Bad Bank and Draft Bill Spook CDS Traders and Wall Street

Early Tuesday, news and rumours about an impending Bad Bank were causing key credit default swap indices to tighten to levels last seen in early November. Later in the day, however, Minnesota Congressman Collin Peterson began circulating draft legislation seeking to ban short positions on credit default swaps and to bring the entire $700 trillion derivatives market into a transparent clearing-house mechanism. As of Wednesday morning, while many CDS traders will be checking out the job market, financial analysts are still trying to figure out what the frontal attack on over-the-counter deals will have on the balance sheets of Wall Street’s banks which are already stumbling from one bailout to another.

It is too early to tell what medium-term impact a ban on short (or naked) positions in credit default swaps will have on CDS spreads. Talk of soon-to-be “good” banks resulted in sharp improvements in the North American and European 5-year investment-grade indices, to 192 and 155 basis points respectively. “The Bad Bank will clean up the system, give the troubled banks a fresh start and allow credit to flow through to business,” an overly optimistic Obama financial advisor told CNBC. “Without toxic assets on their books, banks will return to profitability, inevitably.”

She had obviously not read the “anti-speculation” bill being passed around the House by the Chairman of the Agricultural Committee. If Congressman Peterson has his way in forthcoming weeks, Goldman Sachs (GS) and Morgan Stanley (MS) will need to figure out the extent to which their OTC derivatives business will shrink this year; both rely on OTC derivatives trading for as much as 40% of their profits. “There is no question that more than 70% of interest-rate and currency swap counterparties will fiercely resist the clearing house umbrella being proposed in Congress,” said a Citigroup (C) dealer who estimated that OTC transactions make up 30-40% of his overall trading profits.

In other words, while the proponents of the Bad Bank are focusing on toxic mortgage-backed securities, Congressman Peterson’s bill, which has a fair chance of success, threatens the earning potential of the “residual” good banks. JPMorgan Chase (JPM) held $87 trillion of derivatives as of September 30, 2008, 96% of which were in the OTC market. Bank of America (BAC) held $38 trillion, 94% in OTC contracts. It has been widely acknowledged for many years that OTC derivatives, besides qualifying as a core profit segment in Wall Street balance sheets, are absolutely critical for the operations of hedge funds and multinational corporations.

It is not clear if Congressman Peterson has any worthwhile contact with his colleagues who are pushing for the incorporation of the Bad Bank. Because one unintended consequence of his legislation could be the need for a second Bad Bank, particularly since the ban on non-OTC derivatives is likely to set off panic buttons amongst an exceptionally wide range of counterparties located in more than five dozen countries. OTC contracts do possess certain characteristics common to exchange-traded futures; but their popularity is due mainly to their uniqueness, to the capacity of each contract to absorb specific requirements in accordance with timelines conforming to each specific situation.

In the interim, the CDS marketplace is in danger of becoming largely a “quote-only” phenomenon, where bid-asked prices are quoted daily for 3,000-plus reference instruments but actual deals are hard to identify. “Between the bailouts, the Bad Bank, the anti-speculation bill, the IMF emergency packages and the proliferation of government-backed paper, CDS traders are losing direction, there are too many mixed signals,” a risk specialist at Credit Suisse conceded yesterday. “In fact, we are now going to see exponentially rising demand for political risk and index put insurance coverage.” Arguably, it will take years before lawmakers like Congressman Peterson get down to the task of regulating political risk and index put deals. Credit default swaps may be going out of fashion fast, but financial engineering is still very much alive.

Disclosure: Short BAC, GS, JPM, XLF.

Comments

[Ishortyou:]

those gains on bets on OTC derivatives is just an illusion driven by hegdes and not by real creation of wealth, is not any different than going to Vegas and gamble, the only difference is that Vegas does not allow you to "Hedge" meanwhile the OTC derivatives market does allow you to do that as long as you have the money (most of it borrow from investors), this is exactly in part what got us into trouble in the financial sector. Giving the OTC derivatives market a clearance platform and transparency will eliminate the speculation and make a sincere, clear and honest 'bet'.

Jan 29 07:38 AM

[morph366:]

Your article touches on "unintended consequences" of which you seem to disapprove but you end with the comment "financial engineering is still very much alive". Isn't is precisely the fetish for innovative financial products adopted without adequate understanding and stress testing that has created the largest unintended consequence of all - the virtual collapse of the global financial system.
Still as you suggest companies like GS are going to find it much harder to get away with this kind of stuff in the future - I assume that's why you're short the stock.

Jan 29 07:44 AM

[Ranchr:]

With every Seeking Alpha short screaming bloody murder at the Bad Bank approach, it must be a very good idea.

Jan 29 07:53 AM

[prudentinve...:]

I suspect that it would benefit our economy in the long run if banks were to become a bit less modern, a bit more old-fashioned.

Instead of trading CDS's, or manufacturing CDO's, etc, we just need old fashioned banks that lend or raise capital for companies that make useful things, so they can expand and make more, or build useful projects that can pay back their loans over time. These activities produce real value and employ people with real skills.

This would make banking more stodgy, more stable, and less profitable, and needs a much smaller workforce in banking. But is a proven model. Many of the talented people in banking can apply their creative talents just as well, but in other productive areas.

Jan 29 08:02 AM

[GregT:]

In the very big picture, the purpose of banking and Wall Street is to provide financial instruments and funding to the parts of the economy that need it and deserve it. In providing this funding, our financial industry should make a profit.

What has happened however, is that our financial industry is making profits without actually helping the economy. In fact, many of the financial instruments recently created have hurt the economy. It is one thing for a corporation to use credit default swaps to insure their own risks. It is quite another thing for investment houses to use credit default swaps when they are not insuring any underlying risk. The second use is pure speculation and provides no benefit to the American economy. Furthermore, since this "insurance" is unregulated, there are no requirements that the companies selling CDS's have adequate reserves to pay for defaults as they happen (e.g. AIG).

The net result is that taxpayers have had to fund these losses which never even provided a benefit to the economy to begin with.

Jan 29 08:04 AM

[Rakesh Saxena:]

Dear morph366: Quite frankly, I personally have been part of the derivatives marketplace for a very long time--I don't disapprove of any type derivative as such. FYI, my view has been that it is the balance sheet of the derivatives provider which is critical, and which must guide all derivative trades. Unfortunately, even after all that has happened, nobody is focusing on the contents of the balance sheet and the SEC is not mandating full and complete disclosure. >>>Many thanks - Rakesh


On Jan 29 07:44 AM morph366 wrote:

> Your article touches on "unintended consequences" of which you seem
> to disapprove but you end with the comment "financial engineering
> is still very much alive". Isn't is precisely the fetish for innovative
> financial products adopted without adequate understanding and stress
> testing that has created the largest unintended consequence of all
> - the virtual collapse of the global financial system.
> Still as you suggest companies like GS are going to find it much
> harder to get away with this kind of stuff in the future - I assume
> that's why you're short the stock.

Jan 29 11:34 AM

[Rakesh Saxena:]

Good luck Ranchr. I only hope you are not selling house-and-home to buy up bank shares. Many thanks - Rakesh


On Jan 29 07:53 AM Ranchr wrote:

> With every Seeking Alpha short screaming bloody murder at the Bad
> Bank approach, it must be a very good idea.

Jan 29 11:48 AM

[monday1929:]

The Government will contact you soon to arrange a mandatory Harvard MBA degree. You are a dangerous radical and must be stopped. Old fashioned indeed!


On Jan 29 08:02 AM prudentinvestor wrote:

> I suspect that it would benefit our economy in the long run if banks
> were to become a bit less modern, a bit more old-fashioned.
>
> Instead of trading CDS's, or manufacturing CDO's, etc, we just need
> old fashioned banks that lend or raise capital for companies that
> make useful things, so they can expand and make more, or build useful
> projects that can pay back their loans over time. These activities
> produce real value and employ people with real skills.
>
> This would make banking more stodgy, more stable, and less profitable,
> and needs a much smaller workforce in banking. But is a proven model.
> Many of the talented people in banking can apply their creative talents
> just as well, but in other productive areas.

Jan 29 04:20 PM

[Recourse Bob:]

Counterparty investors who engage in CDS without having equity to back them up should have their contracts voided. Even in Las Vegas, you don't play if you don't have chips on the table.

Jan 29 10:31 PM

[Rakesh Saxena:]

Dear Recourse Bob: You make a very good legal point indeed. Are these contracts void ab initio due to misrepresentations at the very outset? Interesting. Many thanks - Rakesh


On Jan 29 10:31 PM Recourse Bob wrote:

> Counterparty investors who engage in CDS without having equity to
> back them up should have their contracts voided. Even in Las Vegas,
> you don't play if you don't have chips on the table.

Jan 30 03:06 AM

[Rakesh Saxena:]

Dear Pangaea: In my view, you should wait for a thorough restatement of assets, i.e. S&P 500 at 700 or below before buying shares. You are correct, though I am bearish, I am not predicting the end of the world. Buying opportunities will follow deleveraging and realism on valuations. As far as gold is concerned, my concern is the declining real demand in key markets like India and China; besides, there are too many mines which can produce gold if the investment is available. That said, limited purchases of gold may be advisable, given that the general perception is that gold represents the best alternative if asset values deteriorate. Good luck. - Rakesh

On Jan 30 01:32 AM Pangaea wrote:

> Rakesh, thank you for your contributions... I have been reading you
> for some months now, and it helps keep a balance vs. the pumpers
> on the other side. For the past year I've been mostly in cash, with
> select short-term trading. Now, as you observed in another piece,
> we appear to be at a market "crossroads" - yet your bearishness seems
> as resolute as ever, and although your endgame may not be armegeddon,
> it's not a pretty scenario either...
>
> I wanted to ask, what do you think of gold? I am not a "gold bug"
> or alarmist by nature, but events in recent months have got me wondering
> what's the best way to protect my family's wealth in the most likely
> of scenarios in the coming year(s)... Any thoughts there, or view
> onto the answer to that question generally? Many thanks.
>

Jan 30 03:14 AM