Santelli On CDS Regulation And Why Bank Analysts Failed

Tyler Durden's picture

It would seem, just as during the crisis in 2008/9, that now might be an opportune time to push for 'improvement' in how banks are regulated (and more importantly how the instruments they trade in colossal size are priced and marked-to-market). Rick Santelli believes now has never been a better time but as his guest Tim Backshall of Capital Context notes, regulation of the CDS market can be summed up in one sentence "Get Them On Exchange". Something we have been saying for years (and has been tried before) but with dealers holding all the keys (to market-making) and exchanges cowering for fear of losing clients, we remain less optimistic. Santelli and Backshall critically address the complicity of banks, regulators, analysts, and The Fed in giving 'banks the benefit of the doubt' with regard their use of the bottomless pit of capital they implicitly have but what is more important is for the hordes of sell-side analysts and buy-side sheeple to understand just what this JPM debacle exposes about bank risk (VaR is useless), bank transparency (mark-to-model or worse is widespread), and bank valuation (traditional Price/Book metrics have no merit anymore).



Tim sent over some notes from the call (note they are notes and not clear prose)...

Margin/Collateral – CDS is margined but generally large lines of credit will cover a ton of sins. The problem with these positions is that they are more complex and mark-to-model – so until one side really presses for some margin or collateral – there is no real reckoning – I suspect that is what recently happened.
Regulatory change is simple – exchange trade CDS (some details here on the more complex markets and inability to exchange trade but the largest segment of the CDS market could be on exchange in weeks – it already trades electronically with a number of dealers).

Credit markets have been far less excited about JPM and the big US banks for a couple of months now – post stress tests – equities seemed to believe the hype and momentum did the rest but CDS on JPM, MS, BAC etc did very little and in fact started to deteriorate – JPM at one point was over $5 expensive in stock relative to where its credit market price suggested – today has brought that gap back to zero.

Main lesson from JPM fiasco: banks, regulators and Fed are all complicit in their belief in the ‘benefit of the doubt’ that JPM would not use its risk models in vain – or more simply not take advantage of a bottomless pit of capital to press positions that would otherwise seem untenable.

VaR - since JPM admitted its VaR is meaningless, how long until MS, GS and BAC admit theirs too – VaR simply does not give any useful information on positions that are so levered and non-linear as these tranche positions – things get worse in a hurry.

CDS market in general should be on exchange – at a minimum the major credit indices – only thing holding it back is dealers who make the markets and exchanges who are afraid to upset the dealers.

Synthetic CDO market is likely to be dead now. The whole market is premised on illiquidity and mark to model unrealities that at times mean both sides of a trade can be winners (or losers). I suspect this is what happened here – the other side of the trade Iksil had on started to press their position and forced JPM to realize a mark to market change.

Noone knows how big the hole is – today was worst day in IG9 10Y (the credit index that hinged a lot of the position for JPM) in 6 months. And at $200mm DV01 – this could have been a $1-2bn more loss for JPM – the position is too big to unwind (we know that from the changes in net notionals that DTCC provide) and so they will have to hedge their ‘hedge’ somehow – or face a hedge fund community who smells blood – as it clearly did today. The losses could be huge if we merely get back to pre-LTRO levels of risk

Analysts like Dick Bove who come on and push long positions in banks on the back of earnings, or balance sheet dissection are simply out of their minds – this episode (as we have always known) clearly shows that banks income and balance sheets remain (especially for the biggest banks) opaque at best and manipulated at worst as mark to model, Level 3 assets, and prop trades hidden under the auspice of hedges can flare at any time (ask Boaz Weinstein at Deutsche Bank).

Price to book is irrelevant as an indicator since the book has no value because so little of the real assets are marked to market (or even near) – hence the market discounts them

Also – chatter over gross and net positions in CDS (which we heard so much about from Morgan Stanley) are irrelevant as there is no transparency on the haircut on ‘netting’ means we have no way of knowing how ‘netted’ they are

Bottom line is that anyone estimating an EPS impact of this trade has no idea realistically, there are some huge positions that will run off into year-end (but ithers that remain considerably longer-dated - IG9 10Y) or be hedged and we suspect will create significant gaps (up or down) in various credit markets – but certainly less liquidity and more volatility, and if there was ever a time for regulators/market participants to press for exchange trading of CDS, it is now (though this more complex JPM position would be largely untenable on exchange – and perhaps therein lies the problem)

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Sircornflakes's picture

Santelli is great....then again, with hindsight, so is everybody.

ihedgemyhedges's picture


Funny, Brooksley Born said the same thing in the 90s and Greenspan/Rubin shot that down like a wounded duck trying to get away from 8 hunters unloading on it at 10 feet high......................

5880's picture

Floor option Market Makers have been saying this since Clinton changed the rules

We loved when the street would have us quote a Flex option

Gully Foyle's picture

"Main lesson from JPM fiasco: banks, regulators and Fed are all complicit in their belief in the ‘benefit of the doubt’ that JPM would not use its risk models in vain – or more simply not take advantage of a bottomless pit of capital to press positions that would otherwise seem untenable."


I'm confused. It strikes me that this JPM money was Corzined. Wasn't the rumor that the money from MF Global went to JPM? Now roughly the same amount is lost by JPM.

Yet no one seems to be making a link.


The final $680 million or so was transferred to other financial institutions with which MF Global did business, including a substantial portion that went to JPMorgan.

Mountainview's picture

How long will they let him do it???

AlaricBalth's picture

Firms such as JPMorgan carry a portion of its assets and liabilities at fair value. The majority of such assets and liabilities are measured at fair value on a recurring basis. Certain assets and liabilities are measured at fair value on a nonrecurring basis, including loans accounted for at the lower of cost or fair value that are only subject to fair value adjustments under certain circumstances. Under U.S. GAAP there is a three-level valuation hierarchy for disclosure of fair value measurements. An instrument’s categorization within the hierarchy is based on the lowest level of input that is significant to the fair value measurement. Therefore, for instruments classified in levels 1 and 2 of the hierarchy, where inputs are principally based on observable market data, there is less judgment applied in arriving at a fair value measurement. For instruments classified within level 3 of the hierarchy,which is the classification for all CDS contracts, judgments are more significant. The firm reviews and updates the fair value hierarchy classifications on a quarterly basis. Changes from one quarter to the next related to the observability of inputs to a fair value measurement may result in a reclassification between hierarchy levels.

For instruments classified within level 3 of the hierarchy, judgments used to estimate fair value may be significant. In arriving at an estimate of fair value for an instrument within level 3, management must first determine the appropriate model to use. Second, due to the lack of observability of significant inputs, management must assess all relevant empirical data in deriving valuation inputs – including, but not limited to, transaction details, yield curves, interest rates, volatilities, equity or debt prices, valuations of comparable instruments, foreign exchange rates and credit curves. Finally, management judgment must be applied to assess the appropriate level of valuation adjustments to reflect counterparty credit quality, the firm’s creditworthiness, constraints on liquidity and unobservable parameters, where relevant. The judgments made are typically affected by the type of product and its specific contractual terms, and the level of liquidity for the product or within the market as a whole.

To summarize...the firms are guessing at the valuations. Linear scientific structures, such as valuations models, face severe limitations when applied to complex adaptive financial systems due to the fact that the human behavioral component cannot be measured.

skepticCarl's picture

Alaric, you put this audience to sleep with facts and analysis.  Give us profanity, rudeness, and the usual cliches, and you'll get more +'s.

AlaricBalth's picture

Fuck me...we are fucked. It's all a Ponzi!!! So fuck off!!

(Is that better?)

GeneMarchbanks's picture

+1 for this one, the previous one I did not care for.

rocker's picture

I thought both were great. A honest discussion first. 

Then a frustrated with the sytem second.

All in all Santelli proves that he too is another asshole defending the banking system.

Saying, don't look between my sheets.

Xkwisetly Paneful's picture

They're not guessing they are using the most favorable valuation to them available  under the current law.

The solution is not more unaccountable regulators, regulations and even more mountainous reserves basically insuring a smaller and smaller cartel moving forward.  Just like with the health insurance they have successfully perverted governance into the promotion of their own lot in life, stifling competition and using all means within the government to promote their own prosperity. More of the same is not the solution.

Xkwisetly Paneful's picture

BTW huge LOL at the last sentence.

Surely anyone who can drown the audience in the tedium of the vernacular knows that reasonable estimations are possible.  Reasonable, not have no fucking clue, pin the tail on the donkey how can I generate max leverage and enrich myself, maybe call in 20 disconnected physicists and another half dozen never right Ivy league educated economists and go from there estimate.

GeneMarchbanks's picture

Tracey Jordan: Dr. Spacemen, when they check my DNA, will it tell me what diseases I might get, or help me to remember my ATM PIN code?
Dr Leo Spaceman: Absolutely. Science is whatever we want it to be.

palmereldritch's picture

  We have no idea where the heart's different in every patient.

AlaricBalth's picture

Reasonable estimations work relatively well under a normative distribution scenario, however the incidence of fat-tailed distributions has become more prevalent due to numerous reasons, ie. FRB ZIRP and massaged economic data, which makes historical comparisons within valuation models moot. David Li's now discredited "Copula Function" in relation to the mortgage CDO market proved that these models work fine, until they don't. And then things go to hell damn quickly.  

blunderdog's picture

I haven't quite perfected my model to assign every day of history a numeric value representing its relative historical significance yet, either.

Yesterday was a 531, today was a 724.  If I had to guess, I'd think tomorrow is likely to be in the low 200's.

XP?  Any suggestions?

Xkwisetly Paneful's picture

Given most instances, even an idiot like you can come up with a range  that is close enough.

the guy with the most skin in the game will either have grasp of all potential outcomes or won't have the most skin in the game for long.

the notion that valuations are so complex a reasonable estimate can't be ascertained is ludicrous.



blunderdog's picture

I do believe you've just explained why the system is guaranteed to fail.

Xkwisetly Paneful's picture

Sure, and the reason there is so much latitude under the law is because it is rocket surgery, brain science like has nothing at all to do with using the most favorable valuations possible.

and of course using the most favorable valuations possible has nothing to do with any kind of failure.

No it is because any idiot thinks he can evaluate something and can't-I read it on

palmereldritch's picture

We have no idea where the brain's different in every patient.

blunderdog's picture

My comprehension of garbled prose is usually pretty good--I briefly did research on aphasics' speech-samples back in college--but you've got a subtle mastery, sir.

HungrySeagull's picture

In other words, no Business School or training needed. Just a colored keyboard with extra large keys.

smb12321's picture

I'm afraid I'm forced to give you a "down" arrow.  Not only did you not use "bitchez" or "sheeple" multiple times you also did not suggest we hang all financial officers, move to the woods and live like serfs or attribute the troubles to a conspiracy.  How dare you try to speak intelligently and cogently on the subject at hand?

Awesome post!  The whole purpose of capitalism / market economy is determining value (the real reason socialism always fails).  Troubles ALWAYS pop up when manipulated values replace real value and nowhere is this more apparent than in "investment banking". 

veyron's picture

Video was taken down?


I get an Error code 502 and it says "The video you are trying to access is no longer available"

jay28elle's picture

me, too.

Gotta silence the critics?


edited...  it's back.  nevermind.

The Swedish Chef's picture

"The video you are trying to access is no longer available."

sabra1's picture

"The money you are trying to access is no longer available."

francis_sawyer's picture

the reality is... there IS no money...

RobD's picture

True, my niece works at a Chase bank branch and they keep less then 20k in the safe. Funny as hell, has a big walk in safe and there is nothing in it lol.

palmereldritch's picture

Ironic considering the amount of 'printing' the FED does...can't print the phyzzz tho

cbxer55's picture

I just watched in its entirety. Must be your location.

pan's picture

So where is Blythe in all of this?  What is she doing to keep her job these days?

Freewheelin Franklin's picture

Where is Blythe? She's in the JPM vaults covered in chocolate pudding, whipped cream and maraschino cherries....or is that loose, runny feces, semen, and aborted fetuses?

hedgeless_horseman's picture



What does Rick have against unicorns?

scatterbrains's picture

"bank transparency (mark-to-model or worse is widespread), and bank valuation (traditional Price/Book metrics have no merit anymore"

Well that's not really important anyway so long as the giant fire hose connecting tax payers lips to Jamie Dimon's ass doesn't get disconnected.


Garristotle's picture

How long before Santelli finally snaps and chokes out someone on the trading floor? He is literally buried alive under tons of hopium every day.

5880's picture

He is probably 5'5", too short to choke anyone down there

He had a COM seat but used brokers to trade 30y Treasury options

too short

Sechel's picture

Dodd makes sense, but regulators will always be gamed or captured. That is why we need to limit gov't insurance to only those banking activities the greater economy benefits from. Banks can't have it both ways(rewards without the risk). why not bring back double liability stock and force banks to issue subordinated debt to fund themselves instead of via the Fed and FDIC insurance.

Zero Govt's picture

Dodd does not make sense, it is a sham

Dodd didn't even address leverage ..none of the 350 plus useless worthless corrupt crones (regulators) in the world have dealt with leverage ..nor has a single politician

Regulation, like the Law, does not work and will never work. Period.

narnia's picture

The truth is, as long as we have government agencies that feel the need to spend $6.5 trillion and growing annually on a bunch of involuntary purchases, they need a 10% or lower fractional reserve standard with 0% capital requirements on government guaranteed instruments.

Once this behemoth of credit is allowed- or i would even say required- to exist, it's a nuclear stockpile next to a nuclear power plant on a fault line.    

SheepDog-One's picture

Thats ok another qualude and the muppets gonna love the analysts again on the next 'stress test'!

Zero Govt's picture

How would putting CDS's on an exchange clear anything up?

Please in less than a thousand words try to explain given we already have toxic piles of crap quoted on the stock markets (think all the banks in Europe and America) 

people keep thinking the solution to rotten problems is to regulate it

...when the problem is rotten people

regulation does not work (has never worked, will never work) because the regulators are rotten (have a price)

the free market (no rules whatsoever) solves rotten problems by them going to the wall.. all other solutions are a sham ...let's improve our problem solving around here for fucks sake, the debate is just pathetic with non-stop meddlers thinking they have the answer

5880's picture

switching from unknown and unregulated risk to known

options were OTC until the CBOE. CDS and CDOs and swaps brought them back to OTC. A world where you can rip a clients face off and nobody knows for a very long time

you want a world where they make horrible spreads, with commissions, and then run to the market to hedge AFTER it all goes terribly wrong? That was 08

Zero Govt's picture

a number of people are making a point putting CDS's etc on an exchange will clear up the industry... absolute bollocks

we currently have every bank in Europe and the Big 5 in the US quoted on (regulated by the truckload) stock exchanges and their books are cooked as bad as Enrons. So if their bankrupt books can be made to look fine and dandy what makes anyone in their right mnd think it'll clear up the CDS market????

the solution to frauds selling garbage products is for consumers to wise up (Buyer Beware)

there is no rule based solution to any problem... regulators have failed, the stock exchanges have failed, accountancy and auditing has failed, the Law and Judicial system is a failure, Govt is a tragic rotten farce

...only the free market (works) which means taking some pain sometimes as garbage or fraud is discovered


Apocalicious's picture

See, breaking up the big banks fixes everything, though, without new regulation. Make them all systemically less important, but if they can't collude and hold the exchanges hostages, threatening to pull all their business if the exchanges list standardized CDS products - cartel over, exchanges would have listed products overnight. CME or CBOE would have had something up long ago if the five or seven banks who dominate their clientele all weren't holding a knife their throat, saying don't take my off exchange business on exchange and I won't take you on exchange business off. If there are 50 banks instead of 5, that collusion becomes a lot harder to manage...

5880's picture


also, the banks load the exchange committees with their guys

they can't say yes or no until they call NY

they killed so much progression