Stabilize Global Banking – Eliminate (or highly regulate) CDS as a product on Financial Institutions

The post below from ZH is a good summary of an undertow in the markets today. In short there was some speculation that Morgan Stanley might be over exposed to French banks. I’m not going to discuss if the information is either true or relevant.

I am going to try to expand on a very succinct point made by ZH.

For those who need a primer, CDS are Credit Default Swaps which effectively are like insurance on debt. The buyer of CDS (protection buyer) pays someone else (protection seller) for the obligation to be “made whole” if a bond defaults. The protection seller is usually a financial institution (large bank, hedge fund or insurance company) and the protection buyer can either be a bondholder looking to hedge their position or more often these days they can be speculators who don’t own the underlying bond, but instead use the CDS like a option to hedge or bet in a broader portfolio.

In the note from ZH he accurately points out the fact that any institution who is relying on CDS (insurance) in the event of a default particularly one that leads to a system-wide collapse of the banking system has inadequately hedged their positions. As ZH notes when Lehman failed, it set off a shockwave of CDS trades where some protection sellers who were willing to make Lehman bondholders whole were put in the precarious position of having sold too much insurance on Lehman, more than they could make good on thus putting the one who sold CDS themselves at risk. This type of scenario set off a chain reaction within hedge funds, banks and insurance companies who thought they had protection only to find out that their protection seller (counter party) over exposed himself and might not he able to meet the obligation.

Now remember the financial system is fragile, and as we learned in 2008 is built on trust more than anything else. When counter parties (large institutions) begin to distrust each other, no one needs to actually default. A rising level of distrust among who is exposed to who can, in and of itself, create a panic that leads to a default via a liquidity trap. A liquidity trap can be simplified as a moment when a company who is deemed “credit worthy” does not have enough liquid assets/cash on hand to run the business. If to raise the cash they are forced to sell assets, bankruptcy can ensue quickly. The simplest example of a liquidity trap is a bank whose depositors remove all their cash.

Here’s where I get angry. The people buying CDS on a specific bond, unless there is an arbitrage to be had, really have no business owning the bond in the first place. All CDS provide for when matched to the underlying bond is to allow the bondholder to pass the default risk off to someone else less knowledgeable (willing), the patsy. In the absence of the bond insurance the owner might not have bought the bond. And if demand for the bond was lower, the interest rate required to attract enough investors would probably be higher.

Thus the system has used this outsourcing of risk to obfuscate prices in the bond market. Presumably this is great for society because it lowers borrowing costs. The flip side is that when risk is misplaced because the risk holder (owner of the asset) is not fully aware of all the risks they own they become more susceptible to sell an asset when something surprising happens. In 2008 as is today, a number of surprising things happened and are happening.

This dilution of risk in owning bonds was touted by Greenspan as the best thing for the financial system since ATMs. Greenspan loved the idea that any risk could be parceled and packaged and sold to someone willing to own it, making the system more stable, because as the theory went people only buy financial assets whose risks they understand and are willing to own (and not panic sell). Sadly all this did was increase the number of patsies in the financial system. In 2008 AIG was the biggest patsy of all.

Furthermore and Unfortunately in 2008 we learned that the bond rating agencies were flawed at best, and conflicted at worst, ultimately helping to mis-price risk.

Thus when a hint of instability occurs in the financial system, risks have been so sliced and diced that no one really knows who is sitting on a time bomb. And the mere speculation of whose holding the firecracker is just enough flame to light a fuse.

I cannot imagine why anyone would want to continue to see the obfuscation of risk via CDS on financial firms continue. If someone wants to speculate on Johnson and Johnson, go ahead. At the end of the day a non financial company has a very definable balance sheet with known assets and liabilities. A bank or insurance company however, which may be sitting on billions of dollars of CDS exposure (long and short), can easily become the patsy when the global poker game starts counting up the cards.

If we simply disallow CDS on systemically important financial companies we can at least remove part of the ongoing circus that is now officially reoccurring in the global financial system.

tyler_normal.jpgzerohedge (@zerohedge)
9/22/11 8:59 PM
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