I've been catching up to my reading and came across an incredible story in FT which makes a prima facie case for the very strict regulation of credit default swaps. Here's the gist of it:
As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.
Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.
The government finally approved an exchange for trading Credit Default Swaps. With so many financial institutions, from banks to hedge funds, holding on to these things, the question has been how to finally close out all these trades. A lot of the issuers can meet their obligations on these trades, and a lot of buyers of CDSes tied up a lot of their capital into these instruments. Everyone wants out, but there hasn't been an exit until now.
Frankly, I'm glad we're going to have an exchange, it should have been done this way from the beginning. Everyone's stuff will be in the open, let the various market participants do this, not the government. I would rather these folks close out their trades between themselves than having the government buy them and deal with it. Also, this will open the way for a future Credit Defualt Swap product that would be more fungible.
A recent article from reporters Salas and Harrington at Bloomberg pointed to a new dimension in the ever expanding saga of credit default swaps and the enormous damage they have done and continue to do to the economy. The crux of the matter is that bond traders who own swaps have a strong incentive to drive distressed companies into bankruptcy. It’s profitable. In something akin to debt arbitrage, traders buy debt at a fraction of its full value, and buy the swap at a fraction of its payoff value, and if the sum of the two is several points less than the full value of the debt, they profit by either waiting for the difference to narrow or by driving the company into bankruptcy. No wonder Buffett called derivatives weapons of financial mass destruction. But it gets even better. According to the article, a strategist at CreditSights Inc.
Not to beat a dead horse, but this article from the NYT peels another layer of obfuscation away from the truth that is AIG. If you have just had dinner, you may want to wait awhile before reading.
Things are going from bad to worse for our largest banks.
The activity in the nation’s banks suggests that investors believe they are circling the drain, zombies needing only a blow to the head once and for all, or facing an imminent restructuring at the hands of the government.
...
The U.S. government and New York Attorney General Andrew Cuomo opened a joint investigation into the $34.8 trillion credit-default swap market, the top federal prosecutor in New York said
Might be a scapegoat witch hunt though for they are targeting short sellers.
Mr. Cuomo and Mr. Garcia are investigating whether investors drove up the price of swaps in transactions that were reported to data providers but never actually completed, according to people briefed on the investigation. If so, that would have helped anybody who sold short financial shares. In a short-sale, investors sell stocks they do not own in the hopes of buying them back later at a lower price.
Eric Dinallo, who is with the New York State Insurance Deparmtnet spells out the trouble with CDSes (Credit Default Swaps), specifically Naked CDSes. It's about 5 minutes into the video.
U.S. Securities and Exchange Commission Chairman Christopher Cox said Congress should grant authority to regulate the credit-default swaps market amid concern the bets are helping fuel the global financial crisis.
Lawmakers should ``provide in statute the authority to regulate these products to enhance investor protection and ensure the operation of fair and orderly markets,'' Cox told the Senate Banking Committee today at a hearing in Washington.
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