Writing Naked CDS: When Murder (and Betting on It) Is Legal
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by: Brian McMorris May 06, 2009 | about stocks: AIG / BRK.A / GE
seekingalpha.com
Every once in a while something hits me like a ton of bricks and the light comes on (though you might think with such trauma, it should go off!) Such was the case as I read a story by Mike Santoli from a recent issue of Barron's. The subject matter is the very popular strategy of hedgies and other big money investors of buying Credit Default Swaps ((CDS)) in a company and at the same time shorting the stock. This creates a paired transaction that will generate profit on both transactions if the price of the underlying declines.
On the surface, this seems an acceptable strategy. What is the big deal? To understand why it is a big deal, we need to know that a CDS contract is essentially "insurance" on the performance of the underlying company's debt instrument. If that company "dies" or otherwise defaults or becomes insolvent, the contract pays off big time, just like a life insurance policy at the time of death. Such contracts were originally created as a hedging instrument for debt issuance. It allowed big buyers of debt to offload some or all their risk while continuing to recieve interest payments on the debt. CDS were written by companies like AIG against much of the debt that has become toxic. Much wealth has been protected in this market collapse by the owners of CDS contracts.
So far, so good. But what if the buyers of CDS are "naked", meaning they aren't hedging debt that they actually own, but are making an outside bet on something in which they otherwise have no financial interests. Wouldn't this be similar to taking out a life insurance policy on your neighbor or some celebrity (Bill Maher anyone?), a person in which you have no vested financial interest? In most states, this is illegal and is certainly unethical everywhere.
Now, what if you also could take a gun and shoot the person on which you had taken out the life insurance policy. Would that, should that ever be legal? Of course not. That defies every moral and ethical standard known to man.
But as macabre as this idea is, in the financial world, it is not only legal, but it is glorified. Hedge fund manager John Paulson made over $2 billion using this strategy in the mortgage market from 2006-2008, betting against the mortgage industry. His strategy not only made him a lot of money, it accelerated the demise of the world financial markets (though I grant, probably did not cause the collapse).
Maybe writing naked CDS should be outlawed. Read on for more on the subject [links are mine]:
LIQUIDATION. A GOOD SOAKING. PLENTY OF TEARS.
It is real wet out there in the markets.
By Mike Santoli - Barrons
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 in 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."
Before getting too far along with this argument, let's be clear that trading instruments and techniques are almost never themselves responsible for market declines.
The companies attacked most heartily by CDS traders also have impaired assets and/or opaque balance sheets understandably under suspicion.
I never thought the hasty and clumsily imposed partial ban on short-selling last year made any sense, theoretical or practical, for instance. Even the "uptick rule" that, until 2007, required traders to wait for a higher-priced trade to execute a short sale, wouldn't have prevented the market carnage. And the now-popular call to suspend mark-to-market accounting for financial firms strikes me as ill-conceived, mostly because the market simply wouldn't buy it and would go on targeting the same companies now viewed as vulnerable to more write-downs.
But curbing CDS purchases by investors with no other economic exposure to the company seems akin to the creation of baseball's infield-fly rule more than 100 years ago.
It was an imposition on the purity of the long-established rules of play, producing an out in certain situations without the fielders having to actively retire the batter. Yet, it was deemed necessary to prohibit a single specific tactic of trickery (an infielder intentionally dropping a pop fly with two or three men on base and fewer than two outs, so as to get an easy double- or triple-play).
It wouldn't be the first time this baseball rule was invoked to justify legal restraints on what formerly were considered general, unwritten principles of fair play, as the career of this recently deceased legal scholar makes clear. |
