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Tuesday, September 23, 2008

SEC’s Cox Calls for Authority to Regulate Credit Default Swaps

Nothing like a turf war to wake up a sleepy regulator. It seems rather telling that Cox has developed a sudden interest in the credit default swaps market a mere day after New York State announced that it will regulate the product (to the limited extent it can) starting January of next year. (Although the SEC apparently prepared its remarks last week, the New York initiative did not spring into being overnight and the SEC was no doubt notified in advance as a courtesy).

I’d feel a bit happier if these CDS-regulator-wannabes had a clearer idea of what they wanted to do with the authority they are seeking.

From Bloomberg:

U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should “immediately” grant authority to regulate credit-default swaps amid concern the bets are fueling the global financial crisis.

“Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure,” Cox told the Senate Banking Committee today at a hearing on the government’s $700 billion financial rescue plan. Lawmakers should provide the authority “to enhance investor protection and ensure the operation of fair and orderly markets,” he said….

The SEC is concerned investors may seek to profit by spreading false information or making trades designed to drive down financial stocks during the credit crisis that has re- shaped Wall Street. The agency is demanding hedge-fund managers, brokerages and institutional investors describe in sworn statements their bets on the companies, including trades in credit-default swaps, the regulator said Sept. 19.

So at least as presented at Bloomberg, the SEC’s concern isn’t the bugaboo that has caused the most worry, that CDS have the potential to crash the financial system via cascading counterparty defaults. No, it’s that they are an alternative way for evil shorts to attack (supposedly) otherwise sound companies. Indeed, Cox zeroed in on the parallels to stock shorting in his testimony:

Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS. Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can “naked short” the debt of companies without restriction. This potential for unfettered naked shorting and the lack of regulation in this market are cause for great concern.

Mind you, we are not saying that this is not a legitimate concern; indeed, we’ve posted that games-playing in CDS is a far bigger risk to companies than naked shorting, due to the opaqueness of the CDS market. But by seeing the risks of CDS so narrowly, the SEC (in our book) has disqualified itself as the proper regulator for them.

Topics: Credit markets, Derivatives, Regulations and regulators

Email This Post Email This Post Posted by Yves Smith at 3:49 pm

17 Comments » Links to this post

17 Comments:

  • Matthew Dubuque says:
    September 23, 2008 at 4:06 pm

    Matthew Dubuque

    As I stated yesterday in this forum, the move by key CDS players to opt for local state regulation was a last minute attempt to game the system.

    This state “regulation” of GLOBAL systemic risk was a critical part of what got us into the AIG mess.

    What is needed is GLOBAL regulation, including the imposition of capital requirements and reduction in leverage for all CDS trades.

    Matthew Dubuque
    mdubuque@yahoo.com

  • Anonymous says:
    September 23, 2008 at 4:27 pm

    Actions in New York may expose the full nature and value of over the counter trading something the SEC is trying to hide. Let the Federal Reserve take up the book keeping on CDS then that way we’ll never know the full costs.

    BIS has no control of CDS but track the transactions and the amounts at their site along with the rest of the world’s banking totals.

  • doc holiday says:
    September 23, 2008 at 4:57 pm

    Re: " It seems rather telling that Cox has developed a sudden interest in the credit default swaps market a mere day after New York State announced that it will regulate the product"

    >> In the immortal words of Dr. Evil, "How bout no"!

    Cox needs to resign — and for that retard to suggest he should have more power to abuse is… well, retarded and insane! He is the mirror image of FEMAs Brown and the highly respected nepotism boytoy/posterchild Mark Foley, all wrapped into one neat ball of stupidity, corruption and delusion!

    Also see: http://www.youtube.com/watch?v=2Mi9tHxEYZM&feature=related

    ** This is getting less fun every day!

  • Lewis B. Sckolnick says:
    September 23, 2008 at 5:00 pm

    Cox has had his time.

  • Tim says:
    September 23, 2008 at 5:00 pm

    Could CDS contracts be taxed (on the insured amount) on a global basis? Collection of taxes on exchange traded contracts would be easy and efficient, I guess. OTC might be more difficult but sales and vat tax returns are well established and audited. Maybe the tax rate could be lower if exchange traded. Being seen to hit the financial players by turnover taxation might help the populous swallow the inevitable bank bailout pill.

  • doc holiday says:
    September 23, 2008 at 5:14 pm

    There is an interesting pattern of attention deficit disorder and child-like tantrums, that coincide with a lack of regulation and enforcement of law, i.e, why is it that Paulson and Bernanke want instant gratification and now Cox wanting instant on-the-fly adjustments for regulation? This is like watching children that are immature throw temper tantrums wanting more candy, more liquor, more and more cocaine, more money, more of what they don't have in their fat little hands — while they continue to maintain the inability to mange what they already screwed up, and fail to be held accountable for. This is like an out of control twister game, where Bernanke, Cox, Dodd, Paulson, et al — are greased up like young pigs at a wild orgy, waiting for Congress to jump in and play pin the tail on the muddy retard; who wants more mud?? Yippie for America, The Lost Nation!

    >> That's my back talking (there)…

    Re: Cox said Congress should “immediately'' grant authority

    Congress and any adults playing here, need to slow down and let the theatrics exhaust and unwind and when these kids have run out of crap to scream, then, we need to find solutions, until then, either send these people to timeout, spank them, put them in jail,hang them for treason or just read a good book and think it over…

  • Anonymous says:
    September 23, 2008 at 5:23 pm

    The difference between 1929 and now is that we had a lot better quality of government back then.

  • Max says:
    September 23, 2008 at 7:06 pm

    It’s an attack on bear bets, part 2.

  • Anonymous says:
    September 23, 2008 at 7:09 pm

    joebhed said:

    CDSs

    Just another host of billions – er, probably trillions – of US dollars that do exactly nothing for promoting economic growth and productivity.

    Just another of the worthless, gimme-some, capitalist inventions to steal economic well-being from the American people.

    Bet-swapping.
    Yeah, that’s an important contribution to the general health and welfare of Americans.

    Hey kids, I work in finance.
    Can you spell finance?

    Illegalize CDSs.
    Illegalize the fat capitalist practice of creating ALL of the nation’s new money as debt.

    Why don’t you guys get it?
    THAT is the problem.

  • Anonymous says:
    September 23, 2008 at 7:28 pm

    AIG was mostly a money making machine.
    It was the derivatives desk that took them down.

  • proton says:
    September 23, 2008 at 7:45 pm

    Why people think CDSs are evil instruments?!

    CDS is needed because borrowers default on occasion. CDS help reduce the cost of debt for borrowers. CDS would have been totally unnecessary IF there were NO DEFAULTS.

    Eliminating or choking CDS is a terrible idea.

    If we are going that route, I would ask: “Why does not the government ban defaults?” Totally disallow them…Say no corporation can ever file for Chapter 11. Heck, let’s rewrite our laws eliminating all the Chapters 11 and more.

    That would be totally in character with our government’s actions, wouldn’t it?

  • ruetheday says:
    September 23, 2008 at 8:03 pm

    >>CDS is needed because borrowers default on occasion. CDS help reduce the cost of debt for borrowers. CDS would have been totally unnecessary IF there were NO DEFAULTS.

    BS. CDS do none of the above if the firms that write them are not able to make payment on them should they be exercised. And why should "default insurance" be necessary in the first place? The rate of return on the underlying investment is supposed to reflect a risk premium. That is central to how an asset market is supposed to function.

  • I'm smarter than Bernanke says:
    September 23, 2008 at 8:22 pm

    CDS’s enable robotic buying of paper (”if it’s AAA, it’s money-good. buy!”). Robotic buying is what got us into this problem in the first place. There is no way to justify them outside of the context of bubble creation.

  • I'm smarter than Bernanke says:
    September 23, 2008 at 8:22 pm

    CDS’s enable robotic buying of paper (”if it’s AAA, it’s money-good. buy!”). Robotic buying is what got us into this problem in the first place. There is no way to justify them outside of the context of bubble creation.

  • Been there says:
    September 23, 2008 at 8:59 pm

    It’s late in the game and referee Cox and his crew have had a number of missed calls reviewed by the booth. Coaches blatantly cheating, personal fouls on every play- the game has gotten completely out of control. His ineptitude is now obvious to the angry home crowd.

    Doncha just admire when such firm leadership is exhibited just in the nick of time? What a terrific guy!!!

    Makes me proud to be an American.

  • Anonymous says:
    September 23, 2008 at 9:20 pm

    ‘The SEC is concerned investors may seek to profit by spreading false information or making trades designed to drive down financial stocks during the credit crisis that has re- shaped Wall Street.’

    FOMALOL…This is hilarious…Cox is worried about rumors effecting the price of CDS? What about all the rumors that have been started on Squeek Blab that caused lots of players to lose money? Cox had the authority to go after those rumor mongers and did nothing! Cox is a joke and should be thrown in jail for negligence of duty.

    River

  • Peter Schaeffer says:
    September 23, 2008 at 11:32 pm

    For two major reasons, I believe that CDS are deeply destabilizing. The first reason pertains to the nature of the CDS market. Save for the case of where the buy / sell positions are between the same two firms, CDS create a cascading counterparty risk problem that is very hard to avoid. The second is a consequence of the nature of the assets CDS are written on (bonds). Bonds are fundamentally hard to insure because bond performance (default rates) are systemically correlated. In my opinion, the CDS market can be stabilized. However, the cost of doing so would probably greatly shrink the market.

    1. By their nature, CDS create daisy chains of counterparty risk that can not be readily avoid. Essentially they are a house of cards, vulnerable to almost any disruption. Let me offer a very simple example to demonstrate this. Say we have three firms, A, B, and C that buy/sell CDS on a bond (called Lehman) in this case. Assume that B buy credit insurance on Lehman from A and sells identical credit insurance to C. Note that B's book is balanced and it has no net exposure to Lehman. A and C are also balanced with zero net exposure as is the set of firms (A, B, & C) involved.

    Is this set of financial institutions safe? Not all. Imagine that Lehman fails and A has insufficient resources to cover the losses on Lehman bonds. B's book is now highly imbalanced and it may not be able to honor its contract with C. As you see, every firm is vulnerable even though B had a net zero CDS position in Lehman and the system as a whole had a net zero position. In real life, it appears that the bankruptcy of Lehman endangered AIG. If AIG had failed (and it still might), apparently PIMCO would have failed.

    2. Normal insurance is written on assets that are not systematically correlated. For example, in any given year a few homes burn down in the U.S. However, home fires are somewhat randomly distributed and the premiums collected from the many (that don't burn) can cover the costs associated with the few that do burn. In theory, CDS could work this way. However, that would require that bond defaults be uncorrelated with each other in any way. As you know, bond defaults are highly correlated. What this means is CDS contracts will cost the sellers, the most money, when they (the sellers) are likely to be under the greatest financial stress. This is a formula for deep instability both in theory and in real life (now).,

    Can these problems be addressed? Yes, but the solutions are not easy. Several parties have suggested moving all CDS to an exchange where the exchange would be the counterparty for all trades. This would resolve the A defaulting, bringing down B, and in turn C risk. However, the exchange might need vast resources to guarantee that all contracts could be honored in an emergency. This is a consequence of the systematic (correlated) risk of bond default.

    Typically, exchanges and brokers protect themselves by demanding margin from commodity or stock traders. The amount of margin is variable and should be sufficient to protect the broker or exchange from any trader not being able to meet his obligations. By contrast, the current CDS market apparently lets financial institutions use their credit ratings as a substitute. Supposedly, AIG was able to sell hundreds of billions in CDS without posting any margin at all because of AIG's AAA credit rating (sic transit gloria).

    Clearly, this is a formula for ruin. Firms such as AIG will be called upon to put up more collateral at the very point where they have the least (or none) to spare. Indeed, I saw one estimate that AIG needed to post $320 billion in collateral for its CDS positions just before it got the $85 billion bailout.

    These problems could be resolved by requiring CDS sellers to post substantial margin in all cases, irrespective of their current credit rating. How much collateral? I would suggest 100%. Why 100%? Because anything less leaves the CDS potentially exposed to counterparty failure in case of a debt default. I appreciate that 100% is high and perhaps a better formula can be devised.

    Note that the collateral posted for a CDS could take the form of a treasury or some other zero risk interest bearing asset. The CDS seller would continue to receive interest from the treasury for the duration of the CDS. With this structure, holders of treasuries could write CDS against their holdings as a means of obtaining a higher yield (with a consequent increase in risk).

    In summation, a combination of moving CDS from the OTC market to an exchange and mandating adequate collateral in all cases could stabilize the CDS market. However, these steps are likely to make CDS less attractive for buyers (higher prices) and sellers (collateral requirements). Given that the alternative is a system that puts the entire financial system at risk (by making almost everyone "too big to fail"), I would urge these changes be adopted.

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