From Deep Capture:

“Another line of inquiry has not been pursued, however, though it is of equal, and perhaps greater, significance. That line of inquiry concerns the way in which the prices of credit default swaps effect [sic] the perceived value of all forms of debt — corporate bonds, commercial mortgages, home mortgages, and collateralized debt obligations — and as a result, the ability of hedge funds manipulators to use credit default swaps to enhance their bear raids on public companies.

If short sellers can manipulate the price of credit default swaps, they can disrupt those companies whose debt is insured by the credit default swaps whose prices are manipulated.  The game plan runs as follows: find a company that relies on a layer of debt that is both permanent, and which rolls over frequently (most financial firms fit this description). Short sell that company’s stock. Then manipulate the price of the CDS upwards, preferably into a spike, as you spread the news of the skyrocketing CDS price (perhaps with the cooperation of compliant journalists at, say, CNBC).

Because the CDS is, in essence, an insurance policy on the debt of the company, the spiking CDS pricing will cause the company’s lenders to panic and cut off access to credit. As this happens, the company’s stock will nosedive, thereby cutting off access to equity capital. Thus suddenly deprived of credit and equity, the firm collapses, and the hedge fund collects on its short bets.

Moreover, credit default swap prices are the primary inputs for important indices (such as the CMBX and the ABX) measuring the movement of the overall market for commercial and home mortgages.  In the months leading up to the financial crisis of 2008, short sellers pointed to these indices in order to argue  that investment banks – most notably Bear Stearns and Lehman Brothers – had overvalued the mortgage debt and property on their books. Meanwhile, several hedge funds made billions in profits betting that those indexes would drop.

It should therefore be a matter of some concern that credit default swap “prices” and the indexes derived from them are determined almost entirely by a little company with zero transparency and, it appears probable, a high exposure to influence from market manipulators. The company is called Markit Group, and there is every reason to believe that its CDS-driven indices (the CMBX, the ABX, and several others) are inaccurate, while the credit default swap “prices” that they publish  and which rock the market are in fact  nowhere close to the prices at which credit default swaps actually trade.

Last year, the media reported that New York Attorney General Andrew Cuomo had sent subpoenas to Markit Group as part of an investigation into possible manipulation of credit default swap prices by short sellers. This investigation, like Mr. Cuomo’s other investigations into market manipulation, have yielded no prosecutions.

The Department of Justice is reportedly investigating Markit Group for anti-trust violations. This investigation (which is reportedly focused on how Markit Group packages and sells its information) seems to acknowledge that Market Group has near-monopolistic control of information about credit default swap prices. However, if the press reports are correct, the DOJ has not considered the possible appeal of this monopolistic control to market manipulation.

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My Comment

This isn’t the first time that Markit has been fingered.  Pam Martens wrote a detailed piece last year at Counterpunch called “How Wall Street Blew Itself Up” that blew Markit´s cover.

Now I´ve always suspected the indices (including Libor) are manipulated.  The fundamental problem in our markets is corruption..and that´s directly related to size and monopoly. That´s why you do need certain kinds of  “level playing field” or procedural types of regulation (not substantive regulation) to take care of the problem. I think this should also take care of Olagues’ caveat. The Deep Capture team isn’t confining its investigation to simply naked shortselling in the technical sense, but is expanding its work to the entire range of strategies involved in rigging the markets – insider trading, short-selling of all kinds, and the manipulation of indices. (Correction: I am referring to uncovered short sales, where there is no intent to deliver)