Put the credit default swaps market out of its misery

Financial Times ^ | Dec 7 2008 | John Dizard

[Yo-Yo]

"Effectively, there isn't any CDS market now."

David Goldman, an old friend and credit strategist turned private investor, still goes through the credit run sheets from the dealers. "The business looks like the window of a Brezhnev-era Soviet butcher shop. Mouldy scraps hanging in the window. Old women lining up at 4am to try and buy credit protection on General Motors (NYSE:GM) . What are reported as trades are really ways to establish prices to satisfy the auditors."

For several years, I have been among those calling for thoughtful, prudent, moderate steps for the reform of the credit default swaps market. They should be put on exchanges, put through central clearing houses, settlement backlogs reduced and then eliminated . . . etc. etc. etc.

was wrong. The global credit default swaps market should just be liquidated, the contracts allowed to expire and the booby traps defused. Where they can't be defused, they'll explode, and we will have to deal with the loss of capital and litigation.

Essentially, while the back office messes of the CDS market are being cleaned up, that leaves the question of why we need these things. We don't. The outstanding CDS should be offset against each other, where possible, and the rest allowed to run off or be paid out on as defaults occur. Some of the counterparties will default; those losses should be accepted as the price of another huge pile of wasted effort, along with cold war bomb shelters and media studies doctorates.

There are three possible defences for treating the CDS market as a going concern: its support for capital raising, its utility for price discovery and its role as a risk management tool. All have melted like so many Lehman deal cubes in waste incinerators.

Consider capital raising. Writers of protection in the CDS market must now hold increasing amounts of cash as margin against the probability of default for the "reference entities" or borrowers they bet on. This has led to the sale of tens of billions, if not hundreds of billions, of dollars, euros, and pounds worth of securities to raise that cash. Or, in the case of banks, capital that could support new sound lending is tied up, waiting to fund payouts to the buyers of protection on a long line of prospective defaults.

Some of those buyers hold actual exposure in the form of bonds or supplier contracts; many more have just made side bets. In the meantime, those forced sales and frozen balance sheets have helped ensure that the issuance of new shares and bonds trails off to a trickle.

That leads to the value of CDS for price discovery. Bad joke. Price discovery is a useful economic function; that's the rationale for commodities markets. But CDS are derivative instruments, whose price is "discovered" these days as a function of equity volatility, since buying equity puts is one way to dynamically hedge the illiquid legacy books. So CDS dealer sales of Citigroup equity through derivatives means higher equity volatility, then higher CDS spreads, leading to more margin calls, leading to more sales of bank stocks . . . This has become a system-wide tail-swallowing exercise in lunacy. If the default rates implied in investment grade CDS spreads were to occur, the only economic activity would be court-supervised reorganisation. The CDS market has been preventing efficient price discovery.

So, CDS as a risk management tool. Let's ignore the smoking Krakatoa of AIG Financial Products' value at risk, and look at one facet of risk modelling in the market as a whole.

A credit default swap is a very different creature than the traded equity of a "reference entity". CDS cover only one on-off risk, that is, default on reference obligations. So in the airless world of ideal models CDS values are better considered as binomial probability distributions, rather than as the continuous probability distributions that are closer approximations of equity values.

Yes, there are problems with formalistic dependency on either family of distributions, but not as many as with using equity volatilities to price CDS. When implied probability of default, and equity volatility, are relatively low, you can do some seemingly plausible regression analyses to fit the series. But at high levels of default risk and equity volatility if you hedge the one with the other, you get frantic, self-defeating activity.

Risk management with CDS was largely about what the bankers called "reg cap arb" (regulatory capital arbitrage), or making big spreads and bonuses by scamming the regulators whose employers, the taxpayers, now have the bill.

Howard Simons, one of the Chicago traders who always loathed the New York CDS dealers, speaks for many of his comrades in rejecting the trading of CDS on the futures exchanges. "The clearing members of the CME [Chicago Mercantile Exchange] think trading this stuff is the stupidest idea in the world. I didn't work my whole life so some investment bank goombah can take all our capital. Do I look like Hank Paulson?"

Let's rebuild real capital markets.

[Yo-Yo]

Time to put back into place the regulatory safeguards for banks that were removed in 1996

[fightinJAG]

bfl