Banning The Pairing of Short Bets In Shares With Long Bets On The CDS
Barrons reports: Aside from getting washed out to a new 12-year low, the Dow has five of its 30 members bobbing below $10, a level under which more than a fifth of Standard & Poor's 500 members reside.
Given all the known big-picture reasons for this drenching, does it makes sense to continue enabling the folks who make and sell umbrellas to force it to rain at will? The people with a stake imn umbrella prices who are able to trigger a downpour are the traders who bid up credit-default swaps on individual companies, whether they own their debt or not, and short the stock.
In combination, these actions feed signals into the market that companies are at risk of default -- often true, sometimes not, never a certainty. The mix of ballooning CDS premiums and collapsing share prices is a factor that can force credit agencies to issue debt downgrades, make real creditors nervous and scare would-be "real money" buyers away from the shares and bonds of the affected companies.
The results are some alarming pricing relationships. A Merrill Lynch analyst Friday noted it was more costly to protect oneself from the possibility of a default by Berkshire Hathaway (ticker: BRKA) than one by Vietnam. And General Electric (GE) CDS prices outstripped those of Russia -- a country that a dozen years ago actually did default on its foreign debt.
This is all legal, thanks to a law a few years ago exempting CDS from "bucket shop" laws that ban gambling on security prices indirectly. And, as New York State Insurance Superintendent Eric Dinallo testified in Congress last week, one likely reason they aren't termed credit-default "insurance" is that using that term would trigger state regulation and higher capital requirements for the underwriters, making the swaps expensive hedging instruments.
These rumblings moved Mike O'Rourke, a strategist at brokerage BTIG, to remark, "Rightly or wrongly, don't be surprised if at some point, regulators start poking around looking for investors who paired short bets in the common shares with long bets on the CDS."
Theoretically, an unlimited amount of credit-default swaps can be written and bought on any issuer, and there are incentives for buyers to make companies look sickly. If an investor buys a troubled issuer's deeply discounted corporate debt that has little chance of trading again at face value, and then buys CDS as protection, the investor could essentially want the issuer to default so the swaps pay off to the max.
Says Tony Dwyer, a strategist at FTN Equity Capital Markets: "You have turned the buyer of stressed corporate debt from a buyer incentivized to make the company better and worth more, to a buyer with the goal of default. If the total cost of buying a bond and insuring it to par is less than par, it creates an arbitrage that ultimately destroys capital."
Source: online.barrons.com
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