Thursday, January 29, 2009

Banning Naked CDS

Interesting bill being proposed, from bloomberg, I have blogged many times about naked CDS, here, here, here, and here. Finally someone in the house took notice :)

House of Representatives Agriculture Committee Chairman Collin Peterson of Minnesota circulated an updated draft bill yesterday that would ban credit-default swap trading unless investors owned the underlying bonds. The document, distributed by e-mail by the committee staff in Washington, would also force U.S. trading in the $684 trillion over-the-counter derivatives market to be processed by a clearinghouse.

As much as 80 percent of the credit-default swap market is traded by investors who don’t own the underlying bond.

Naked CDS are evil because they demultiply the effect of bad debt. 1x bad debt is bad enough but if many Nx people bet against bonds then you have Nx the impact of debt imploding. Apparently that ration is 80 to 20 or 4x. Of course there is some noise in there about a professor who think it is a bad idea and wants to see the bill dead but to me, both propositions are no-brainers and I will ignore this particular professor. JPgoldmorgmanstanley however make 40% of their profits on these OTC markets so expect some lobbying.


Barry Kelly said...

The proposed law is completely bone-headed. It reduces liquidity in CDSes and removes sources of information from the market.

Pretty much all economists and financial experts I read are against this kind of move.

For example: the Financial Times, The Economist, Felix Salmon. All far more noteworthy and credible than just some random professor.

It makes perfect sense, too. Bonds tend to be illiquid instruments, bought by very risk-averse institutions, and held to maturity. CDSes are necessary to get good pricing information on them.

Marcf said...

yeah, I should not have been condescending, my bad.

I did read the criticism of liquidity, and have 2 points on it

1/ Liquidity will be 1/5 by definition of 80/20. Big fucking deal, in a market that has a nominal of 60T that is still a nominal of 12 or roughly the GDP. Who's complaining, oh yeah! the bankers... 40% of profits from from that and it is about to be cut in 5?

2/ Getting 'correct' pricing on CDS instruments out of the flow feels like a MARGINAL excercise in optimum. Peanuts compared to NOT MULTIPLYING BAD DEBT BY FIVE.

But hey, what do I know ;) how is that better for humility?

Jack said...

"All far more noteworthy and credible than just some random professor."

Noteworthy no doubt. More credible? That's nothing more than a subjective opinion. It would be a more compeliing opinion if they had the foresight to have forewarned us all. Too the point of "getting good pricing information" as a function of CDSs.
So exaclty when did that happen in the current situation. The cost of the CDS, it wouold appear, had no basis in reality. Oh yes, I forgot, no one could have foreseen this financial crash. Yeah, sure.
That's why so many "investors" wanted to by naked swaps. They were being kind to AIGFPs and just wanted to donate the costs of the swaps in order to illucidate the value of the CDOs.