Greek CDS and the New House Rules: Get Over It

"Derivatives shift wealth opportunistically. The theory behind them is to stabilize risk in volatile markets by providing a means to rectify a portion of the losses incurred in less liquid activities. However, every transaction produces a winner and a loser. In other words, 50% of market activity results in a realized loss to one party. Thus derivatives enable smarter firms with deeper talent pools to exploit lesser players. Herein lies the flaw for the financial industry. While volatility is stabilized for a few, the net effect on the system is that the losses are merely passed to the dumbest player at the table."

"Complex Structured Assets: Feds Propose New House Rules"
The Institutional Risk Analyst
May 24, 2004

I decided not to say much about credit default swaps or CDS over the last little while.  The reason was that the "reforms" in Dodd-Frank seems to have disturbed the collusive equilibrium between the exchanges and the large dealer banks enough for the former to finally go after the lunch of the latter. This had to happen.  Now the fact of MF Global seems to have reminded all in Chicago who is the real enemy.

The large banks led by JPM are effective acting as mini-exchanges for CDS, but with paltry disclosure and transparency and often equally poor risk management.  There is no collective oversight of exposure by the dealers in the fantasy world of OTC CDS, only opaque bilateral relationships that allow counterparties to create and hide risk from other dealers as well as regulators. 

This deliberate dysfunction in the government oversight of OTC dealers is the legacy of Gerry Corrigan, who shut down dealer surveillance at the FRBNY in 1993 before leaving in a swirl of personal scandal to join his clients at Goldman Sachs. Later Corrigan spawned the "Counterparty Risk Management Group" so that the large dealer banks could continue to obfuscate on and delay any true reform of the OTC derivative ghetto. Today, the only people in the market with a partial view are at DTCC, but even this dataset is incomplete and, by design, inconsistent in terms of the data structure.   

The Greek situation, however, has focused everyone on the basic unfairness of the OTC market model.  A private group called ISDA, which is dominated by the big banks, is the supposed standards setting body for a marketplace measured in the trillions of dollars.  This body has no set rules for judging when a default occurs, but instead uses a set of guidelines to direct a case-by-case assessment of default events.

Because of the changes in the ISDA rules post-Delphi that allow for cash settlement of CDS and other OTC derivatives, it is possible to create exposures that are orders of magnitudes larger than the cash basis -- if there is a cash basis for the contract.  The ratio of open positions to actual debt in the Delphi default was about 40:1.  In those days, holders of CDS had to deliver the underlying debt to get paid on the insurance.  In the case of today's CDS, there is no effective limit to the ability of counterparties to create long or short exposures in most corporate or soveriegn names.

The first question to ask is whether it is reasonable for market participants to be surprised by the decision taken by ISDA saying that the Greek restructuring is not a default event.  Given that this market is run by and for the dealer banks, why should any of the merry gamesters trading these cash settlement derivatives be surprised?  My friend Barry Ritholtz, for example, expressed the general sentiment -- "bullshit" -- in a fine post yesterday.  Bruce Krasting captured same in a review of the more notable yowling over the Greek CDS decision by ISDA: <…;

But why are we all surprised? 

The second, more basic question is whether it is reasonable for market participants to be surprised by the Greek outcome given the political stakes.  A greek default will probably push some of the other EU perifery states into default as well.  We already saw the EU suspend short-selling on the banks in the Eurozone.  This is just the latest step by Angela Merkel to pull up the drawbridge on Fortress Germania.

But the third and most important issue involving CDS generally is why anybody with their head screwed on tight would be surprised to see the house changing the rules on CDS in the middle of the proverbial game.  Just as casinos can now change the look, feel and odds of most slot machines on the fly and in real time via the Internet, the dealers in the world of CDS are constantly changing the contractual template, legal rules and custodian arrangement to give the house maximum advantage. 

Again in this regard, re-read the ZH post from last week on MF Global, "Where's the Cash."  <;

And what is the lesson from MF Global?  That the lawyers and lobbyists for the large banks have rigged the legal game in favor of the OTC markets and the large dealers to allow them to steal customer funds in individual accounts from a broker-dealer with impunity.  The age of financial repression turns investors into chattel.  Why are market participants so surprised that the large bank lackeys at ISDA are now enabling the banks to welch on these supposed credit default insurance "contracts?"

Some of you may recall that Tim Geithner and the Wall Street CEOs made a great fuss over the sanctity of OTC derivatives contracts during the failure of Lehman Brothers, Bear, Stearns and American International Group.  At the time of these failures, we were told that a restructuring was "impossible" because of the potential for systemic contagion if a market resolution occurred. Today, however, Tim Geithner and his clients in the large Wall Street banks prey upon investors like the creatures in the film Jurassic Park.

So please do be angry at the developments with respect to MF Global and Greece, but please do not tell me that you are surprised by any of this. The cash settlement world of OTC derivatives is not investing, but gaming.  And the House sets the rules.