Tag Archives: credit default swaps

Zerohedge On Banning Credit Default Swaps

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Zerohedge has a technical discussion of why hedge fund manager David Einhorn’s call to ban Credit Default Swaps is essentially a call to dismantle the entire fiat money system. Some of the details elude me, as they’re very technical, but the rest seems right to me. There’s no inherent difference between a credit default swap and, say, an interest rate swap, of which there are many more. So Einhorn’s demand is in effect a demand to ban all derivatives…

“Remember the liquidity pyramid?

As the graphic shows, derivatives account for 1,000% of world GDP, in essence allowing the world to believe fiat money is worth something only courtesy of financial sleight of hand which involved derivatives and securitizations. Yet all those calling for an end to CDS also have to realize that due to CDS intertwined nature, the world fiat system would need to do away with all derivatives (not just CDS), and when you do that you basically eliminate the other hybrid asset classes: securitizations being chief among them. What this would leave us with is a liquidity pyramid which ends with bank loans, which are much more manageable and whose risk can be controlled. It would also leave the world with a fiat currency system, which would lose about 10x of its value overnight, thereby leading to an instantaneous and global unwind of fiat money, and rolling waves of domestically denominated hyperinflation. A spectacular race to the bottom of the asset pyramid. And who will rather commit suicide than see that happen: why the Federal Reserve of course.

Which brings us full circle: an attack on CDS is an attack on excess liquidity, which is an attack on the global asset/liability imbalance (as world GDP and otherwise output has no chance of catching up with the liquidity that is currently available), which is an attack on fiat money, which is an attack on the perpetually low price of gold (because if and when derivatives and securitizations are done away with and tangible assets regain their true value, gold would go up by at least the same magnitude that fiat currencies are devalued), which is an attack on the heart of our broken financial system itself, and, an attack on the Federal Reserve, the Fractional and Central Banking System in principle. Well done David.

We hope Einhorn is successful in bringing more people to understand not just what the risk implications of CDS are (while also demonstrating the positive value that they do in fact provide in a rigged and broken capital market), but also what the underlying thematic subject of his attack really is: a busted fiat system. In essence, David believes in a fresh start. So do we, because on a long enough timeline…”

My Comment

Just to make it clear – I am myself not in favor of banning all derivatives. Why? Not because I think they´re profound innovations..or vitally necessary. But I think it´s the wrong way to go about tackling the problem. Banning one set of financial instruments will only prevent the smaller players from using them. The largest and best connected players will game the ban in some way, or make use of other sorts of compensating structures.  A better way would be to undo the fiat money system altogether…

So my agreementis with Zerohedge´s assessment of the situation and not necessarily with Einhorn´s recommendation on that point.

Besides, Einhorn, who made his money off of CDS´s, is an odd person to be pushing a ban.

Mark to “Markit” Manipulation

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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)