Playing by the rules

New regulations recently proposed for publically listed US financial institutions aim to prohibit proprietary trading (that is trading by the bank for the bank rather than on behalf of clients) and restrict investments by those public institutions in hedge funds. In a further recently mooted change hedge fund and private equity traders are to be subject to ordinary income tax rates, in lieu of the lower capital gains tax rate that currently applies to their free equity stakes.These long overdue proposed changes once implemented will limit banks ability to place bets on the markets and reduce some of the speculative trading which featured in the global financial crisis.

A recent poll indicated 77% of investors thought such measures were anti –business and a number of business luminaries continue to be critical of the Obama administration citing the probability for tightening of business credit as an unintended consequence. Personally I think such moves will prove to be very positive for the banking sector, and, combined with recently announced increased support for community banking will not impinge on banking services as feared.

However no effective changes have been announced in response to the more critical causes for the prior global financial collapse which was due to the unprecedented growth in leveraged non transparent derivative trading and particularly in the form of credit default swaps. It was the subsequent failure of counterparties dealing in these instruments, which precipitated the turmoil and collapse in markets and these new measures fail to address these issues excepting that public firms will now be prohibited from taking a principal position in trading firms involved. Credit default swaps continue to be traded under a system where virtually no rules exist over their issuance or in market transparency.

How do they work? –

There is a price paid by a buyer to a seller for cover for a bond or a loan where the seller is liable in the event of a defined event termed a default. Hence the buyer buys protection from a seller in consideration for a future payment if a bond or loan defaults whose events are generally defined as bankruptcy, restructuring or due to a credit rating downgrade.

However this seemingly innocuous idea for parties wishing to cover their exposure to loans or bonds is far removed from the typical Credit default swap which operates in the market today. The amount typically paid is a measure of the decrease in the market value of the referenced obligation arising from a credit event, usually without any regard to whether a holder actually suffers a loss. This has lead to the market participants to characterize credit default swaps as “covered" or "naked." A "covered" CDS refers to a transaction in which the protection buyer has an economic exposure which is more in line with sensible commercial principles. However virtually all credit default swaps provide that the parties to the swap need not own the referenced obligations.

The "naked" Credit Default Swap is where the protection buyer does not own or have economic exposure whatsoever to the underlying instrument.

Furthermore Credit default swaps can be used to mitigate the risk of defaults in a debt portfolio market value where a holder of a bond, may hedge exposure risk by buying protection in a Credit Default Swap with respect to that bond. Should the bond default, the proceeds from the Credit Default Swap will cover the resulting decrease in market value of the underlying bond. But if the bond subsequently recovers value, as is oft the case the Credit Default Swap protection buyer will have received reimbursements despite the fact he never suffered a loss.

By now it is apparent to even the most casual observers Credit Default Swaps although touted as resembling insurance policies are vastly different in a number of critical areas; E.g.

1. There is no requirement to actually hold any asset or suffer any loss as payments can be triggered for various events, providing an opportunity for coercion and market manipulation.
2. There is often no insurable interest between the parties or any incentive not to make claims. Traditional insurance seeks to work out schemes of arrangements with defaulters or to help mitigate respective party losses. There is usually an element of a self insurance loss in any financial or trade insurance which mitigates against fraud or prior inadequate disclosure of the risk.
3. The parties can profit in the demise of a company. It is often in the interest of the holder to hasten the firm’s demise as the holder stands to profit from such an event. Hence the opportunity for market manipulation.
4. Prudential requirements do not apply to the issuer of these instruments and a highly geared hedge fund can sell a large amount of credit default swaps without the need to have mandated reserves to cover any subsequent losses which may be higher than anticipated.
   

One might well ask how such reckless arrangements to open the door to coercion and market manipulation could ever come into existence in the public company arena in the first place.

A significant milestone on the road to the ensuing chaos occurred in 2000, when Congress passed a piece of seemingly innocuous legislation called the Commodity Futures Modernization Act, which made derivatives off-limits to agencies that regulate stocks, bonds and futures contracts and was subsequently signed into law in December 2000. The reality of such legislature to exempt regulatory control was to open the door to a form of derivative trading which was to inflict havoc in markets and lead to some of the worst market excesses in 60 years and subsequent failure of counterparties.

An interesting analogy would be to exempt a sport temporarily so that the rules are, there are no rules. I would suggest severe chaotic outcomes would be experienced immediately since inevitably some form of guidelines is required for any game together with the desire to appoint an umpire. Democracy is after all a system that depends upon fair and equitable distribution where players play by the rules, the alternative being corruption and acceptance of that corruption as your corrupt way of life.

Let’s hope eventually, in addition to the recent moves we also see a return to common sense regulatory measures.