Yesterday's Wall Street Journal featured a lengthy piece on swaps regulations. With the recent Greek bond problems as a context, European regulators want to ban dealing in naked swaps, i.e., trading/holding swaps when one does not hold the underlying instrument on which the (risk of default) swap is written.
I had a long conversation with a colleague about this yesterday over lunch.
Why, I asked, is there a presumption of pressure on the interest rate and value of the underlying instrument from naked dealings in a side bet which is the default swap on the instrument?
Swaps are not options. They are simply insurance against default.
If there is any basis for disliking their naked trading, it would seem to be more akin to the aversion regulators have for people purchasing life insurance on third parties in whom they are disinterested. It's become a hot field lately, with investors picking up life insurance policies for the aged, in exchange for paying the premiums.
Our society has had moral reservations against bets on death of this sort for a long time.
As my colleague pointed out, nobody would probably mind if you could bet on a bond's performing as promised. It's the bet on failure that seems to arouse angst and emotion.
Yet, in the case of Greek bonds, it's hard to see how an unrelated, naked derivative position would or could possibly affect the bonds' values as much as the simple trading in the bonds themselves, isn't it?
It's understandable how heavy pressure on an equity's price from options or shorting can occur. Shorts have obvious affect by causing selling pressure, driving equity prices down. Lopsided options activity can create arbitrage opportunities which affect equity prices, too.
But simply executing a parallel bet on an event by buying, or selling, a credit default swap, wouldn't seem to do more than, as today's Journal piece on the topic notes, provide a sentiment indicator. Since the swap confers no rights to buy or sell the underlying bond, it simply can't have an influence on the bond's price beyond that of trading activity in the actual debt instrument.
The entire discussion topic seems, to me, to be one sparked by hysteria, emotion and faulty logic, rather than a genuine, proven causal effect between swaps prices and the price of the underlying debt instrument.
Showing posts with label Swaps. Show all posts
Showing posts with label Swaps. Show all posts
Thursday, March 11, 2010
Thursday, October 15, 2009
Holman Jenkins' Rare Mistake
I finally got around to reading Holman Jenkins' interview with Goldman Sachs CEO Lloyd Blankfein in the weekend edition of the Wall Street Journal. The colleague who urged me to read it was correct- it's primarly a public relations piece by Blankfein to try to smooth over the bank's image prior to news that it will be again paying stratospheric bonuses after being rescued by the Fed and Treasury last fall.
Of course, now, Blankfein will have none of that, as conveyed in the interview. Note, for example, these passages,
"Then there's the matter of AIG, source of snarling recriminations even among Goldman's Wall Street brethren. If AIG, a huge player in all kinds of markets, had gone down, the impact on the economy would have been incalculable. Mr. Paulson and Fed Chief Ben Bernanke wouldn't risk it. They reversed course after Lehman and bailed out the insurance giant to a tune that now has reached $180 billion. To this day, charges fly that the AIG bailout was a backdoor bailout of Goldman.
AIG had been a big issuer of guarantees on subprime-backed paper; Goldman had been a big buyer of those guarantees. Nonetheless, when government officials rang up to ask what would be the potential impact of an AIG bankruptcy on Goldman, Mr. Blankfein says his answer was: "negligible." He did not, he says, ask Washington to save AIG: "It never occurred to me, having lived through Lehman Brothers weekend, that there was government money for anything. People wanted to know how we were going to do when AIG went down. I was telling them we were fine."
Mr. Blankfein points to what he calls a fundamental aspect of Goldman culture—its risk-management discipline. AIG had been regarded on Wall Street as a gold-plated client, not just a "Street" counterparty. But Goldman had nonetheless taken the usual step of requiring AIG to post collateral nightly against any deterioration in the market value of the guaranteed assets.
Mr. Blankfein placed some of the phone calls himself. "AIG was being beastly, difficult to deal with, not responding well to our calls for collateral. And I called them up and fought with them, and it was always because they were disagreeing with our 'marks.' They never said, and I never had reason to suspect, 'We're illiquid. We don't have the money.' It never occurred to me."
Goldman, in its rigor, reinsured any shortfall with other counterparties, who were also required to post collateral nightly. "We had one day of exposure with them. It doesn't mean I can't lose $300 million if they don't pay because that's how much a market can move in a day, but basically I'm not worried about it."
These estimates, of course, have a theoretical element. The underlying assets would certainly have collapsed even further in value if Wall Street firms and AIG began dropping like nine-pins. We'll never know. In the event, AIG was rescued—though that now meant that taxpayer money, in a sense, was being shipped to Goldman to meet AIG's collateral obligations.
Some say today the government should have spurned Goldman's collateral demands. Some say it should even have forced Goldman to settle the outstanding positions at a discount.
Realistically, though, AIG faced hundreds of counterparties; and short of bankruptcy, which Washington had ruled out for AIG, no obvious formula presented itself for rewriting thousands of AIG contracts without risking the market panic Washington was trying to forestall. For its part, Goldman would have been on thin ice with its own shareholders if it had voluntarily relinquished valuable contract rights to make nice with Washington."
There's just one problem with that last paragraph. Mr. Jenkins is wrong.
In an article that appeared in the Wall Street Journal within a few months of the financial sector meltdown of last fall, one astute observer noted that there was, in fact, an existing process by which AIG's numerous counterparties could have been fairly and equally treated.
That option, of course, was bankruptcy. And it's rather curious to me that Jenkins glosses over this with a simple "Washington had ruled (that) out for AIG."
As that editorial writer noted several months ago in the Journal, putting AIG's swaps through bankruptcy, quickly, would have resulted in all counterparties taking a known, equal percentage haircut on the value of their positions. This is no different than learning that the value of your swap declined for some market reason. Swaps gain, and lose value all the time.
The source really is somewhat immaterial.
I'm surprised Jenkins gave Blankfein, Goldman and Washington all passes on this rather monumental corruption of capitalism.
AIG's takeover by the federal government is precisely the sort of unnecessary appropriation of private property, followed by draconian, confusing Congressional and administration rules impositions, that begs for more use of bankruptcy and less entanglement of Washington with private enterprise.
Of course, now, Blankfein will have none of that, as conveyed in the interview. Note, for example, these passages,
"Then there's the matter of AIG, source of snarling recriminations even among Goldman's Wall Street brethren. If AIG, a huge player in all kinds of markets, had gone down, the impact on the economy would have been incalculable. Mr. Paulson and Fed Chief Ben Bernanke wouldn't risk it. They reversed course after Lehman and bailed out the insurance giant to a tune that now has reached $180 billion. To this day, charges fly that the AIG bailout was a backdoor bailout of Goldman.
AIG had been a big issuer of guarantees on subprime-backed paper; Goldman had been a big buyer of those guarantees. Nonetheless, when government officials rang up to ask what would be the potential impact of an AIG bankruptcy on Goldman, Mr. Blankfein says his answer was: "negligible." He did not, he says, ask Washington to save AIG: "It never occurred to me, having lived through Lehman Brothers weekend, that there was government money for anything. People wanted to know how we were going to do when AIG went down. I was telling them we were fine."
Mr. Blankfein points to what he calls a fundamental aspect of Goldman culture—its risk-management discipline. AIG had been regarded on Wall Street as a gold-plated client, not just a "Street" counterparty. But Goldman had nonetheless taken the usual step of requiring AIG to post collateral nightly against any deterioration in the market value of the guaranteed assets.
Mr. Blankfein placed some of the phone calls himself. "AIG was being beastly, difficult to deal with, not responding well to our calls for collateral. And I called them up and fought with them, and it was always because they were disagreeing with our 'marks.' They never said, and I never had reason to suspect, 'We're illiquid. We don't have the money.' It never occurred to me."
Goldman, in its rigor, reinsured any shortfall with other counterparties, who were also required to post collateral nightly. "We had one day of exposure with them. It doesn't mean I can't lose $300 million if they don't pay because that's how much a market can move in a day, but basically I'm not worried about it."
These estimates, of course, have a theoretical element. The underlying assets would certainly have collapsed even further in value if Wall Street firms and AIG began dropping like nine-pins. We'll never know. In the event, AIG was rescued—though that now meant that taxpayer money, in a sense, was being shipped to Goldman to meet AIG's collateral obligations.
Some say today the government should have spurned Goldman's collateral demands. Some say it should even have forced Goldman to settle the outstanding positions at a discount.
Realistically, though, AIG faced hundreds of counterparties; and short of bankruptcy, which Washington had ruled out for AIG, no obvious formula presented itself for rewriting thousands of AIG contracts without risking the market panic Washington was trying to forestall. For its part, Goldman would have been on thin ice with its own shareholders if it had voluntarily relinquished valuable contract rights to make nice with Washington."
There's just one problem with that last paragraph. Mr. Jenkins is wrong.
In an article that appeared in the Wall Street Journal within a few months of the financial sector meltdown of last fall, one astute observer noted that there was, in fact, an existing process by which AIG's numerous counterparties could have been fairly and equally treated.
That option, of course, was bankruptcy. And it's rather curious to me that Jenkins glosses over this with a simple "Washington had ruled (that) out for AIG."
As that editorial writer noted several months ago in the Journal, putting AIG's swaps through bankruptcy, quickly, would have resulted in all counterparties taking a known, equal percentage haircut on the value of their positions. This is no different than learning that the value of your swap declined for some market reason. Swaps gain, and lose value all the time.
The source really is somewhat immaterial.
I'm surprised Jenkins gave Blankfein, Goldman and Washington all passes on this rather monumental corruption of capitalism.
AIG's takeover by the federal government is precisely the sort of unnecessary appropriation of private property, followed by draconian, confusing Congressional and administration rules impositions, that begs for more use of bankruptcy and less entanglement of Washington with private enterprise.
Thursday, November 20, 2008
What About Those Swaps?
Last week's Wall Street Journal of Wednesday, November 12, sounded an alarm regarding AIG's continuing credit default swaps positions.
However, just this week, a Journal article contended that, of all the malfunctioning fixed-income markets, the CDS market had actually done remarkably well during the past few months, including settling the now-defunct Lehman positions.
According to the editorial, CDS pricing now provides a better, more continuous measure of the value of debt of many firms than their own, non-trading debt does.
Even so, I can't help but believe that the CDS market would do better in the future if two things were changed, as I have suggested in prior posts: create a formal exchange, and; restrict the leverage allowed for entities holding and trading CDS.
The first change would provide greater transparency for many aspects of the CDS market, including gross and net outstanding volumes, trading volumes, and a better identification of the major players who, therefore, are exposed to risk in the market.
The second change would limit the damage to the CDS market and, by extension, to other markets, by assuring the availability of equity for CDS positions which require more collateral, as could be required by the exchange on an intra-day basis.
Together, these improvements would limit the likelihood that another mess like that which consumed AIG could occur. Exchanges monitor the financial ability of members to fulfill their obligations to other members, which would have provided a more public warning regarding AIG's over-extension in CDSs.
I don't doubt the CDS market is vital. But leaving it to exist as an over-the-counter market with no clear rules or standard clearing mechanisms invites another disaster by another firm as inept as AIG was at correctly assessing its risks under the many billions of dollars worth of securities price protection it sold as CDSs.
However, just this week, a Journal article contended that, of all the malfunctioning fixed-income markets, the CDS market had actually done remarkably well during the past few months, including settling the now-defunct Lehman positions.
According to the editorial, CDS pricing now provides a better, more continuous measure of the value of debt of many firms than their own, non-trading debt does.
Even so, I can't help but believe that the CDS market would do better in the future if two things were changed, as I have suggested in prior posts: create a formal exchange, and; restrict the leverage allowed for entities holding and trading CDS.
The first change would provide greater transparency for many aspects of the CDS market, including gross and net outstanding volumes, trading volumes, and a better identification of the major players who, therefore, are exposed to risk in the market.
The second change would limit the damage to the CDS market and, by extension, to other markets, by assuring the availability of equity for CDS positions which require more collateral, as could be required by the exchange on an intra-day basis.
Together, these improvements would limit the likelihood that another mess like that which consumed AIG could occur. Exchanges monitor the financial ability of members to fulfill their obligations to other members, which would have provided a more public warning regarding AIG's over-extension in CDSs.
I don't doubt the CDS market is vital. But leaving it to exist as an over-the-counter market with no clear rules or standard clearing mechanisms invites another disaster by another firm as inept as AIG was at correctly assessing its risks under the many billions of dollars worth of securities price protection it sold as CDSs.
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