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Questions for Gary Gensler and Henry Hu
Preface: CDS traders, read the note at the end...
Tomorrow, the House Committee on Financial Services will be talking about regulating over the counter derivatives. Committee Chair Barney Frank has already circulated a draft of the proposed legislation.
The
star witnesses are Commodities Futures Trading Commission chairman Gary
Gensler and Henry Hu, who is the Director, Division of Risk, Strategy,
and Financial Innovation, U.S. Securities and Exchange Commission.
I urge members of the Committee to ask the following question (you're welcome to hand this out to the witnesses):
Nobel prize-winning economist
Myron Scholes - who developed much of the pricing structure used in CDS
- said that existing over-the-counter CDS were so dangerous that they
should be “blown up or burned”, and we should start fresh.
A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown.
U.S. Congresswoman Maxine Waters
introduced a bill in July that tried to ban credit-default swaps
because she said they permitted speculation responsible for bringing
the financial system to its knees
Nassim Nicholas Taleb said
this month, "To curb volatility in financial markets some financial
products 'should not trade,' including complex derivatives."
Warren Buffett’s sidekick Charles T. Munger,
has called the prohibition of CDS the best solution, and said “it isn’t
as though the economic world didn’t function quite well without it, and
it isn’t as though what has happened has been so wonderfully desirable
that we should logically want more of it”
George Soros
says the market is still unsafe, and that credit- default swaps are
“toxic” and “a very dangerous derivative” because it’s easier and
potentially more profitable for investors to bet against companies
using them than through so-called short sales
Satyajit Das, a
leading credit default swap expert - the commonly-accepted figures for
the CDS losses suffered due to Lehman's bankruptcy have been understated. He also says that the justifications for the value of CDS for the economy are phony.
In addition, the proposed regulations of CDS won't really fix the problem, because they will only cover "standard" derivatives contracts, not the slew of "creative" contracts.
Indeed, Das says that the new credit default swap regulations not only won't help stabilize the economy, they might actually help to destabilize it.
The overwhelming majority of derivatives contracts are held by just 5 banks. So are we really basing our entire strategy on CDS on protecting those 5 banks?
Credit default swap counterparties drive company after company into bankruptcy, and - once a company the counterparties are betting against goes bankrupt - the counterparties cut in line in front of all of the bankruptcy creditors to get paid (and see this).
Given
the above, why shouldn't we ban or heavily tax over-the-counter credit
default swaps, at least where the CDS buyers isn't itself the
referenced entity?
For background, see this.
Note to current or former CDS traders: I'm not against CDS, but I think they need to be reigned in.
And I don't think Congress really understands CDS or their effect on the economy.
If any traders know how CDS can be reigned in without reducing the size of the CDS market, I'm all ears.
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Actually why stop there.
CDS starts life as a regulatory arbitrage tool in the late 90s. Some point in early "noughties" we start to see the tail wagging the dog. The first defaults where the outstanding cash debt is less then the derivative product, on which there is suppose to be some call so the participants can work out fair value in the unwind.
(All the time by the way, the loan departments have forgotten about that chinese wall thing, because in practical terms, firmwide credit lines means that you get the inside on a credit the firm has extended or transacted on aloan with)
The we start to see the really exciting stuff: Enron, Jedi, Jabbawooky structured products, stupid packaging and more non sense. Embedded options into structures that end clients dont know about, allowing seller/trader to tweak vol to dial in his bonus. More mismatching of risks, misunderstanding of novation, poor documentation and anyway, who cares. Everyone is too busy making more money then they have time to count.
Not wishing to underplay things, more dysfunctional idiots start to think that abstract mathematical formulae can represent all the nuances of the world. So as a consequence we start to see crazy-assed structures like CDOs and CBOs and (why its always 3 letters), before excelling themselves with SIV lite structures. Thats like one of those Star Wars defense contracts, promising so much in the future that the disappointment of nothing, is almost a pleasure.
Once upon a time you could argue that CDS with its speed and flexibility gave you price transparency, but then we had the last 2years where banks such as JPM and GS think nothing of using CDS positions to extract collateral from likes of Bear Stearns or AIG to worsen their target trade positions own financial wellbeing to breaking point, thereby conveniently triggering a default close of (any) sorts.
(truth to be told of course that AIG started under the wonderfully greased back, stick-man-like Hank Greenberg. An insurer of impeccable track record, then became the insurer of everything and banked the revenue stream designed for that rainy day event instead of some even polite form of hedging)
Not content with that, in a period where they have received staggering bail out support from tax-payers, the same banks make sure they are paid whole(highly unusual for a CDS unwind, after all what happened top the typical auction process to establish the residual value), and then(and this is really funny) become advisers to AIG helping them unwind their positions, in the process seeing their book(A la LTCM) and showing the widest bid-offer spreads in market history(oh,forgot because SEC has no terminals they dont know anything about historical spreads in CDS).
The greed and myopia just dont seem to end, and the brief period of reflection/rehab has only galvanised the survivors in to more no value crap(HFT, Flash etc) and shouting claims for pre-crisis paydays, for averting a global meltdown.
Like the child who burns down the lounge, their hands blisteredt from not following advice,exclaiming how good it was the house wasn't turned to a pile of ashes and good they go to Hagen-Dazs now.
Dear George Washington and Zero Hedge, up on Capitol Hill they haven't seen the internet yet. Try faxing them your quotes, then you know its reached them physically. And of course make sure there are no traces back to ZH HQ or anyone else for that matter.
Awesome string of quotes
Goldman has CDS on CIT. Who rated them, who sold them. Hopefully this isn't another blatent raid on the taxpayer. No matter who it is there should be no bail out, especially if it is AIG.
Why do we keep calling them banks. They are financial speculators that bought a bank so they could call themselves a bank. Let's not go along with this charade.
There is a really simple cure all....
All securities that are public ....or that affect the
public....will have to trade on a direct access fully electronic securities exchange....
No dark pools.....no internal matching...etc....
First come....first served....
................................................
First off....
Some derivatives are a fraud in that there is no underlying security that has to move in terms of price as to substantiate the price movement in the derivatives....
In other words....if there is no cash underlying...by default the security is fraudulant....and therefore not allowed....
Secondly....the bid ask will tighten on all instruments that are traded on a direct access electronic exchange....
Furthermore margin requirements have to be established on all instruments....
So here it is.....WANT TO SOLVE ALL OF IT ?
Establish a defragmented securities for all asset classes....There will be size requirements based on float....
No uptick rules....SS is limited by float size first come first served by electronic tag....no need for locates....
Margin 4:1 intraday or overnight....All account sizes....
No minimum or maximum account size....
All securities can be transacted for 20 cents per 100 units....no differing amounts will be be allowed for buy/sell costs regardless of size....
All information...fact based...not opinion based....wiki format....
The SEC is abolished and replaced by electronic surveillance
regarding size per account....margin etc...shorts not exceeding float....
Opinions are to be allowed in the non-fact based area....where track records are handily viewed....
No taxes of anykind on any securities for any reason in the name of efficient capital....
To be made available in the language/currency of choice....
.........................................
Then welcome to the Golden Age of Innovation....and
proper wealth distribution by merit....
As we've seen, if Goldman is on one side of a negative basis trade, the taxpayer is on the other. These banks only have $28T notional CDS, how is Blankfein supposed to feed his family on profits in that measly market? Timmy needs to let them jack that to $300T.
The good news is that the Fed is forcing deleveraging. US Banks held $10.5T notional CDS when the trouble started in March 2007. Now they hold $28T. Bernanke has overseen a -3x deleveraging, great job Al, uh, I meant Ben.
"The overwhelming majority of derivatives contracts are held by just 5 banks. So are we really basing our entire strategy on CDS on protecting those 5 banks?"
Of course, JPM is in many respects an extension of the FED.
Non-standard derivatives are being used by the "5" as a form of black mail. Black mail is crime. I expect indictments soon.
You will be waiting a very long time.
Henry Who sucks Chris Cox...
Love Munger's comment. So right on the money.
Doubt banning speculative CDS will do much to harm the real economy (things are bad enough after a decade or so of this "innovation"). On the positive side, there will be a gaggle of 26 year old math geeks who can use their skills for something more than looking up DV01 on the CDSW screen on Bloomberg.
Seems pretty easy to agree with George Akerlof's real point, which is address moral hazard, not ban CDS (which is simply the latest financial innovation to exploit moral hazard).
Aren't there around $100T in outstanding CDS? How can you have something that has greater value than all the money in the world, and still consider it legitimate? I especially agree about the moral hazard.
We've already crossed over into the wholesale abrogation of financial contracts, so why not these, too? I really can't see any reason not to just tear them up, no one is paying any attention to the real financial condition of any major financial institution anyway, why does it matter? Is there more loot to be gathered, businesses to be smashed and grabbed by abrogating these agreements? Has someone calculated that Goldman and JPM will wind up owning an even larger share of the financial system if we tear them up?
Who fucking cares anymore? We're so far from reality that I can't imagine why it would possibly matter to anyone.
/rant