essential part of western finance since the days of the Dutch Republic.  Nor are we concerned with banks, insurance companies, pension plans, endowments, mutual or money funds, or any other party who used simple, straightforward contracts, whether publicly traded or not, to insure themselves against loss in the course of properly managing risk, and who would face the risk of seeing those contract terms altered in bankruptcy court.

The "derivative counterparties" who are in a class of their own are holders of complex instruments such as collateralized credit-default swaps, 95 percent of whose U.S. bank trading has been conducted by the 5 largest U.S. banks.

What makes these players different from bondholders?  The answer is that, far from "just playing by the rules as they were", they were happy both to evade "the rules" entirely  - by purchasing product purposely designed to be exempt from the financial industry regulations that apply to vanilla credit or insurance products - and to have rules written especially for them: as Josh has pointed out, the counterparties' derivatives, unlike bonds, are now protected from the reach of bankruptcy courts thanks to rule changes passed in 2005 after extensive input from securities industry lobbyists.

In fairness to many of these counterparties, it is true many of the same institutions also own vanilla investments like high-grade corporate bonds.  (Just as the same person can be both a wonderful parent and have a fatal attraction to gambling.)  The moral here isn't that derivative counterparties are evil, and bondholders are angels.  It's that holders of complex derivatives had no problem with laws being evaded or manipulated in their favor, and consciously participated in a dangerous game whose risks to themselves and the financial system they utterly failed to comprehend.  

To pretend investing in credit default swaps was the same as buying bonds, that the players involved simply played by the rules and wanted to make money like everybody else, misses what was so damaging and reckless about the counterparties' behavior.  It essentially condones the aggressive self-serving of the parties who created unregulated products, then manipulated the legislative process to insure holders of those products would receive preferential treatment in a bankruptcy, catering to their own and their clients' short-term greed without any regard for the well-being of the financial system that provided them all with a comfortable living. Remaining obtuse to this distinction, whether you call it "moral", or simply "practical", can only help encourage such dangerous manipulation in the future.

But then, on the other hand, I'm a  bondholder myself. Perhaps this is simple prejudice talking.