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Politics : The Obama - Clinton Disaster -- Ignore unavailable to you. Want to Upgrade?

To: GROUND ZERO™ who wrote (2243)	11/25/2008 11:09:13 AM
From: DuckTapeSunroof	Read Replies (1) \| Respond to of 103300

Tying Interest Rates to CDS Is a Recipe for Main Street Disaster by: Mark Sunshine November 24, 2008 seekingalpha.com Warren Buffet called credit default swaps “weapons of financial mass destruction” and they are about to annihilate Main Street. In a disturbing new trend, money center banks are “weaponizing” credit default swaps (CDS) by using the trading price of a borrower’s CDS to adjust the borrower’s interest rate. Unfortunately, banks don’t understand that they are arming speculators with the power to ambush and kill unsuspecting and otherwise healthy companies. Regulators appear oblivious to the market realities and dangers of CDS, and the banks are unwittingly putting their own portfolios at risk by potentially damaging their borrowers. CDS are unregulated derivative instruments that are essentially a bet on the creditworthiness of a company. Unfortunately, the market for CDS is an over the counter opaque market with no regulation and prices with questionable value. Recently, Bloomberg reported that several money center banks are inserting terms into loan documents that automatically adjust a borrower’s interest rates based upon the trading price of a borrower’s CDS. This seemingly innocuous loan provision allows speculators to bet that a borrower’s stock price will go down and insure that the bet pays off when speculators manipulate the borrower’s CDS prices upward. Higher prices on CDS increase the borrower’s interest expense and destroy its earnings per share. Dropping earnings per share cause the borrower’s stock price to fall, which means that the speculator makes money on their bet that the borrower’s stock price will decline. Banks don’t realize that they are creating an unfair investment game that is the dream of every rotten short seller and speculator. Today the Wall Street Journal reported how similar trading schemes have virtually destroyed brokers and banks. A hypothetical example can illustrate how speculators can use this loan provision to kill an otherwise healthy and unsuspecting borrower. Sunshine Widgets is an imaginary and otherwise healthy company that is actively traded on the NYSE. Sunshine Widgets has a new credit facility that includes an interest rate that is tied to the trading price of its CDS. Three speculators read Sunshine Widgets SEC filings and decide that it will be their victim. They bet on a decline in Sunshine Widgets’ stock by shorting the stock and buying puts in a careful series of trades that don’t attract market attention. Then the speculators start daisy chain trading in Sunshine Widgets’ CDS. Speculator #1 sells CDS to Speculator #2 at an artificially inflated price. Speculator #2 hedges its position by selling CDS to Speculator #3 at the same inflated price. And, Speculator #3 hedges its position by selling CDS to Speculator #1 at the same inflated price (which also acts as a hedge to Speculator #1’s original trade). The next day, the three speculators enter into the same daisy chain scheme at a higher price and the next day they do the same at an even higher price. The high CDS price causes an increase in Sunshine Widgets’ interest expense, which reduces Sunshine Widgets’ earnings per share (EPS). Because of falling earnings, equity investors punish Sunshine Widgets stock price in a broad selloff. As Sunshine Widgets’ stock goes down, the speculators make money on their short stock position, but the worst is yet to come. Sunshine Widgets’ interest cost rises with the increase in its CDS prices. As a result, its ratio of cash flow to debt service declines. This means that the underlying creditworthiness of Sunshine Widgets deteriorates. As a result, legitimate investors start to trade the CDS at higher levels. Equity investors continue to sell the stock. Speculators started a negative feedback loop where higher CDS prices cause deterioration in the creditworthiness of Sunshine Widgets which in turn cause higher CDS prices. The way to stop this negative feedback loop is for Sunshine Widgets to raise equity and deleverage. But Sunshine Widgets’ lower earnings has destroyed its stock price and made issuing new stock very dilutive and potentially impossible. On Friday the Fed, the SEC and the CFTC announced that they are cooperating to bring transparency to the CDS market by working to create a central CDS clearinghouse. Unfortunately, Friday’s news doesn’t reflect today’s realities and illustrates how regulators continue to fall behind dynamic and changing problems. Without substantive regulation, CDS clearinghouses will provide false transparency and legitimize abusive and manipulative behavior. For CDS clearinghouses to add value, all trades need to go through the clearinghouse, substantive regulations need to be enacted that make market manipulation a crime, and the reach of regulators needs to be global. What regulators are doing is analogous to arms inspectors declaring that nuclear proliferation is under control because the International Atomic Energy Agency counted the number of centrifuges being used by rogue nations to producing nuclear weapons for terrorists. The unintended consequences of using CDS for dynamic credit pricing are predictable, unnecessary and dangerous. Regulators shouldn’t be wasting their time working on systems to keep track of trades that put financial nukes in the hands of economic terrorists. Instead, they need to immediately and unconditionally ban the tying of loan interest rates to CDS prices. They need to think clearly about the why it is “good” to allowing speculators to make naked bear bets on companies and then “shave the dice” by playing in the unregulated CDS market. Substantive regulation of CDS is needed immediately before a few good companies are sacrificed on the altar of “free markets”.