Tuesday, October 6, 2009
Preface: CDS traders, read the note at the end...
Tomorrow, the House Committee on Financial Services will be talking about regulating about over the counter derivatives. Committee Chair Barney Frank has already circulated a draft of the proposed legislation.
The star witnesses are Commodities Futures Trading Commission chairman Gary Gensler and Henry Hu, who is the Director, Division of Risk, Strategy, and Financial Innovation, U.S. Securities and Exchange Commission.
I urge members of the Committee to ask the following question (you're welcome to hand this out to the witnesses):
Nobel prize-winning economist Myron Scholes - who developed much of the pricing structure used in CDS - said that existing over-the-counter CDS were so dangerous that they should be “blown up or burned”, and we should start fresh.
A Nobel prize-winning economist (George Akerlof) predicted in 1993 that CDS would cause the next meltdown.
U.S. Congresswoman Maxine Waters introduced a bill in July that tried to ban credit-default swaps because she said they permitted speculation responsible for bringing the financial system to its knees
Nassim Nicholas Taleb said this month, "To curb volatility in financial markets some financial products 'should not trade,' including complex derivatives."
Warren Buffett’s sidekick Charles T. Munger, has called the prohibition of CDS the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it”
George Soros says the market is still unsafe, and that credit- default swaps are “toxic” and “a very dangerous derivative” because it’s easier and potentially more profitable for investors to bet against companies using them than through so-called short sales
Satyajit Das, a leading credit default swap expert - the commonly-accepted figures for the CDS losses suffered due to Lehman's bankruptcy have been understated. He also says that the justifications for the value of CDS for the economy are phony.
In addition, the proposed regulations of CDS won't really fix the problem, because they will only cover "standard" derivatives contracts, not the slew of "creative" contracts.
Indeed, Das says that the new credit default swap regulations not only won't help stabilize the economy, they might actually help to destabilize it.
The overwhelming majority of derivatives contracts are held by just 5 banks. So are we really basing our entire strategy on CDS on protecting those 5 banks?
Credit default swap counterparties drive company after company into bankruptcy, and - once a company the counterparties are betting against goes bankrupt - the counterparties cut in line in front of all of the bankruptcy creditors to get paid (and see this).
Given the above, why shouldn't we ban or heavily tax over-the-counter credit default swaps, at least where the CDS buyers isn't itself the referenced entity?
For background, see this.
Note to current or former CDS traders: I'm not against CDS, but I think they need to be reigned in.
And I don't think Congress really understands CDS or their effect on the economy.