I’m glad someone is trying to keep his eye on the ball. With serial bailouts artists Paulson and Bernanke working full bore on their showstopper, they’ve somehow managed to overlook the most obvious culprit for a systemic crisis, namely, the credit default swaps market (yes, rescuing AIG was an effort to keep that market from imploding, but that one-off did nothing to address its inherent wobbliness). While creating an exchange for CDS will enable new contracts to be handled with procedures that will help promote greater safety (the biggie being posting of collateral), existing contracts cannot be migrated to an exchange, so that threat will hang over our collective heads until the maturation of existing contracts brings their value down in magnitude.
We’ve written repeatedly about the risks that CDS pose, and other bloggers who have been attuned to the risks are repeating and updating their warnings. From Overhedged:
The plan to buy distressed mortgage related assets and derivative products, referred to by some as TARP (the Troubled Asset Relief Program) and by others as MOAB (the Mother of All Bailouts), may provide some short term relief to the global financial markets, which perhaps will suffice to head off greater disaster. However, putting aside the concerns raised regarding the wisdom and efficacy of the proposal, the larger question remains as to how to mitigate the threat posed by the still-completely-unregulated $62 trillion credit default swap market….
The financial markets may not be so lucky the next time a company whose debt is the subject of over $1 trillion in CDSs goes into default. If, for instance, one of the Big Three automakers were to seek bankruptcy protection, its bonds will almost certainly be worth substantially less than par, and the settlement amounts owed by CDS sellers to CDS buyers could be overwhelming. While most trades will net out, the failure of a financial institution or hedge fund to make good on its obligations as a protection seller could trigger another financial crisis equal in scope or greater to what has been faced over the past two weeks.
It also gives rise to the even more unsettling possibility that the government may be forced to step in and prevent such a major bankruptcy filing. The perils continue. TARP / MOAB [Mother of All Bailouts] may be just the beginning.
From Accrued Interest:
Now, I’ve got no problem with enforcing some basic short-selling rules, but it won’t make a difference until something changes in the credit-default swap (CDS) market.
Let’s stipulate that speculation and manipulation is part of the problem here. Let’s stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.
To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan’s falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.
In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn’t help either. Media reports suggesting that a particular “expected” default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.
So New York State’s move to step into this regulatory vacuum is understandable, but given all the concerns about this market, one wonders why the Federal Reserve, which has been engaged in a regulatory land-grab, hasn’t tried to get this market under its jurisdiction (to at least the extent it could). The problem, as a Bloomberg article outlines, is that the New York effort will be limited to cases in which the contracts are insurance, that is, they hedge a position or exposure. Many investors use CDS to punt or create synthetic bonds, and those uses presumably would not be covered. But the New York move may push the Feds to step to the plate.
The usual suspects, such as the International Swaps Dealers Association, issued predictably dire warnings. It isn’t clear how much of this is well founded and how much is self-serving (the ISDA, like the Securiites Industry Association and the American Securitization Forum, is as much a lobbying group as a standards-setter). But partial regulation is likely not to be effective, as much as progress in this arena is badly needed.
New York State will start regulating a part of the $62 trillion market for credit-default swaps, calling it a culprit in the global financial crisis.
Credit-default swap protection sold to investors who also own the security they’re protecting will be treated as insurance, Governor David Paterson said in a statement today. State insurance regulators would require entities selling credit- default swaps in those cases to show they can actually pay the claims if there is a default.
“The absence of regulatory oversight is the principal cause of the Wall Street meltdown we are currently witnessing,” Paterson said in the statement. “I urge the federal government to follow New York’s lead once again by regulating the rest of the credit-default swap market.”…..
The state’s actions wouldn’t apply to contracts where an investor buying credit-default swap protection doesn’t own the underlying security….
The state action “threatens to disrupt global derivatives markets,” said Robert Pickel, chief executive officer of the International Swaps and Derivatives Association, an industry group that represents dealers and investors in the market and sets standards for trading.
“The state of New York should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good,” Pickel said in a statement…..
Insurance companies, which are prohibited from entering into derivative transactions directly, created special purpose vehicles to sell protection using the swap market. These SPVs were minimally capitalized because their obligations in the event of a security defaulting were guaranteed by the insurance company.
Yet, credit-default swap contracts sometimes require protection writers to make payments unrelated to defaults, such as providing collateral against a contract in the event an insurer is downgraded or is taken over by regulators….
“We are concerned that this plan has not been well thought through,” Tim Backshall, chief strategist at Credit Derivatives Research LLC, said in a note to clients today. “These ad hoc actions are more likely to cause further dislocation than help any realignment and normalcy.”
The new guidelines will become effective in January, Patterson said.
“Theoretically, it could decrease liquidity and increase protection costs for people who are looking to use it as a hedge,” said Brian Yelvington, a strategist at independent bond- research firm CreditSights Inc. in New York. “It doesn’t seem to be the solution to the problem at hand. A nationally regulated exchange would seem to be a better fit for the market.”