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They have got to do away with naked CDS contracts


Guest JackRiver
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Guest JackRiver

If you don't own the underlying debt it should be made illegal to transact in CDS on that debt.

 

Yours

 

Jack River

 

 

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thats the dumbest thing ever. why don't they just do away with naked options, futures, forwards, and every other derivative? 

 

It is a CONTRACT between two private parties.  Who are you to say two private parties cannot contract?

 

This is totally different from naked shorting.  Naked shorting is the failure to deliver; it is the failure to fulfill a contract.  Naked CDS is not.  It is merely a contract, where one party is paid if a certain event occurs (credit event).

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I would agree if the derivative market is smaller than the primary market.  For CDSs you have the tail wagging the dog because for a small fee you can buy insurance on some elses default.  The system breaks down because you have seperated the interest of the bondholder to support the firm to one that is neutral at best.  The holder of the CDS has a huge invested interest to cuase the firm to fail.  This is why you can't buy insurance on your neighbors house.  How is that differebnt here?

 

 

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You could argue the same "moral hazard" with buying put contracts when not owning the underlying stock.

 

Also, Packer, I disagree with you as well.  The derivatives market on equities (futures, forwards, and options) is larger than the equities market.

 

I think the problem is there is no netting and no standardization and no clearing house.  If we go these problems solved, it would operate just like the futures market, or just like the options market.  The problem isn't CDS, the problem is the way it is traded.

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What you need is to have them trade on a exchange with some regulation.   Just as you need to maintain margin to write naked puts, you should need the same to write naked CDS.     Many of the problems we're having right now are due to institutions writing contracts that they could never cover.   Hence the bottomless pit of govt. funds called AIG.

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Guest JackRiver

I understand full well the counter arguments some of you are making, but I'm not trying to live in a made up free market world (it doesn't exist and most likely never has).  The CDSs (and naked puts as well) are creating a massive negative feed back loop both in the equity markets and the broader economy.  Now eventually the insurance will get too expensive, but I don't think the government should wait around for that to happen. 

 

Yours

 

Jack River

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another "tail wagging the dog" phenomena that packer referred to might be the proliferation of the leveraged short etf's. eric oberg an ex goldman sachs alumni has been wriiting a series of articles about these for a while.

 

his latest:

 

"UltraShorts and the Fall of the Uptick Rule

 

had mentioned in one of my early articles on levered short-side ETFs that I thought it would be tough to reinstate the uptick rule with these products outstanding. I never really thought much more about it beyond that one fleeting sentence. Revisiting the thought now, though, I wonder if the massive proliferation of these vehicles would have ever been possible had the uptick rule not been eliminated to begin with. (Don't miss "Uptick Rule: Meaningful or Meaningless?")

This week [Feb. 23-27] on "Mad Money," Jim Cramer showed a clip of Fed Chairman Ben Bernanke's Humphrey-Hawkins testimony. Bernanke said that, if asked, he would advise SEC Chair Mary Schapiro that there may be merit to the concept of bringing back the uptick rule.

 

While the clip aired, a line flashed across the screen stating that the uptick rule was eliminated in 2007. That got me thinking a little bit about the timing -- I frankly couldn't believe the uptick rule had only been gone for less than two years. Please note, I am not a conspiracy theorist at all, but I was interested in reconstructing the time frame around the growth in levered and short-side ETFs and the elimination if the uptick rule.

 

ProShares, "the world's largest provider of short and leveraged funds," launched its first Ultra Funds (two times levered) and Short Funds in June of 2006. In July of 2006, it launched its first UltraShort (two times levered short) funds. These initial funds were based on broad indices -- the Dow Jones Industrial Average, the S&P 500, the Nasdaq 100 and the S&P Mid Cap 400. All of these indices had active futures markets at that time, which made the hedging of these products relatively easy, and such hedging would create minimal market disruption.

 

Then in January and February 2007, ProShares expanded its product offerings to include Ultra/Short/UltraShort Funds based on the Russell 2000, the Russell 1000 Value and 1000 Growth, the S&P Small Cap 600 and a few other broad indices, most of which had futures or could have been hedged using a simple beta in relation to the futures contracts. ProShares also launched a series of Ultra/Short/UltraShort products on 11 specific sectors that did not have active futures contracts and would have been much more difficult to hedge using a simple beta vs. a broad index future...."

 

rest of the article here:

 

http://www.thestreet.com/_rms/s/ultrashorts-and-the-fall-of-the-uptick-rule/university/etf/10467076.html

 

 

 

 

 

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Guest JackRiver

watsaisarandianhero

 

To be clear, I'm not advocating doing away with the options market or the broader regulated derivatives market.  What we have is multiple levels of derivatives and financial instruments that are actually effecting the underlying price of the securities they derive from.  This is the negative feed back loop.  What I'm suggesting is to take the unregulated leg in this mess, the CDS, and chop it off.  Then you can focus on the regulated parts.  At least there you will have some good data on what is going on, and in addition you reduce the fuel that is being added by the CDS. 

 

Now, the CDS fuel ends up in the options market anyway by use of hedges.  So we still need to deal with the options markets.  The best way to solve that is to do away with the Madoff exemption (as oldye points out).  But you've got to really do away with it.  No fails of size  should be tolerated both through DTC or ex clearing.  This would limit option MM activity, but should kill the speculative bear raids.  I believe that settlement (fails) are rampant still.

 

Yours

 

Jack River

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CDS's should be banned entirely, & made prosecutable under RICO laws.

 

Simple example.

- Buy an insurance company with longer tail business

- Pump up its premium by UW badly

- Reach for yield & write CDS's to boost P&L & raise cash to cover the UW losses

- Do successive equity issues to fund acquisitions & capitalize costs, further boosting P&L

- Buy a CDS on yourself, put the coy in Chapter 11, & put the book into runoff.

 

You walk away scott free, as the guy who sold you the CDS covers your losses.

 

You knew the CDS purchase was integral to your strategy. It could not be executed without it. It is hard to see how this is not white collar criminal behaviour. The CDS enabled & abetted a criminal act.

 

 

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Watsa,

 

I agree that some derivative markets are huge but those are associated with very liquid and deep markets for the underlying securities.  For single-name CDSs this is not the case.  The CDS outstanding par value is multiples of the underlying security and the underlying market is illiquid.  This is the first clue that something is amiss. 

 

Second, the market is dominated by a few large players (this is my understanding from Damodaran who does not consider the data from this market to be a true indication of the cost to hedge a debt instrument).  CDSs I think is more akin to portfolio insurance, where an unstable hedging mechanism is at play which will work if the derivative instrument is a small part of the market bit will collapse once a certain critical mass is reached.

 

Packer

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I disagree that the CDS market is "inherently evil."  I agree that it needs to be be regulated and a clearhouse would help also. 

 

Jack-

 

I agree options market makers should not have naked short ability.  However, that is a seperate problem and does not mean that CDS should be done away with.  Also, with a clearhouse in place requiring the posting of cash daily (same as futures market) would solve systematic risk issues.  Again, we are talking about contracts between private parties here.  One should not be concerned with with what two other private parties do with their money (you can see my Randian philosophy here).

 

BTW, if you are upset over CDS, why are you not concerned with futures?  ChicagoOne allows the trading of Single stock futures.  I can leverage 5x on that exchange.  I can short BAC with total disregard to any uptick or share location rules.  This, and equity index futures have a larger potential to influence stocks because of the leverage involved.  You can be 20x leveraged with equity index futures.

 

However, even the futures should not be a concern (as long as market makers are not naked shorting, this is the real problem).  If I short BAC with single stock futures, the market maker has to locate shares to short themselves to offset the risk.  The cost of borrowing will be passed on to me in the price of the futures.  Again, my advocation of these markets is predicated upon no party being allowed to naked short the shares.

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Watsa,

 

I am not saying they are evil just not extensively tested in real markets (especially illiquid markets).  I am a very free markets guy but I think regulation is need to prevent things from blowing up.  How can having multiples of the underlying face value of the debt be good?  This in my mind is set-up for negative feedback loops.  Why has the concept of buying insurance on your neighbors house not allowed in the past?  I think the issue that has not been addressed is the liquidity issue of the underlying.  All of the other markets you spoke of have deep liquidity where hedging can take place in single-name CDSs it cannot.  This how portfolio insurance blew-up.  Once the volume became so great the hedging no longer worked.  In addition, CDSs change the incentives of the holder of the underlying bond from a willing participant in a restructuring and a well informed investor to a neutral observer.  In addition, arbitrage between the instruments can enhance the feedback loop.  Maybe there is a way to make CDSs non-toxic (limiting open interest) but moving them to an exchange is not going to address the issues described above and the issue of feedback loops.  As a matter of fact it may increase the potential for such loops.

 

Packer   

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Guest JackRiver

Watsa

 

I'm all over the place in my comments (a little busy and stressed to say the least), and I'm not advocating doing away with CDS completely. 

 

There are many good rules and regulations that limit the type of transactions that private parties can agree to.  In all these cases one could make the argument for free markets or private transactions, but that's not the world we live in, nor is it a world I would want to live in.

 

Now, the life insurance example is a good analogy in a number of ways.  Imagine I could buy life insurance on you.  In fact I go out and buy a 10 million dollar policy from my friend Steve.  Strange enough, there is a website that tracks these types of transactions.  Your bank, your health insurance company, your employer, and various other parties you deal with are active consumers of this information. 

 

Now, as crazy (stupid) as this example is, what will happen to you if the consumers of this information actually start taking it seriously?  For starters, you health insurance premiums are about to go up.  Assuming you can still get health insurance.  Your credit card rates will also go up, that is if you can keep your credit cards.  You wont be able to get a mortgage, a car, a loan.  Your employer might be looking for your replacement.  Your wife might even leave you for me, betting that I'm coming into 10 million dollars soon enough.  All this and more based upon a bogus transaction between me and Steve.  I say to you, "Watsa ole boy, you should have kept more cash on hand and gotten rid of that ole gal years ago."

 

It's not about private transactions between private parties.  What one is really saying when they say this, though unaware they are saying it, is that anarchy is the best policy.  That's troubling to people, because surely they are not advocating for anarchy.  Well, I think they are.  They are just not thinking it through.  And yes, I'm aware of the other extreme, absolute control.

 

Given the nature of the CDS beast, that we just don't know much about what is really going on, I think it a good idea to remove, for now, that portion that is not a direct insurance contract on the underlying debt.  This does not necessarily mean forever, nor does it mean there aren't bigger problems in our more regulated markets, but it is a simple and quick fix so that attention can be focused on the other multitude of problems. 

 

Yours

 

Jack River

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CDS contracts are not evil per se but some of the players are.The futures, options and other derivatives mkts have changed over the years. There was for may years position limits on options and futures which ensured that no single player could corner a market ,for markets to function properly they need to be fair and have many participants none of which singly can affect prices for anything other than a fleeting moment. Unregulated free market capitalism is not a pretty sight we are seeing some of the  result of the lack of no adult supervision in the play ground we call the market place today.

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