Thursday, April 1, 2010

Gaming CDS (non-)rules continues

Original posted on Reuters by Rolfe Winkler:

In Wall Street’s Wild West, it’s OK to rob the stage coach because there’s no sheriff to enforce the law.

The Journal’s Kara Scannell has the story of defendants in an insider-trading case trying to get off on a technicality.* They claim swaps aren’t “securities” and therefore the SEC has no jurisdiction.

There’s a broader theme at play, which I note below. First the story…

The case has triggered a broader debate: Can federal securities regulators pursue insider-trading charges in the unregulated market for “credit-default swaps,” financial contracts that provide insurance against debt defaults. Banks, hedge funds and traders use them to bet on the likelihood of bonds or loans going bad. The SEC says it has purview over policing the market.

The defendants in the New York case argue, among other things, that swaps aren’t securities, but private contracts between financial players outside the SEC’s jurisdiction. Unlike most stocks, bonds and options, swaps aren’t traded on an exchange….

Insider trading occurs when someone makes an investment decision based on material information not available to the general public, and knows that information is coming from a person who has a responsibility to keep it private. The SEC traditionally has pursued insider-trading cases involving stocks, options and other securities. But as swaps have exploded in popularity in recent years, regulators have grown concerned that investors have been using inside information in trading them.

The broader theme is how those trading CDS continue to exploit regulatory loopholes wherever they can, sometimes making contradictory arguments.

This came up in the case of Ambac in Wisconsin last week, about which I wrote a column.

Buyers and sellers of credit default swaps have long argued CDS are executory contracts, not insurance policies. For accounting purposes, for tax purposes, for not-holding-capital-against-their-positi on purposes, they want it to be treated like a contract. But this is problematic when the sellers of CDS — the Ambacs/MBIAs/other monolines — run into trouble and face bankruptcy.

Executory contracts are junior to insurance policies in bankruptcy. For an insurance company like a monoline, that means capital might be sequestered in order to protect policy-holders over the life of their policies. What’s left after policies lapse can then be paid out to other creditors.

The monolines were mainly in the business of insuring municipal bonds, insurance policies that can run for decades.

But CDS holders want their money now. The mortgage-backed securities for which they bought protection are going bad now, so they’re getting paid now. Nevermind that payments on these CONTRACTS would wipe out what’s left of Ambac’s capital needed to back its municipal bond INSURANCE POLICIES.

Ambac’s regulator put a stop to payments on the contracts last week. A smart and entirely defensible move.

But CDS holders are unhappy because they think they should keep getting paid.

In this case, in other words, they want their contracts treated like insurance policies. But of course they’d never want CDS regulated as insurance, since this would burden them in other ways.

Derivatives reform is not a case where the “pendulum of regulation” is swinging too far. It’s a case where there’s virtually no regulation and a sensible baseline needs to be established.


*Previously Bloomberg’s David Scheer reported on these guys mounting a similar defense about the underlying Dutch Bonds (ht SMI).

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