Monday, March 1, 2010

FT: time to ban naked CDS

In all the studying I have done of the financial crisis, one instrument stood out as nefarious: the naked CDS. I have long been convinced that they need to be banned.

Last week Bernanke said they would investigate their use in the Greek crisis. This morning Munchau, pens an article calling for their outlawing.

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer.

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

Greece CDS is quoted at 350 bips this morning and accusing fingers are pointing to hedge funds. So it seems Paulson and GS went one CDS too far by shorting government debt and are now attracting the political ire of regulators.

I find the article doesn't go far enough in analysis and just skims the reasons why they are nefarious. The biggest one being that when a CDS triggers they are a liquidity drain. You have to come up with a cash settlement for large sums of money. I remain convinced that the panic of aug 2007 can be directly linked to a liquidity drain triggered by naked CDS on subprime. There was a 4:1 naked to non-naked ratio...

Of note, Goldman Sachs (GS) and many others were in the business of selling the short side of these securities to speculators (and themselves) and marketing the long side to investors with AAA ratings. "Abacus", for example, was built from naked CDS. When subprime blew up those CDS blew up and with a lever of 4:1. AIG was at the end of the line, meaning the government... Ouch... GS will be investigated in conjunction with AIG and these securities is my guess.

In the meantime, I feel rather good about myself. It just makes me feel good to know I was on the right track in analyzing the mess. Go me.

2 comments:

Anonymous said...

Say I do a large amount of business in IckyYuckistan. IckyYuckistan has debt problems, and a transparent market signals people are getting nervous. I don't own any IckyYuckistan debt, but their default would result in me losing a great deal of my income from the business I do in IckyYuckistan. One thing I could do to offset this risk to me is buy CDS protection on IckyYuckistan debt that I do not own. And just like that, I'm an evil naked default gambler. - JCH

Marcf said...

yes, and you should be trialled by fire. This case seems like a edge one that will indeed disappear and with a 4:1 naked ratio I won't buy for a second that it wasn't pure speculation. But you are right, GS and Paulson should have people speaking to protect their interest as they are being abused these days. (I know I actually defend them on nakedcapitalism).

In the case where you own the debt, you are taking insurance on something you own.... in the second case, you are taking insurance on something you might own in the future (your revenue stream).

And when that cash stream disappear, supposedly from a bad economy, you want other cash streams from other parts of the economy. This is a destabilizing liquidity drain. Aug 2007 with subprime is a great example of this. This is how the subprime virus mutated and infected other parts... it was multiplied 4:1 and then it wrecked havoc on liquidity in many securitization markets.

Also when people are doing naked 4:1, it is clear that most people are speculating with VERY LARGE SUMS. There is a question of scale.

This one is pretty black and white for me... you are indeed a evil naked default gambler, or at least associated with :)