The CFTC Intervenes To Prevent Moral Hazard In The CDS Market - But Why The CFTC?

by: Craig Pirrong

The WSJ reports that the CFTC engaged in extraordinary efforts to prevent manipulation of the CDS market by Blackstone Group. Blackstone had bought about $333 million in protection on homebuilder Hovnanian, and then extended a low-interest loan to the company to induce it to make a technical default on debt the company itself owned (having bought it back). The CFTC caught wind of this, and put on the full court press and eventually, uhm, persuaded (by intimating that it considered such behavior manipulative) Blackstone to negotiate an exit from the CDS with its counterparties.

In the Allen-Gale taxonomy, this would be best characterized as an "action-based" manipulation, as opposed to trading-based, or information-based. It is clearly not a market power manipulation.

The conduct at issue is clearly a form of rent seeking-a set of transactions engineered for the purpose of obtaining a wealth transfer. Unlike a market power manipulation, the direct welfare costs of this activity were probably small, and limited to the costs of negotiating with Hovnanian, and executing the CDS transactions. However, as in most manipulations, the big costs here were indirect. Blackstone's scheme undermines the CDS market as a risk transfer mechanism. In effect, Blackstone's stratagem was a form of moral hazard, in that the insured could affect the probability of loss. Moral hazard raises the cost of insurance, and leads to suboptimal risk transfer. (Yes, I know that CDS market participants shudder at the use of the word "insurance" to describe CDS, in part because they want to avoid insurance regulation. I am not using the word in its legal sense, but in an informal way to describe a risk transfer mechanism.)

CDS are particularly prone to moral hazard because individuals (notably, the managers of corporations) can do things to trigger defaults, and CDS can provide them directly or indirectly with an economic incentive to do so. Further, CDS contracts are incomplete (i.e., not all possible contingencies can be specified) and often as a result contain ambiguities that clever rent seekers can exploit to win a payoff.

The CFTC's actions are therefore laudable. What's particularly curious about this, however, is precisely the fact that it was the CFTC that intervened here. Under Title VII of Frankendodd, the SEC has jurisdiction "over 'security-based swaps,' which are defined as swaps based on a single security or loan or a narrow-based group or index of securities (including any interest therein or the value thereof), or events relating to a single issuer or issuers of securities in a narrow-based security index"-the CFTC has jurisdiction over everything else.

The Hovnanian CDS are clearly in the SEC's ambit, and not in the CFTC's. But in the case of the Hovnanian CDS, the SEC has been conspicuously absent. IIt is not mentioned at all in the WSJ piece.) Curious, that. Even more curious given the jealousy with which the SEC (like most government agencies) defends its turf against perceived incursions-especially the CFTC. Why did the SEC let the CFTC take the lead on this, without a peep of protest? And why did the CFTC apparently overstep its authority?

Things could have become interesting had Blackstone persisted with its scheme, and the CFTC filed an action against it. In the event, an obvious legal response by Blackstone would have been to claim that the CFTC had no legal authority to take enforcement action.

Given this legal issue, the CFTC's intervention may have less of a deterrent effect on future manipulations than an SEC intervention would have.

The SEC does not have the reputation of being a shrinking violet by any means, but it has been noticeably shy in some high profile events, the Hovnanian CDS story being one, and Tesla being another. Makes me wonder . . .