Some of the discussion on yesterday's post regarding GE Capital turned to the problem of credit default swaps. Back in October, I outlined some of the major problems as well as the potential solutions to the CDS problem. You can read that piece here if you'd like, but otherwise here is a quick summary of the problems:
- CDS aren't really that liquid. In order for any market to be liquid, there needs to be a large numbers of buyers and sellers. In the old days, the big dealers were always willing to write CDS to their customers because the risk was easily passed off in some other manner. Either sell it to AIG (snicker) or put it into a synthetic CDO or some such. Today dealers aren't making a market the way they used to. They have their own credit problems to work out and aren't willing to leverage their balance sheet on this kind of trade.
- Thus when an event leads investors to grow concerned about a company, everyone wants to buy CDS protection at once. Yet who is willing to sell? Goldman? Morgan Stanley? There aren't a lot of players left. And let me tell you something. If Goldman is willing to sell you the CDS, it won't be 10bps back. It will be 10 points back.
- The problem becomes that much bigger with a name like GE Capital, which is so widely held. Goldman might be willing to quote you CDS on $10 million of some off-the-run name at a stupid price, but when the whole investing world wants protection on GE at once, its another story. No one has the balance sheet to accommodate the demand.
- Exacerbating this problem is that bonds aren't easy to short. As a result, firms that write CDS are almost always writing naked.
- Putting all this together, CDS are infinitely more manipulable than stocks. If I can't see where something is trading and at what volume, only that the quoted price is 10 points wider, my only conclusion is that the credit is cratering.
Many of these problems could be solved with exchange-traded CDS. This would open up the writing of CDS to a much wider audience. If it were done with regulated margin requirements, with the exchange acting as universal counter-party, there would be far less contagion risk related to a failed counter-party.