Karl's call for regulation has some merit but for the wrong reasons. Insurance companies, in their stupidity assuming that markets would never crash, overwrote CDS, in other words took on abnormal synthetic bond long positions. The reason where AIG is now is because of this lack of foresight for six sigma events. And of course as they sold protection prudent buyers would take the other side of the trade expecting a credit market blow up of historical proportions at abnormally cheap levels (the reason Hayman Capital made millions shorting subprime is because the cost of carry on CDS for lower tranched ABX trades was so low thanks to idiots like AIG.) As such the only regulation should have been of insurance companies who were following Buffett's example believing that annuity derivatives would always cover their cost on short-term blow ups. If you want to blame someone, blame the Oracle of Omaha.
But back to the original point: the interplay of freely traded securities is actually a benefit: credit traders provide a perspective on company valuations (focusing on covenants, maturity rolls, leverage, and other more arcane and trivial from an equity point of view concepts) which equity traders and analysts often have missed. Curbing the CDS model artificially would simply prevent shorting credit, thereby leaving the only downside expression via shorting stocks. And as the "short stock" ban recently showed, these kinds of interventions only lead to utter chaos from price discovery opacity. Regardless, I present Karl's reading here as it is thought provoking and has some nice visuals.
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I buy a CDS on GE (a few weeks ago) for a couple hundred basis points ($200,000 per $10 million) The SELLER of that CDS protects against possibly having to pay by shorting whatever he can against that short credit position. This means he buys PUTs, he shorts the common, he does whatever he needs to in order to lay off that risk. He does this because if GE goes bankrupt their stock would presumably go to zero; therefore, if he has a potential $10 million
exposure on the CDS he will short $10 million face value of the common stock, or buy enough PUTs to pay him $10 million if the stock goes to zero.
The PUT writer (assuming he buys PUTs), being a market-maker, will in turn short the common to lay off the risk as well.
This hammers the stock price which then reflects into the pricing models for the CDS, driving them higher.
This cycle repeats; unfortunately credit rating models include market cap as one of their inputs, which causes a credit downgrade (eventually.)
That in turn adds more pressure.
This cycle is repeated until the company is destroyed.
Why is this not a problem with options and straight short sales?
Because with both straight short sales and PUT purchases the short side is required to post margin every night, and if the price goes the wrong way they get an immediate margin call and are required to buy that position back at a loss. That in turn puts pressure UPWARDS on share price and arrests the slide.
As such the people selling short (whether stock or listed options) do not dare short in unlimited amounts, because if they get caught on the wrong side of a squeeze they are dead.
The enforcement of risk against the people betting on a bankruptcy through regulated instruments puts a natural limit on their activity and prevents an unwarranted "death spiral".
But in the CDS world there is no mark-to-market margin supervision, because there is no central counterparty supervising exposure and demanding it.
As a consequence it is only the counterparty and the written document that can demand collateral posting and usually that is either on an infrequent schedule (monthly, quarterly, annually or on an "event") or in some cases not at all provided the writer maintains some specific credit rating criteria themselves!
Without nightly margin supervision on CDS short positions these vehicles have turned into the means to launch monstrous focused attacks on specific companies; the buyer has limited risk and virtually unlimited reward.
This is exactly like me buying fire insurance on your house, and in addition I can name the amount of insurance I want to buy, even exceeding the house's value!
How nervous will you get if I buy $10 million in "fire insurance" against your $100,000 bungalow and then start stacking up gasoline cans in my driveway?
As a direct and proximate cause of this ability to distort the market it becomes possible to create self-fulfilling prophecies almost on demand, with the people doing it profiting handsomely - at the expense of American workers and otherwise-sound companies.
This form of exploitation of the market must stop.
As I have repeatedly noted "The Bezzle" will be removed from our financial system one way or another. The problem with what we're doing now - refusing to address this issue - means that we will see companies dismantled one-by-one using this "tool" until huge parts of our corporate structure are laid waste, whether they deserve it or not.
Had CDS been "common" during the 2000-03 tech wreck Cisco and many other sound firms (Amazon anyone?) would not now exist as a public company as they would have been driven to zero by this very same vehicle.
President Obama: You can stop this with the stroke of a pen. Issue an executive order today that says: "Naked", that is, CDS that are not insuring an actual bond, which are not traded on a public exchange with nightly margin supervision, are uncollectable as contrary to the public interest.ALL CDS, covering a bond or not, are uncollectable six months hence unless they are traded on a public exchange with nightly margin supervision. This will force all CDS onto a public exchange and stop OTC dealing in these instruments. It will stop dead the writing of these instruments without the capital behind them to pay. It will stop the speculative attacks right now, resolve most of the AIG issue immediately, and within six months put a stop to all abuse of the CDS marketplace.
If President Obama fails to do this imminently we may not have a functioning capital market for long enough for Congress to act and put these provisions into a statute.
The CDS monster must be stopped NOW.
Yes, I know the ISDA's members and some others would likely sue the government immediately claiming a "taking". Nonsense; this executive order would only delay collection until the contract is posted to a public exchange and both sides net against the central counterparty, not prevent collection, provided the writer is solvent.
If the writer is not solvent then the money isn't there to pay in the first place and the arguing over "takings" is academic since the agreed actions in the contract cannot be performed.
A contract to do an impossible thing is not a contract.
Let 'em sue - doing so will force discovery of the solvency of the writer of these contracts along with the identification of exactly who owes who what. THAT isn't something that the "market participants" want out in the public, is it?
The insanity must stop now before the capital markets literally consume themselves, destroying not only the guilty firms but those that are otherwise solvent and able to operate through these rough economic times.
If you're looking for a scenario where the shotguns could come out if the CDS insanity is not stopped that's one of the ways it can happen.