"The regulatory drive to shine a light on the complex and opaque world of credit derivatives has brought into focus the links between pricing and clearing. Regulators have expressed a clear desire to push credit derivatives on to central clearing houses as a way of bringing transparency to the market in the wake of the financial crisis. But pricing is crucial - particularly in the credit default swaps market, one of the fastest-growing segments of the derivatives universe and an engine for Wall Street profits in the last decade. If you have the right price for a CDS, you can assess the risks properly. If you have the wrong price, there could be a loss once the "real" price comes to light. Importantly, companies that own the best pricing data can sell it. The start last week of an investigation into anti-competitive practices in the credit derivatives market by the US Department of Justice has highlighted these issues. Hence an intensified effort to establish "closing prices" in a CDS market now worth about $26,000bn in outstanding contracts."

Financial Times
July 24, 2009

Watching the progress of legislation to reform the financial markets and in particular the world of over-the-counter derivatives, we cannot help but note that the discussion has shifted rather dramatically over the past year. Likewise the debate over the ratings agencies seems to be advancing. Read Larry White's letter in the Financial Times, "No Monopoly on Credit Wisdom," in that regard.

Whereas last summer the major dealers and rating agencies, and their political tools in Washington, were unapologetic in defending the status quo in the retrograde market for OTC derivatives, including derivatives and complex structured assets, now the French retreat from Moscow seems a more apt metaphor. Horror of horrors, Members of Congress are discussing the issue of "price discovery" with respect to OTC. And the hungry politicians on both side of the issue smell blood in the water, prompting a "fund raising frenzy."

Last week saw House Financial Services Committee Chairman Barney Frank (D-MA) throw an outright ban on "naked" speculation via credit default swaps or "CDS" on the political table. This was followed by the even more remarkable spectacle of New York Senator Charles Schumer calling for limits on program trading, a direct attack on Goldman Sachs (NYSE:GS.

We are shocked, shocked to hear reports that the GS firm, which controls half of all program trading in the New York equity markets, has been accused of "stealing" money from the markets by gaining privileged access to trading ahead of other investors. Perhaps the managers of GS forgot to make their monthly payment?

As in many other parts of the economy, the flow of political largess seems to be ebbing from peak levels, thus Members angling for votes overtly "throw" issues on the table much like a striped bass on the fish monger's table. Just imagine Chairman Frank in a rain slicker and hat, covered in fish slime, crying out the price for his fresh "catch" on the Boston waterfront.

This week's special is "Naked CDS." As Chair of the House Financial Services Committee, Frank has a monopoly very much like that of the dealer bank in the CDS bazaar. But you understand that, like the dealer market for CDS, the inside of Frank's office in Washington is competitive and the fish goes to the highest bidder.

Aside from the complete absence of transparency and true price discovery in markets such as CDS, one of the outrages of our time is the fact that politicians will not stay bought. Despite engaging in shameless commerce for their political assent - that is, asset -- Members of Congress like Frank, Schumer and, frankly, most constituents of the "national" parties, will embrace multiple partners during the political season, sometimes on more than one occasion in a single day and often in the same room. Exchange of gratuities (or at least the promise of same) have been witnessed in the hallways and lavatories of congressional office buildings.

The facilitator of this political intercourse between the Member and the political equivalent of the Buy Side is known as the concierge, who usually occupies a senior position on the Member's personal staff and collects the campaign contributions before the supplicants are taken in to see the selected official. Being a congressional concierge is seen as a plumb position since it enables the ambitious, enthusiastic young American to aspire to become a lobbyist or even Membership in the great national congress.

Perhaps we could even fashion indicia for groups of Members on key issues and trade these contracts OTC. Indeed, we could even have a forward CDS market for whether a given Member of Congress is to be reelected. You can buy such contracts at Ladbrokes in London, so why not trade them OTC? Media outlets could carry breathless coverage of whether smaller or larger banks had stuffed more money into the pockets of Schumer, who is one of the most powerful Democrats in the Congress, or say Robert Bennett (R-UT), the second ranking Republican member of the Senate Banking Committee and a well known "team player."

One tough implementation issue is the question of price discovery. Like credit default swaps of "CDS", political favors do not trade in the secondary market. The dealers - call them Members to make it easier - make prices to create new favors, but the buyers are not allowed to trade these promises amongst themselves. In order for a buyer to sell a favor, if at all, they must go back to the dealer or the Member of Congress who originated the contract.

Of interest, one of the big fish currently flipping about on the monger's table is the investigation by the Department of Justice into price fixing in the CDS markets. It's not so much price fixing as a complete and deliberate lack of a) price discovery and b) disclosure of even end-of-day pricing. That's why we've called it "deceptive by design" for the past several years and, with a Democrat in the White House, the DOJ is now at least pretending to enforce the laws prohibiting such behavior - even in the name of innovation.

"Having people who are in there speculating adds liquidity and depth to the market so that anybody who is a pure hedger, they can tap that market and know they have a deep and liquid market to turn to," ISDA head Bob Pickel said in an interview with Bloomberg last week.

Now Bob is an honorable man and ISDA is arguably a voice of reason compared with some of the positions on OTC coming from the financial services industry. But the fact remains that there is as much "price discovery" in OTC CDS as there is at Lloyds of London or say inside Senator Schumer's office, which is to say, zero. This is a dealer market, priced by counterparties with extensive conflicts in terms of existing exposures to one another.

You see, the Fed's imposition of a "solution" to the obvious operational risk problems with OTC meant that secondary market trading in OTC has been effectively banned and only the dealers make prices to buy or sell. Or put another way, all parties in CDS must face the dealers, who in turn face the DTCC for clearing these transactions. But there is virtually no "price discovery" in this market, as illustrated by the fact that the dealers still, even today, refuse to report all trades. This dealer monopoly model is one of the "innovations" that the Geithner proposal for regulating OTC contracts would set in concrete.

While a dealer monopoly model also exists in politics, we continue to be optimistic about the outcome of the debate over OTC derivatives, in part because most of the US Senate and a growing proportion of the House (excluding Chairman Frank, of course), seem to understand that there is a causal link between the unfettered leverage in OTC and the appearance of systemic risk. And a growing number of Members of both houses seem to understand that the only way to avoid further public expense and limit systemic risk is to limit risk in all derivatives instruments. So long as infinite leverage exists via OTC derivatives, systemic risk is also unlimited.

We've known of the mechanistic connection between leverage and systemic risk for a long time, of course, because we have the benefit of speaking with people like Walker Todd and Martin Mayer. Earlier this year, we had the privilege of participating in a discussion at American Institute for Economic Research on CDS with Martin, Walker, David Michaels, Chief Financial Officer, AIER; Arthur Kimball-Stanley, a student at Boston College School of Law known for his research on CDS and insurance; Patricia McCoy of the University of Connecticut School of Law, and a number of other colleagues. Below are Martin's notes for the event where he makes some telling points about CDS, the nature of markets and life in general, which we publish with his permission.

On Credit Default Swaps: Comments at AIER, June 25, 2009
By Martin Mayer

Let me open with a large thought you can carry with you when you leave. Note how we are no longer being told that the chairman of the Federal Reserve is the second most powerful man in America. Why do you think that is true?

One of the truly awful moments of my time in this business was the early evening of December 9, 1982, an incident not in any of the histories but highly revelatory. What happened that evening was that Banco do Brasil failed at CHIPS (the Clearing House Interbank Payments System). Neither National City Bank nor Chemical, which represented Banco d Brasil in New York, was willing to pony up the $300-plus million the Brazilians couldn't find. So they kept the window open until midnight, while the Fed worked its necromancy on its member banks and the money was found.

Subsequent examination revealed that after the Mexican collapse the previous summer, Banco do Brasil had found it increasingly difficult to roll over its loans, and had steadily switched a higher and higher share of its borrowings out of the conventional lending and borrowing market and into the overnight infrastructure market. For more than six months, the Brazilians had increased the size of its overnight position, until somebody at National City noticed and said, No more.

The Treasurer of Chemical was an exceedingly able young man who went on to a great career at AIG, oddly enough. I went to see him to help my understanding of what had happened. Finally, he said, "You have to understand. They were paying an extra eighth." A banker will turn himself absolutely inside out for what looks like a safe extra eighth of a point. The change over the quarter century is that now he will probably do it for five basis points.

Meanwhile, on a less cosmic scale, let us start with the thought that Wall Street gets in its worst trouble not by taking risks but by following false prophets who promise to make finance risk-free. The nomenclature and some of the equations change, but the truth is that there are only six scams, and each of these financial panics is rooted where the others were.

What made the market break of 1987 so sharp and so deep was the widespread adoption of dynamic hedging, a mathematically proven plan to provide portfolio insurance by selling futures contracts on stock indexes if the stocks themselves fell hard. Dumbest idea ever accepted by any substantial part of mankind, said Howard Stein, who then ran the Dreyfus fund. How could anybody believe that everybody could sell at the same time?

It then took twenty years for the magnificently rewarded innovators of the new paradigm in banking to find an even dumber idea that everybody could safely and profitably hedge everybody else's risks through credit default swaps.

We make bad policy in this country because we do not inquire about how we got to where we are. There are every few second acts in American finance. Not one in a thousand of the people now commenting on the future or regulation of the CDS knows where the instrument comes from. The truth is that the CDS is one of many of what I shall call GSIs - "Government Supported Instruments" -- that would never have come into existence without dumb ideas from on high.

The Collateralized Debt Obligation or CDO, which came into existence in the late 1890s, is a single instrument expressing a garbage pail of loans and notes and bonds. It is all but impossible to value because it mixes together many disparate risks. Most people who think about it at all come to the conclusion that its not very useful for trading or for investing. In short, it is an excrescence that ought not to exist.

The CDO came about because Bill Seidman, when he was given control of the S&L workout in the late 1980s, wanted to sell whole banks rather than gather the tainted assets in FDIC control and auction them off in the usual FDIC procedure. Instead of taking, say, the real estate loans of six failed S&Ls and lumping them together as an offering on which real estate experts could paste a price, he wanted to take the entire portfolio of one or more failed thrifts and sell it off for what it would bring.

Note that this multiplied the amount of business Wall Street would get from the workout. The way you got people to bid on this sort of package was to give them the right to substitute other assets for assets in the package, or to guarantee the cash flow from the package.

The idea that a bank could be rid of its bad stuff through the device of a bad bank was then picked up by Mike Milken, and carried through with Mellon Bank in Pittsburgh, where the operation was funded through junk bonds. I wrote a piece for Barrons about how intelligent all this was. I spoke with some of the brilliant kids Milken assigned to this project.

The damage these CDS instruments do has not yet been exhausted. The publicized stress tests to which the federal bank examiners recently subjected the 19 largest banks was not really a serious enterprise, because all these banks rely on swaps to protect them against their losses on the toxic legacies they accumulated under the gaze of these same examiners -- and nobody knows whether or not these hedges will pay out if they are needed.

Swaps, after all, are bilateral contracts, and if the loser under the contract can't pay, the fact that he has theoretically hedged his risk in a separate contract with a third party does not necessarily mean that the winner can collect. Hence the "systemic risk" when AIG or Lehman, signatories to tens of thousands of these contracts, blows up, leaving a paper litter of unimaginable dimensions.

Sixteen years ago, I testified before the House Banking Committee to urge that it should be public policy to discourage over-the-counter derivatives contracts and encourage the use of exchange-traded instruments instead. To assure that losers pay, exchange-traded contracts impose overnight deposits to meet margin requirements rather than collateral that may show up some day. The Treasury Department, after years of fighting on the other side, has now discovered the virtues of settling derivative contracts through clearing houses.

But what Treasury Secretary Timothy Geithner has proposed will not do the trick, because it leaves the actual trading of these instruments in the hands of inter-dealer brokers who do not publish the prices at which they arrange the deals (and may not offer the same prices to all bidders). And because it does not show the way to meeting the legitimate needs that spawned this illegitimate market, the Geithner proposals invite evasion of the rules.

The legitimate need is for a place where traders can short bonds.

Shares of stock scan be borrowed (fees for such borrowings are an important source of income for brokers) and delivered to buyers who don' know that what they have bought is borrowed stock. Much publicity has been given to traders who abuse these rules, sell what they have not borrowed and then fail to deliver and suffer no significant punishment for their failure. The SEC had been and remains asleep at the switch when it comes to this issue. And even when stock cannot be borrowed, there is an options market offering puts in a trading context where open interest is public knowledge. No such institutions exist in the bond market.

It was the difficulty of shorting bonds that produced the T-bond contract at the Chicago Board of Trade thirty years ago, permitting participants in the fixed-income markets to protect themselves against interest-rate fluctuations. Interest-rate futures are a legitimate instrument because there is a generic interest-rate risk, expressed in the market-determined yield curve.

It is easy to understand that traders once they have hedged interest-rate risks would seek to insure also against credit risks. But there is no such thing as a generic credit risk that can be traded. Like all instruments with a trigger option, they promote the illiquidity that drives markets out of the patterns the white swan people need.

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