with you on this one…

“Wes Schott Says:
July 12th, 2009 at 4:37 pm

CDS without owning the underlying security is like a naked short

CDS could be restricted the same way as not allowing naked short stock sales – you have to own the security

…of course we know how effectively the rules against naked short sales have been regulated…

…given “speed” of the GS high frequency trading platform, why 3 days to deliver, anyway?”

Chris, like many other commentators, seems to be confusing the customized CDS that AIG wrote with corporate CDS (default insurance on corporate bonds).

For corporate CDS:

“Most corporate bonds are illiquid, so whatever price the Street uses for models is pretty poor quality. No “crowd” to vote on the price.”

Comment: There is an observable cash bond market which CDS prices off of. Its called the corporate bond market and billions trade daily. Plus, you cannot buy corporate CDS on illiquid issuers. Corporate CDS is focused on the largest issuers whose bonds trade daily.

“More important, because users tend to price these instruments against short-term price/yield, I would ague that most CDS are always under-priced vs. default risk. ”

2. CDS pricing is based on the credit risk premium investors demand. This credit risk premium is not known but can be estimated from the Libor curve (ie, short-term yield). Just because the credit risk premium is not observable does not mean investors cannot have their opinions (think equity risk premium or VIX – not observable but investors can place bets in future options markets). You may think CDS is under/over priced relative to default risk, but, like any other tradeable asset, people are entitled to their opinion. Future default rates will allow you to decide whether the models were pricing correctly or not.

“To price an option that has a strike of 100% of par vs what is costs to rent money for a year is a great bargain for buyers of protection. ”

3. Not exactly sure but I think you are back onto LIBOR. I think you are saying that CDS should not be priced off of LIBOR (cost of short-term borrwings from AA bank for less than 1 year) for five year protection. Again, what should the price be and how can you be so certain?

I can just see the glazed over faces of the Congressman when you go through all these points.

How about just saying this: corporate CDS markets needs to be regulated and transparency increased because its an illiquid, easily-manipulatable market controlled by brokers.

As for AIG, insurance companies should not be taking massive one-way directional bets at their holding companies?

Great job addressing the Senators’ questions and sticking by your position. Having watched the hearings and now having read your replies to the follow-up questions, I am even more convinced you are on the right track to at least partially controlling the derivatives monster, especially CDS and other speculative, non-cash market basis toxic gambling games.

My Senator, Merkley, while not on the securities sub-committee, is on the Banking, Housing and Urban Affairs. I have been writing to him about the need to reform banking and you put it, “return banks to being what they should be – namely low-risk utilities – and end the threat of systemic risk one and for all”.

I would like to forward to him the Q&A, but its a long post (rightfully so), is there a link to a PDF at IRA with all of the same (and more strong reasons?) that I can at least link to in my next email/communication to him?

Thanks,

Dave in SW Oregon

If the Congress has the courage and sense of purpose to reject the pretense that OTC markets for instruments such as CDS actually enhance market stability or bank profits on a rick adjusted basis, then we can return banks to being what they should be – namely low-risk utilities – and end the threat of systemic risk one and for all. So long as the Congress refuses to act, then the most irresponsible and aggressive speculators will continue to use our banking system to create ever more complex and opaque securities, and systemic risk will increase and eventually destroy our economy and our nation.

The dilemma is simple: “De we keep on taking this awesome flow of campaign contributions from the banks and the nation be damned, or do we tell the banks to go to hell by doing the right thing?”

Hmmm! That will be fun to watch.

And puhleeeze, don’t give me this grade-AAA crapola about the “sanctity of contracts.” I’ve read my Bible since elementary school and there is no mention of that anywhere in the Sacred Texts.

Has any evidence surfaced regarding so called “side letters” between the buyer and seller of the CDS’s?

AIG and GS, etc….

just like you described the side letters in the re-insurance business that the regulators were gradually uncovering

CDS buyers must own the underlying security – I agree, see my comment @4:37

otherwise they are buying insurance to cover something they do not own

that is why the cds value outstanding is so much greater than the cdo they cover

just like naked shorts in the stock market – selling short as asset that you do not own

What you refer to as “empty creditor” was just the point I was making.

The Senator asked, “How do we take away the incentive for credit default swap holders to force debtors into bankruptcy to trigger a credit event rather than re-negotiate the debt?”

Mr. Whalen basically replied (if I understand him correctly) that you make CDS buyers own the underlying. The problem is that they still have an interest in forcing a bankruptcy on the debtor and are entirely divorced from the idea of working with the debtor. I don’t see how requiring someone to own the underlying changes anything about CDS positions.

If a well regulated exchange+clearinghouse solution can’t be done, at the very least, they need to put down some stiff collateral requirements so that a CDS seller faces the disincentive of freezing up assets (and couldn’t pull an AIG of entering into a systemically dangerous amount of contracts).

If that’s the best they can come up with, maybe there’s hope for Barnie yet?!!