Wednesday, June 10, 2009

Fair Deals and Bad Dealers: CDS, Regulatory Reform and Other Tales from Washington

Posted on the Institutional Risk Analyst:

During our regular New York lunch meeting last week with The Gang - Josh Rosner, Barry Ritholtz and the former emergency room physician, recovering hedge fund trader known as "Tyler Durden" - we heard some interesting chatter about stress tests, executive changes and rate hikes. One question: Is there some reason why we are not having further bank stress tests in Q3 and Q4?

We also heard some gripping from members of the dealer community, who also get a seat at the table. They accuse us of having a "chip on our shoulders" when it comes to the debate over reforming the market for over-the counter derivatives and particularly credit default swaps ("CDS"). By way of summarizing our remarks for today's conference in Washington sponsored by Professional Risk Managers International Association, "Regulation of Credit Default Swaps & Collateralized Debt Obligations," some thoughts follow below.

Excuse us for not liking a market that is rigged in favor of the sellers, the monopoly dealers, who even today refuse to allow open price discovery in CDS among and between the other dealers. We hear about this issue constantly, from clients large and small, from hedge funds to huge pension managers. If the range of end-users from whom we hear are at all representative of Buy Side views of the CDS market, change will be welcomed.

And yes please pardon us for not putting our stamp of approval on a market structure that creates more risk in financial institutions and their clients. Every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity.

Simply stated, the supra-normal returns paid to the dealers in the CDS market is a tax. Like most state lotteries, the deliberate inefficiency of the CDS market is a dedicated subsidy meant to benefit one class of financial institutions, namely the large dealer banks, at the expense of other market participants. Every investor in the markets pay the CDS tax via wider spreads and the taxpayers in the industrial nations pay due to periodic losses to the system caused by the AIGs of the world. And for every large, overt failure like AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets.

What offends us about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks.

No, what bothers us about the CDS market is that is violates the basic American principal of fair dealing. Jefferson said that "commerce between master and slave is barbarism." All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets, how can we expect our financial institutions and markets to be safe and sound?

Equal representation under the law went hand in hand with proportional requital, meaning that a good deal was a fair deal, not merely in terms of price but in making sure that both parties extracted value from the bargain. A situation in which one person extracts value and another, through trickery, does not, traditionally has been rejected by Americans. Whether through laws requiring disclosure of material facts to investors, anti-trust laws or the laws and regulations that once required virtually all securities transactions to be conducted across open, public markets, not within the private confines of a dealer-controlled monopoly, Americans have historically stood against efforts to reduce transparency and make markets less efficient - but that is precisely how we view the proposals before the Congress to "reform" the OTC derivatives markets.

To that point, look at Benjamin M. Friedman writing in The New York Review of Books on May 28, 2009, "The Failure of the Economy & the Economists." He describes the CDS market in a very concise way and in layman's terms. We reprint his comments with the permission of NYRB:

"The most telling example, and the most important in accounting for today's financial crisis, is the market for credit default swaps. A CDS is, in effect, a bet on whether a specific company will default on its debt. This may sound like a form of insurance that also helps spread actual losses of wealth. If a business goes bankrupt, the loss of what used to be its value as a going concern is borne not just by its stockholders but by its creditors too. If some of those creditors have bought a CDS to protect themselves, the covered portion of their loss is borne by whoever issued the swap.

"But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars' worth of economic costs that would not have occurred otherwise.

"This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today's immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers' money if they have bet the wrong way. But here as well, no one seems to be paying attention."

When we see too many people in "agreement" on a given issue, like the rebound of equity market valuations for the largest zombie banks or the growing chorus of economists that the "recession" is ending, we usually lean the opposite way instinctively, just to keep the rowboat from capsizing. Fact is, the professional investment crowd is mad to see financials recover and is getting even madder over the prospect of any sort of reform of OTC markets, restructuring of financial regulation or links between risk taking and executive compensation.

Here's our bottom line on CDS reform, banks repaying TARP and the growing crowd at the zombie dance party:

First, the pressure bearing down on the Congress not to touch the OTC derivatives markets is enormous and stems from the fact that banks like JPMorganChase (NYSE:JPM) cannot survive without the supra-normal returns from these dealing activities. But at the same time, the risk from these activities is arguably going to destroy JPM and the other dealers unless changes are made to reduce aggregate risk-taking. See our comments yesterday on Tech|Ticker about JPM and the other money center banks by clicking here.

Perhaps the fact of this huge, unmanageable risk embedded in the OTC model explains why none of the major partnership exchanges have been willing to propose themselves as alternatives for the OTC derivatives model. As one Chicago insider told The IRA: "None of our members are comfortable with the economics of CDS contracts nor would they be willing to backstop settlement of these instruments as they exist today."

Second, the decision to allow the larger banks to repay their TARP money is a mistake of the first order, in our view, and illustrates the degree to which Washington is letting the large dealers call the shots on regulatory strategy. If our estimates for loss rates by US banks prove correct, many of the TARP banks repaying capital now may be forced to come back to Washington seeking more help in Q4 2009 or in 2010. And the large banks not repaying the TARP money bear a stigma that may cause regulators and bankers serious problems as the year wears on.

Whereas the regulators had rebuilt some credibility with the public as a result of the stress test exercise, allowing the largest US banks to exist the TARP before we transit the most serious part of the financial storm strikes us as very reckless. If the Fed and Treasury want US banks to be seen by the public as safe and sound, then allowing them to reduce their capital - before ending dependence on FDIC debt guarantees and Fed repurchase agreements for toxic waste - seems contrary to the public interest.

Third, the repayment of the TARP capital by some banks does not end the GSE status of all of the major banks, Chrysler, GMAC, AIG and GM. While the White House is talking about "exit strategies" for some of these zombies, the reality is that the US government could end up as the long-term owner of both automakers, Citigroup (NYSE:C), GMAC and AIG. The cost of keeping the doors of these zombies - plus the housing GSEs -- open will consume all of the discretionary cash flow that Washington thinks is available for other pressing needs. Waive "bye bye" to health care reform, Mr. President, if we are going to feed all of these zombies in 2010.

We are told by one of our favorite Democratic economists that the Obama White House is beginning to understand the concept of resource constraints when it comes to federal spending and obtaining the dollars to spend via Treasury borrowing operations. Until and unless the Obama team accepts that keeping the zombies alive will mean putting aside plans for health care and other political priorities, there is not likely to be any action to resolve any of the GSEs.

But we do see signs of change within the White House. Just as Secretary Geithner was finishing his high profile but low substance visit to China, former Federal Reserve Board Chairman Paul Volcker was observed quietly arriving in Beijing for talks with the senior Chinese political leadership. The Chinese have made it clear, we are told, that the opinions of Chairman Volcker are more reliable than the at times sophmoric statements of Secretary Geithner.

The Treasury Secretary, do not forget, is seen in China, Europe and elsewhere as a representative of the largest US banks. The Chinese and Europeans have an intense distrust of the US dealer community for causing the financial crisis, thus Geithner's ties to Wall Street work against the interests of the US, both in Europe and in many conservative investor communities throughout Asia.

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