Monday, September 22, 2008

Stock shorting isn't the problem. CDS are.

There has been much hubbub over the SEC's new naked short-selling rules. Now, I've got no problem with enforcing some basic short-selling rules, but it won't make a difference until something changes in the credit-default swap (CDS) market.

Let's stipulate that speculation and manipulation is part of the problem here. Let's stipulate that John Mack is right and that if Morgan Stanley were to go down, it would be solely because of short-selling.

To make that claim, you have to assume that pressure from short-sellers is feeding upon itself. That Morgan's falling stock price is creating panic, bringing out more sellers and causing more panic. But if you really want to create panic, the CDS market is a better choice. In stocks, you can always offer a stock below the current price, and that may spook people. But the CDS market is traded over the counter. The trading volumes are unknown. Bid and offer sizes are unknown. In such an environment, anyone can throw any bid or offer out there and move the market.

In addition, buyers and sellers need to be matched in this market. In a time when there are few sellers of protection (the seller is effectively long a credit), eager buyers of protection can move the CDS market wider extremely rapidly. The general lack of knowledge about the CDS market doesn't help either. Media reports suggesting that a particular "expected" default rate is predicted by a certain CDS trading level shows a complete misunderstanding of the CDS market.

What could be done? The first step would be to move CDS trading to an exchange. This would allow for more disclosure and less mystery. It would also reduce all the country-party confusion that has surrounded AIG and Lehman and eliminate the need for novation.

Second, make the CDS contracts more standardized. Currently many CDS players don't actually close out their contracts, but rather buy off setting contracts. As a result, any given contract becomes less liquid than it really should be, which makes price discovery all the more difficult.

Another step would be for market makers in CDS to increase the margin requirements on CDS trades. Margin requirements on CDS are set by individual investment banks, but there is no reason why there couldn't be a coordinated effort on this. Increasing collateral requirements would force protection buyers to be more judicious about which names they short. By the way, having an exchange would make monitoring collateral requirements much easier.

There may be other solutions to the CDS problem, some of which will take time. But the steps I've outlined could get done quickly. And they need to be.


santcugat said...

I imagine this must look like an enormous knot that they are trying to untie. If you start yanking on a thread it's not really going to help.

At least with an exchange you know what an offsetting trade is and you know you are out of a position.

Right now, you might have a perfectly hedged position, but it is impossible to get out of because there's no buyers or sellers.

PNL4LYFE said...

I think the LEH default guarantees that the banks themselves will try to implement this as quickly as they can. There has long been talk of an exchange or clearinghouse system, but I don't think they ever expected to deal with the bankruptcy of a large counterparty.

As far as standardization of contracts, that would definitely benefit everyone. Under the current system, market makers are naturally at risk whenever there is a default because they buy low strike and sell high strike contracts. So even if they are theoretically flat, they lose the value of that annuity. They are also at risk when they bid to unwind old low strike trades and have to pay out cash up front. Anecdotally, I've heard that the FNM/FRE CDS trigger cost the street somewhere in the hundreds of millions. Ironically, the winners are the CDOs and other synthetic vehicles that recklessly sold low strike CDS on highly levered banks...

Unité 6.2 said...

Much too rational.

Anonymous said...

we are all at Herstatt risk.

cap vandal said...

bI don't see any bona fide social purpose for these.

They facilitate taking huge speculative positions in securities that could not be made with the underlying issues.

If they are selling true credit insurance, why aren't they regulated like an insurer? Haven't we been reminded over and over that you can't hedge systemic risk? If they are taking net credit risk, they need tons of capital and supervision.

I suppose their are plenty of examples of "meeting clients needs" with synthetic securities or whatever. However I think it is more like the egg contracts on the Chicago Board. They took em off and there was total silence from the farmers that were supposed to be using them for hedging.

Unknown said...

CDS on traded names and shorting are intertwined (how do you think a protection writer hedges?).

PNL4LYFE said...

Late yesterday, NY state announced that they will regulate CDS sold as insurance (i.e. whenever the protection buyer owns a deliverable bond). I think their primary goal is to regulate the MBS and CDO protection sold by the monolines, AIG, etc., but it will also affect corporate basis packages. If the regulation makes it more difficult to buy basis packages, corporate cash spreads will widen since basis buyers have made up most of the demand lately.

It's a tough situation because some kind of regulation or exchange/clearing house is clearly needed, but it would be unfortunated if it made it even harder for companies to borrow money.

Unknown said...

I can't actually believe that they haven't included this as part of bailout.

I think states regulating this is a bad idea.

Current problems:

1) Formerly AAA MBS/ whole home equity loans have no buyer - prices low.

2) Financial institutions undercapitalized.

3) No trust because no one knows what lurks in derivatives portfolios.

4) Real risk of contagion because of CDS direct credit risk and indirect credit risk of CDS (i.e. exposure to writer).

An exchange would solve 3&4, might even provide more liquidity to hedge values, then top up with some taxpayer capital injections where warranted. Others, like Lehman, can disappear without taking everyone out.