CDS Reform: Making Wall Street Safe for Capitalism

by: Tom Armistead

CDS reform is getting closer to becoming a reality: here is a link to the Treasury announcement. In addition to Geithner's version, which links to a draft of proposed legislation and states the intention to eliminate fraud, manipulation and abuse, there is an outline of principles from Barney Frank and Collin Peterson, which proposes the elimination of naked CDS, by forbidding transactions where the non-dealer party is not hedging a risk. Taken together, the two documents show that the Administration and Congress are moving closer to outlawing the conduct which came within inches of destroying the entire financial system. It has been a long wait: far too long. But the battle is not won: it is imperative to push our recalcitrant representatives to do their jobs and undo the harm they perpetrated by the Commodities Futures Modernization Act (CFMA), which completely exempted CDS from regulation and sowed the seeds of the debacle we have endured.

Financial regulatory reform is going to occur. The remaining questions have to do with the political agenda, whether the forces who stand to benefit from the continuation of the status quo will be successful in emasculating the coming legislation in order to maintain loopholes or niches where they can continue to exact spoils and tribute from legitimate investors, those who work, save and invest. The challenge while this plays out is to keep track of the important issues, one of which is naked CDS.

Naked CDS - Here is what Barney has put on the table:

1. Limitation on Speculation

Prohibition on any purchase of credit protection using a CDS contract unless:

  • The party owns the referenced security or (one or more) of the securities in an index of securities.
  • The party has a bona fide economic interest that will be protected by the contract.
  • The party is a bona fide market maker.
  • Regulators will have authority to monitor market activity and impose position limit where necessary.

2. Enhanced Oversight of Speculative Positions

Require confidential reporting to the appropriate regulator of all short interest in CDS contracts by:

  • OTC derivatives dealers;
  • Investment advisers that manage in excess of $100 million;
  • Other entities that are deemed “major market participants”.

In order to prevent abuse, the appropriate regulator has authority to:

  • Impose position limits on market participants;
  • Ban the purchase of credit protection using CDS by any non-dealer that is not hedging a risk.

Moral Hazard - Back in December of 2007 I wrote an article, highlighting the issues that will now be coming before Congress. I sent copies to my elected representatives and to appointed officials whose duties were in any way related to the issues involved:

Buying a credit default swap on a security backed by sub-prime is insurance, a very good idea if you actually own the security.

But I would submit that these mechanisms create moral hazard when used for speculative purposes. A determined group of negativists can short a company's stock, go long credit default swaps on the same company, and create the appearance of a disaster in progress, meanwhile lining their own pockets at the expense of legitimate investors. Speculation in energy futures at times harms ordinary citizens who must buy energy.

... Perhaps speculators will succeed in destroying the economy - in effect, burning down the house we all live in. That is the true moral hazard.

I now regret the use of the word “speculators”: speculation is a legitimate economic activity, necessary as a source of capital to take the other side of hedges. I should have said “manipulators.” But the point about moral hazard still stands, more clearly following the destructive financial inferno which immolated vast tracts of Wall Street and Main Street, not to mention countless 401ks. We must rid our financial system of this moral hazard.

Undoing CFMA – this was one of the most insidious and destructive pieces of legislation ever churned out by the sausage machine in Washington. Inflated by the gaseous effusions of politics as usual, this pork sausage floated out in late 1999, supported by Larry Summers, completely exempting CDS from regulation and opening the door of opportunity for Enron. Enron, you may recall, created a giant bubble in electrical costs, gouging the citizens of California mercilessly, before imploding from its own fraudulent accounting practices. The bill was never debated in either house and got Bill Clinton's signature just before Christmas, in time for everybody to go home for the holidays.

The worst thing this bill did was to carefully and specifically exempt the innovative miracle, CDS, from any regulation of any kind whatsoever.

The draft legislation comes to 115 pages. I read it, not too carefully. But what I saw was a careful job of undoing the harm perpetrated by CFMA, bringing CDS under regulation and making them subject to the Securities and Exchange Act of 1934. That piece of legislation was developed with the wisdom acquired by the very hard experience of a Depression brought on by the wretched excess on Wall Street. It was and is an excellent piece of legislation and if properly enforced by the SEC it will prevent further recurrences of what we have just experienced – a deep recession caused by more wretched excess by financial manipulators.

Politics of Power and Turf – Geithner's version leaves much of the regulatory power where it is and requires the SEC and CFTC to co-ordinate on CDS. The issues are complex and having more agencies to deal with may result in some loss of focus. Certainly the politics of getting the legislation through will involve a lot of debate over who gets what turf, etc.

Making it safe for Capitalism - In reality what is important is that we the people force our elected representatives to stop dickering and deal-making long enough to create an environment where regulators have both the power and the will to make Wall Street safe for those who work, save and invest.