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Monday, April 19, 2010

Derivative Reform a Good Idea But..

Here is an interesting aspect of credit default swaps.

As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky.

To understand how dangerous this is one has to understand what a derivative, which a credit default swap is, is. A derivative is a financial instrument that DERIVES its value from another security. Let's look at one of the most popular derivatives, stock options. Let's say you own stock option on AT&T. The better AT&T stock does, the better your option does. (assuming you buy a call option which bets the stock goes up but I digress) The reason is that a stock option is an OPTION to buy/sell an underlying stock. Inherent in such an investment is the availability to buy/sell said stock. In other words, AT&T stock is always available to buy/sell said stock in order to exercise that option if the holder chooses to do so.

In the case of CDS', the underlying security need not be available to exercise the CDS. That's what that aspect of CDS' was saying. You may in fact be holding onto the debt instrument, or you may just make a bet on said instrument. Now, I'm no fan of regulations but I do believe that a derivative needs to actually be a derivative. The world of Credit Default Swaps are so wild, wild West that they are derivatives that don't even follow the rules of derivatives. The underlying security need not be available to exercise the derivative. It's one reason why the size of derivatives grew to such a massive size in 2007-2008 (over $60 trillion at one point) People were just making bets long after the underlying security had been accounted for.

So, clearly, something needs to be done vis a vis derivatives. The problem is that derivatives are one step below rocket science and government officials are stupid. While there is a need for regulation of derivatives I have no confidence that our current government has the first clue what it is. So far, the president is adamant something must be done regarding derivatives.

resident Barack vowed Friday to veto a financial overhaul bill that doesn't regulate the eclectic derivatives market, even as Senate Republicans lined up en mass against it.Legislation pending in Congress would for the first time regulate derivatives, complex financial instruments like the mortgage-backed securities that contributed to a near economic meltdown in 2008 when their value plummeted during the housing crisis.

Just because you do something doesn't mean you've done the right thing. Yet, all I've heard from both sides are sound bites. Soundbites aren't actual regulations. That's what concerns me. So far, neither side has gone beyond soundbites. Republicans can't get beyond the idea that this bill will "bail out Wall Street". Even after the bailout fund was removed, they still said the same thing. I haven't heard about any specific regulations that they think are necessary. Meanwhile, Democrats continue to want to "hold Wall Street accountable". Holding Wall Street accountable is not an actual regulation.

What we have are two clueless sides. Meanwhile, the world of credit default swaps is a world of nuance and complexity. Trying to regulate such a world is no easy task. Doing it wrong is disastrous.


AG said...

Can't we just say that you can't issue more CDS than there instruments underlying them?

I do agree with you that my faith in Washington to competently handle this is rather limited though.

mike volpe said...

You'd think. It's still not clear that will happen. Beyond that, this is just one issue of one derivative. Sure, they can fix this issue. That's obvious. There's a lot of other issues that are less clear.

Anonymous said...

All CDS are derivatives but not all derivatives CDS's and I think that's where congress will really goof up. I think there certainly needs to be something done about the synthetic derivatives, why do you need synthetic derivatives on top of derivatives on top of stock? Perhaps to hide something (be more opaque)?

Clearinghouses or exchanges would be the best thing to do, but the initial lack of buyers in a market can drive prices up and down in a very erratic fashion. Which can be catastrophic when you add leverage (see bear sterns or lehman). I think you'd need some pretty smart heads to craft this and I'm not sure we'll see any.