Posted on 09/23/2008 8:33:51 AM PDT by joinedafterattack
Credit default swaps, potentially the next domino to fall in the ongoing financial crisis, are the debt equivalent of naked shorts on stocks, according to the chairman of the Securities and Exchange Commission.
In prepared testimony that he will deliver before the Senate Banking Committee this morning, SEC chairman Christopher Cox equated the sale of the unregulated bond derivatives with naked short selling and called on Congress to give his agency authority to regulate the derivatives.
"Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS," said Cox. "Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can 'naked short' the debt of companies without restriction."
Equating credit default swaps on corporate bonds with short selling of corporate stocks will resonate on Capitol Hill, where short selling, particularly naked short selling, has come under fire for purportedly driving down the stocks of financial institutions and undermining public confidence. The SEC has a partial ban in place on naked short selling and also temporarily limited short selling of 799 financial stocks in response to the financial crisis.
Credit default swaps — the unregulated derivatives that are supposed to offer their buyers a payout if the company against which they're written defaults or goes bankrupt — were, until recently, hailed by many as a valuable financial innovation. In fact, the notional value of credit-default swaps soared to some $62.2 trillion in 2007 from $34.4 trillion in 2006, according to the International Swaps and Derivatives Association.
But the bankruptcy of Lehman Brothers, a major issuer of credit default swaps, combined with the government takeover of AIG, which had covered more than $440 billion in bonds with credit default swaps, has raised serious concerns about the default of the default swaps themselves.
The Financial Accounting Standards Board voted last month to push forward with a disclosure requirement aimed at helping investors get a better read on the financial instruments, rejecting recommendations by its own staff and many in the financial industry that the provision be delayed. Under the rule every derivative — or group of similar derivatives — the seller must disclose the nature of the instrument (term, reasons for entering into the contract, and current status of the payment/performance risk); the maximum potential amount of future payments the seller is required to make under the contract terms; the fair value of the derivative; and the nature of any recourse provisions that would allow the seller to recover the amount it pays out — such as collateral pledged or assets held by third parties that the seller has the right to liquidate.
The new rule will be effective for fiscal years ending after November 15, 2008. That means that investors may have a much clearer picture of the credit default swap market by February of next year, when calendar-year companies begin releasing their year-end results. But that may not be soon enough.
Indeed, during the August meeting in which FASB voted to issue the new disclosure rule, board member Thomas Linsmeier was adamant about acting sooner rather than later. "In this market, with the credit crisis, two or three months may be a big deal" in terms of investor disclosures, he said.
In prepared testimony that he will deliver before the Senate Banking Committee this morning, SEC chairman Christopher Cox equated the sale of the unregulated bond derivatives with naked short selling and called on Congress to give his agency authority to regulate the derivatives.
"Economically, a CDS buyer is tantamount to a short seller of the bond underlying the CDS," said Cox. "Whereas a person who owns a bond profits when its issuer is in a position to repay the bond, a short seller profits when, among other things, the bond goes into default. Importantly, CDS buyers do not have to own the bond or other debt instrument upon which a CDS contract is based. This means CDS buyers can 'naked short' the debt of companies without restriction."
Equating credit default swaps on corporate bonds with short selling of corporate stocks will resonate on Capitol Hill, where short selling, particularly naked short selling, has come under fire for purportedly driving down the stocks of financial institutions and undermining public confidence. The SEC has a partial ban in place on naked short selling and also temporarily limited short selling of 799 financial stocks in response to the financial crisis.
Credit default swaps — the unregulated derivatives that are supposed to offer their buyers a payout if the company against which they're written defaults or goes bankrupt — were, until recently, hailed by many as a valuable financial innovation. In fact, the notional value of credit-default swaps soared to some $62.2 trillion in 2007 from $34.4 trillion in 2006, according to the International Swaps and Derivatives Association.
But the bankruptcy of Lehman Brothers, a major issuer of credit default swaps, combined with the government takeover of AIG, which had covered more than $440 billion in bonds with credit default swaps, has raised serious concerns about the default of the default swaps themselves.
The Financial Accounting Standards Board voted last month to push forward with a disclosure requirement aimed at helping investors get a better read on the financial instruments, rejecting recommendations by its own staff and many in the financial industry that the provision be delayed. Under the rule every derivative — or group of similar derivatives — the seller must disclose the nature of the instrument (term, reasons for entering into the contract, and current status of the payment/performance risk); the maximum potential amount of future payments the seller is required to make under the contract terms; the fair value of the derivative; and the nature of any recourse provisions that would allow the seller to recover the amount it pays out — such as collateral pledged or assets held by third parties that the seller has the right to liquidate.
The new rule will be effective for fiscal years ending after November 15, 2008. That means that investors may have a much clearer picture of the credit default swap market by February of next year, when calendar-year companies begin releasing their year-end results. But that may not be soon enough.
Indeed, during the August meeting in which FASB voted to issue the new disclosure rule, board member Thomas Linsmeier was adamant about acting sooner rather than later. "In this market, with the credit crisis, two or three months may be a big deal" in terms of investor disclosures, he said.
Knock me over with a feather. Finally, somebody in power actually gets at least one component of this.
There’s a cogent solution presented here: fedupusa.com
How can you be naked if you are wearing shorts?
Oh.. Never mind
They should outlaw all these financial derivatives and let the market take it from there.
The solution is to bar the issue of CDS's and other derivatives unless they are 100% backed by cash or T-bills (which will kill the profitability of issuing them).
Derivatives were created by the free market. They are an essential tool for price discovery.
Banning short positions in equity and debt is pure interventionism.
If we are bailing out these banks so that the traders of these swaps can get paid, you can count me out...
Mike
That's ridiculous.
Should insurance companies be banned from issuing insurance policies unless they have enough cash to cover all future liabilities simultaneously?
What would satisfy the financial Luddite contingent on FR?
A return to barter?
The derivatives market is international in scope. They don't have the power to outlaw it.
I agree. It's like asking the tax payers to cover someone's bets.
Both swaps and options, when owned, have an equity component. A net short position, whether covered or naked, does not.
The naked short sides of plenty of swaps out there, created off-exchange in good times, are in many cases easily beyond the financial capacity of the writer(s). That they have an equity component may pertain, but that doesn’t prevent the kind of cascading defaults we are allegedly rushing to prevent.
Not really. Treat them like the insurance product they are, regulate them as such under the normal insurance regulations, and they’d be OK.
Credit default swaps, potentially the next domino to fall in the ongoing financial crisisHow many dominoes do we have in this game? Hopefully we're not playing with a full set. Let's hope the kids lost a lot of them.
A short position does not distort the size of the float or the apparent market capitalization. It is therefore wholly reasonable in the market. The NAKED short on the other hand does both and can lead to enormous damage. There has never been a reason to permit such practices. The SEC has been grossly negligent. It has allowed this situation to develop to the point that the whole system is under threat.
“The solution is to bar the issue of CDS’s....
I disagree, that is a bludgeon solution. The effect I believe you’re thinking about would occur if such swaps were brought onto an exchange where the financial capacities of the contracting parties HAD to be guaranteed by a third party. Like the OCC or the CFTC. If you had that, then you’d have a neutral party in the middle who, by virtue of having to guarantee a default, would make damn sure the contracting parties could perform, and would notice those parties with a full statement of their attendant liabilities so that those parties could file proper financials with the SEC and for investors. Then, these instruments could exist and perform their valuable functions with transparency, without generating vast fogs of uncertainty as they are doing now.
Should an insurance company be allowed to collect premiums from home owners in Florida while having so little capital that the first hurricane to hit would wipe it out?
That's the current problem with derivatives. They allow companies to paper over their losses and vulnerabilities until finally it has snowballed to a point where it brings down the whole country -- thus forcing the US taxpayers to foot a $700B bill.
It's like taking a bet where you have a 99% chance of making a $million, but a 1% chance of losing $1billion. Lots of people would take that bet. You are almost certain to win the $mil. And if you lose? "Hey, I don't have a $billion, get stuffed".
We've been there before with the Savings and Loans wipeout in the late 80's, when the insurance obligations of the FSLIC exceeded their assets, and the taxpayer had to pick up the tab. As long as it's something that can be stuck to the taxpayers, there will NEVER be adequate oversight. The reason for that is, when there's $billions on the table, there's ALWAYS enough money to bribe some congresscritter to get the regulators off your back.
If we do this again, then in 10-20 years there will be yet another bailout where the taxpayers are stuck with the tab after people have already taken out their millions of dollars in bonuses and options over many years.
I said nothing at all regarding the seriousness of the problem, and it is serious. My original post ONLY addressed Cox' use of a faulty analogy (which, btw, does nothing for my confidence level in his handling of the SEC side of this mess).
bump .... looks like what you are proposing is an SEC for CDSwaps.
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