By George Washington of Washington’s Blog.
Preface: CDS traders, read the note at the end…
Tomorrow, the House Committee on Financial Services will be talking about regulating about 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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I followed your link to here:
http://www.house.gov/apps/list/press/financialsvcs_dem/otc_draft.pdf
The draft is 187 pages. It is in the typical unreadable format which references insertions and deletions without giving the initial and proposed texts.
It is mostly the stuff we already know about in terms of exchanges, types of swap to be traded, reporting requirements, etc.
It sets margins to reflect “normal” business conditions so no defense against a general downturn.
Collateral put up is to be segregated but can be composed of non-cash assets which given the current mark to fantasy is really pretty dubious.
I thought the references to the “price discovery function of swaps” were funny considering how swaps mostly destroy that function.
GW is right that this is mostly about the big banks. These will be exchanges where the big banks will be the buyers and the sellers, they will sit on the boards of the exchanges, and like with the ICE as far as I could see they will be able to continue to own them.
There will be a Prudential Regulator that may or may not oversee the exchanges and their functioning. It sort of reminds me of the fact that you can have all the regulators and regulations in the world but if they are not applied, they don’t mean a thing.
There is an repeal of some or all of Gramm-Leach-Bliley and a return to the Security Exchange Act of 1934. This is what you would expect for a bill like this.
Interestingly, the exemption from state gambling and bucket laws was not. Swaps through foreign exchanges remain enforceable contracts. I searched the text for naked swaps, or even credit default swaps, and found no mention of them. They might be there under a different name, but I didn’t see them.
All in all this is BS legislation. The fundamental question about whether swaps, especially CDSs, naked or not, should even exist is unaddressed. That exchanges can possibly control the risk inherent in swaps likewise is not reflected in this draft. As we have seen, when we do not have “normal” conditions, swaps blow up. That remains the case. I see this all as an exercise in political and regulatory capture. But as soon as the name Barney Frank came up I expect we all knew that.
A suggestion (from a non-trader and non-specialist): Legislate that CDSs don’t pay off until the original due date of the underlying debt. Acceleration clauses in the underlying debt contract would be ignored and such clauses would be banned in the derivative contract.
With this provision in place, derivatives would be much less likely to cause liquidity crises since defaults would not trigger any immediate need for cash to cover CDSs.
It may even be possible to apply this rule to currently outstanding contracts, without hitting constitutional roadblocks.
Hugh said “The fundamental question about whether swaps, especially CDSs, naked or not, should even exist is unaddressed. That exchanges can possibly control the risk inherent in swaps likewise is not reflected in this draft. As we have seen, when we do not have “normal” conditions, swaps blow up.”
Tend to agree with your point. It seems to me that markets fail to predict the future more often than not (how did the tech bubble expand but that people thought tech stocks would grow forever, a logical impossibility). So it seems odd to have another financial instrument that is rather opaque to most people, who cannot discern the true impact. How many CEO’s said that nobody foresaw the subprime fiasco (never mind that many did, but the BANKERS did not…whether purposefully or not, the outcome is the same – disaster)
“Hugh”
By the way, thanks for reading through the bill and giving your analysis.
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