Stupid Is as Stupid Does: The SEC and CFTC Legalize Electronic 'Gambling' 12 comments
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Forrest Gump said “stupid is as stupid does” and the latest move by the SEC and CFTC to license clearing houses for credit default swaps is about as stupid as it comes. Rather than questioning the underlying economic rationale and legality of credit default swaps, the SEC and CFTC have decided to facilitate the proliferation of these financial derivatives by licensing “casinos” for gaming of these contracts.
On Tuesday, Federal regulators approved a clearing system for credit default swaps which is the first in a series of anticipated actions that will increase and legitimatize the overall use of these over-the-counter instruments. However, Federal regulators have missed an essential truth - credit default swaps fall into two categories; they are either insurance contracts or gambling, and most of them constitute gambling. A clearing house for credit default swaps will essentially legalize electronic gambling by speculators posing as legitimate investors. In their current form, credit default swaps are bad for the United States and financial regulators aren’t using common sense in what they are doing to regulate these instruments.
Credit default swaps are agreements between two parties that bet on the credit worthiness of a company. For a fee, one party agrees to indemnify the other party in case of a credit default of the company that is being bet upon.
The vast majority of credit default swaps are used for one of two reasons; hedging or speculation, with the numbers heavily tilted toward speculation.
Credit default swaps for hedging
When a credit default swap is entered into for hedging purposes one of the parties in the credit default swap has a financial interest in the payment or default of an underlying debt obligation. Usually, the party purchasing the credit default swap is owed money by the underlying company and wants to make sure that if the underlying debt obligation defaults they won’t take a loss. In case of a default, the party that purchased the credit default swap is indemnified against loss by the person selling the credit default swap. Of course, this transaction is indistinguishable from credit insurance but for some reason regulators have decided to look the other way and not regulate credit default swaps as insurance contracts.
For about two months, from the middle of September until the middle of November, it appeared that New York was going to regulate credit default swaps as insurance contracts. Governor Patterson announced this initiative in a September 22nd press release, sections of which are set forth below:
Eric Dinallo, New York State Insurance Superintendent, said: “The severity of this crisis was substantially increased by what the government chose not to regulate, principally credit default swaps. This is primarily a credit crisis, not an equity crisis, and that is where the focus should be now. What New York State is doing fits our role as insurance regulators. We are providing an appropriate way for those with an insurable interest to protect themselves and we are going to ensure that whoever sells them that protection is solvent, in other words, can actually pay the claims. There is currently no such protection for policyholders…”
…The primary goal of insurance regulation is to protect policyholders by ensuring that providers of insurance are solvent and able to pay claims on policies they issue. The goal of regulating these swaps is not to stop sensible economic transactions, but to ensure that sellers have sufficient capital and risk management policies in place to protect the buyers, who are in effect policyholders. At AIG, for example, insurance companies regulated by the state are required to hold substantial reserves and as a result those companies are solvent and able to pay claims. However, a major part of AIG’s problems were created when credit default swaps were issued by a non-insurance unit that did not hold sufficient reserves…
…Credit default swaps played a major role in the financial problems at AIG, Bear Stearns and the bond insurance companies. A credit default swap is a contract under which the seller promises to pay the buyer if the insurance provider of the bond cannot pay principal and interest. Credit default swaps can be used by the owners of bonds who want to protect themselves if the company that issued the bonds is unable to pay interest and principal. In those cases, the swap is insurance, because the swap buyer is like a homeowner insuring a home…
…The new guidelines establish that when the buyer owns the underlying security on which he is buying protection then the swap is an insurance contract. Under these new regulations, such swaps would be subject to regulation for the first time and can thus only be issued by entities licensed to conduct insurance business.
But by the middle of November, Governor Patterson reversed his position and decided not to regulate credit default swaps used for hedging as insurance. Just before Thanksgiving, Dinallo stated that the change was because there was going to be a clearinghouse for trading credit default swaps. Dinallo’s reversal because of a proposed clearinghouse has nothing to do with the underlying transaction and shouldn’t have been a consideration in deciding whether or not hedging swaps are insurance contracts.
Credit Default Swaps for Speculation
Governor Patterson’s press release from September states:
“…most swaps are now used by speculators who do not own the bonds and the value of swaps outstanding are generally much more than the value of a company’s debt. Swaps bought by speculators are known as “naked swaps” because the swap purchasers do not own the underlying bond…“
Unfortunately, Governor Patterson concluded that New York State didn’t have jurisdiction to regulate naked swaps. But he was wrong, the state has such jurisdiction. Naked credit default swaps fit the definition of gambling contracts and are illegal in New York (as well as most states). Section 225 of the New York State Constitution defines “gambling” to be when:
“A person… stakes or risks something of value upon the outcome of a contest of chance or a future contingent event not under his control or influence, upon an agreement or understanding that he will receive something of value in the event of a certain outcome.”
In the case of naked credit default swaps speculators bet on future contingent events, the ability of companies to pay their debts. And, when the speculator doesn’t have an underlying economic interest or other underlying reason to purchase the contract it’s high stakes gambling at its best.
The Clearinghouse For Credit Default Swaps Redefined
Governor Patterson said it best when he stated that most swaps are used by speculators and for “destructive speculation” that damages “the health of targeted companies.” The proposed clearinghouse will mostly be used for naked credit default swaps and will be the biggest and most technologically advanced gambling joint in the world. And, the destructive impact of naked credit default swaps will grow.
Rather than facilitating the casino mentality that has almost ruined the economy, the SEC, CFTC and other state and Federal regulators should be outlawing naked credit default swaps as gambling contracts and regulating hedging credit default swaps as insurance contracts. And, New York shouldn’t have abandoned its effort to regulate these derivative contracts.
Stupid is as stupid does and until financial regulators and government officials start to use common sense the United States won’t be able to fix its economy.
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Likewise, speculators should be prohibited from gambling on the 'life' of a company where they have no direct business connection.
Allowing CDS purchase on unrelated companies leads to abuse and rumor mongering for profit.
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If that's the definition of gambling, most of any kind of investing would be. For example, if I buy TIPS, I have no influence on future inflation but I will receive something of value if it occurs. Seems like the law defining gambling needs to be revised.
There's a simple solution to the CDS problem: if you don't want to insure 'em, don't write 'em.
Moody's and S&P won't admit it, but they rely on CDS spreads as a way of determining credit ratings: if a company's CDS spreads go up because of rumors or speculation, Moody's and/or S&P will be looking for a reason to downgrade their credit.
CDS spreads also determine the cost of credit, so speculators and manipulators have the power to destroy the credit market, as they have done.
Finally, CDS have been bundled up in CDO's and sold as "synthetic" CDOs to "sophisticated investors. What the investor gets is the privilege of providing insurance on a bunch of adverse selected risks.
Any economic recovey we achieve is likely to be unstable until this game is shut down. The only possible justification for establishing a clearing house is to get all the information available in one place so regulators can shut the game down without blowing up the system.
Once the naked contract is allowed to proliferate, untethered by the underlying asset, it becomes its own beast. It is unfathomable that one could have 5 swaps on one bond, or five calls on one stock...which call actually retrieves the stock if it rises? It is as if a chicken laid an egg, and gave birth to three pigs.
As in mathematics, derivatives in general should be worth much, much less than the underlying asset, and derivatives of the derivatives worth even less, by a logorithmic degree. Unfortunately, we have allowed for these derivatives to multiply as if they were the money supply, with correspondingly catastrophic results. That these derivatives are worth many times more than the underlying assets is proof that Wall Street has suffered from hubris, and our regulators were totally asleep at the wheel. Only money should be allowed to proliferate to this order of magnitude, as it is guaranteed by the federal government, and carries minimal risk when compared to the stocks, bonds, and etc that are used as underlying assets for derivative contracts.
I am no expert in the field, but I have until the past couple of months believed that derivatives behaved like the futures market - you would expect delivery of some sort of physical good (or asset) upon expiration of the contract - therefore, the path to value could always be traced. To find this not to be the case is appalling.
Wouldn't playing options fit the law of "contest of chance"??
Don't throw out the baby with the bathwater. CDOs are neither good nor bad simply a risk transferrence tool
I am somewhat concerned that the insurance type of CDS is so inexpensive. If I own a building that is a firetrap, no sprinkler system, poor wiring etc, I should have to pay through the nose for insurance. But for companies in deep trouble, such as Lehman, you could buy CDS on Lehman bonds for a few cents on the dollar, and then gotten 91 cents on the dollar on settlement day in October.
If I bought insurance on a firetrap of a building for a small premium, there is no incentive on my part to make the building safer. So if I can get CDS on a CDO for pennies on the dollar, there is little incentive to assess risk correctly. In the case of AIG, I think the guys in Financial Products were fraudulent in assessing risk, merely getting as much money in premiums as possible to enrich themselves.
I hope these guys are all getting fitted for handcuffs, but if in fact they broke no laws, they should never be allowed to have a job in the financial sector again.
Sad