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Transparency in the CDS Market

Of course the government goes to the extreme and is talking about “Banning ‘Naked’ Default Swaps“.  Let me first say that Barney Frank is a bloody idiot.  He kind of sounds like Elmer Fudd and his face makes you wonder just how corrupt our government is.

Credit Default Swaps are pretty simple instruments and I explained how they worked in “Financial Weapons of Mass Destruction and the Credit Crisis“.  The problem in the CDS market is also rather simple to solve, but the way in which the market has been manipulated is quite complex.  A credit default swap allows an investor to own a significant amount of a company’s debt, say General Electric, and hedge out all of the credit risk.  First you buy $100,000,000 of GE debt, then you call up an investment bank and purchase $100,000,000 of CDS protection on GE with a similar underlying bond and similar maturity.  Now you effectively own $100M of treasuries.  Nifty.  The complexity comes with the question: what if you buy $100M of GE debt, $500M of CDS protection on GE?  Now the investor has a negative economic interest in General Electric debt, but they still have their rights as a bondholder such as putting the bond back, demanding repayment upon the breaking of a covenant, negotiations in restructuring the debt, a seat in bankruptcy court etc.

Let’s take this one massive step further.  What would happen if you bought bonds, bought a ton of CDS protection, bought a bunch of stock, and sold a ton of equity forwards.  Whoa, that’s a lot of transactions…let’s break that out:

  1. Buy $3B CIT Group Bonds
  2. Buy $6B CIT Group CDS
  3. Buy $1B CIT Group Stock
  4. Sell $2B CIT Group Equity Forwards

Let’s pick a point in time that this transaction could have occurred (but more reasonably it would be built up over time).  Let’s just say it happened January 1, 2008.  Five year CDS was trading at 383bps or 3.83% per year.  The stock was trading at 23.84 meaning the market cap was about $9.3B at the time.  So what we are saying is that Investor X has bought $3B in CIT bonds but overhedged that position and bought an 11% stake in CIT’s stock but overhedged that position as well.  This means that Investor X has a negative economic exposure to CIT’s stocks and bonds, but a powerful say in how the company is managed.  This idea was really brought to light by Henry Hu’s research paper “Debt, Equity, and Hybrid Decoupling: Governance and Systemic Risk Implications“.

How many companies have actually been brought to their knees by predators using derivatives to overhedge long positions?  Could it be possible that Goldman had a $3B revolving loan facility but overhedged that position and actually would benefit from a CIT bankruptcy?

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Posted in Conspiracy, Derivatives, Educational, Markets, Media, Politics.

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5 Responses

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  1. Travis says

    So if you have $1 billion in GE bonds, why is it legal to buy $5 billion in CDS protection? This constitutes insurance fraud. I can’t buy homeowners insurance on Joe Schmoe’s house, because I don’t have an insurable interest in his house. Isn’t the conflict of interest obvious enough?

  2. SurlyTrader says

    That argument can be made for a lot of things right? Shouldn’t be able to short stock you do not own, buy puts on shares that you do not own, own a life insurance policy on someone else etc etc. I think the easy fix is that you have transparency in the market and force the buyer of CDS to post the entire payment upfront versus have a quarterly premium. That way it takes the form of a put option and would raise the upfront cost of purely speculative plays. I will discuss what I believe would help fix the market in a follow-up post.

  3. Travis says

    Can’t say as I agree with how you’re lumping shortselling, and put options in with swaps, but maybe I should have elaborated a bit more on why default swaps should be considered fraudulent. The number of put options doesn’t exceed the number of shares in existence. Not true with swaps. The short interest on a stock can’t be greater than the number of shares in existence. Even if you’re buying puts and selling calls to synthesize shorts, it’s my understanding that the short interest still can’t exceed the number of shares outstanding, but I may be mistaken on this. Derivatives are supposed to be a zero sum game. I’m not sure how you could argue that default swaps make any sense, much less are legitimate considering the notional value of the whole market exceeds the money supply four times over. And we’re not even talking about the interest rate swaps yet.

  4. SurlyTrader says

    The gross notional of any derivatives market could certainly be larger than the trading in an individual name, but it wouldn’t happen practically. Oftentimes the gross notional is cited with regards to CDS, but the important key is what is the net notional exposure on given names and who holds it? If these contracts reside on an exchange that effectively manages collateral and margin, then we no longer need to worry about bailing out AIG, Lehman or Bear Stearns… The exchanges will make sure they have enough margin and collateral to settle customer exposures.

    So I think there are two keys:
    1) via OTC markets, collateral is not managed effectively to mitigate system risk to the financial system
    2) via the OTC markets, there is no transparency as far as aggregate and individual positions/exposures

    These issues will be explained better in my second post

Continuing the Discussion

  1. Transparency in the CDS Market (part II) – SurlyTrader linked to this post on July 27, 2009

    […] In the first part of this post, I framed how CDS could be abused in the market by unethical investors.  It is questionable how often these devious plans have worked out or how widespread their fraudulent use has become, but it is pretty clear that it is occurring behind the scenes.  Insider trading is difficult to stop in the public markets on the major exchanges, but it is impossible to stop it in opaque derivatives markets between dealers and private investors/institutions. […]

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