Michael Moore could not seem to pinpoint exactly what is wrong with a Credit default swap. Here are some pointers
1. A naked credit default swap (without an underlying exposure )creates the incentive to bankrupt companies.
Say we have a hypothetical strong company B that has issued very little debt. Maybe one five year bond. The stock is doing middlin to ok depending on the state of the overall market. However, it may still have short-term borrowings and lines of credit to finance its day to day activities.Say another smart master of the universe broker-dealer, lets say G, buys credit protection from dumb insurance company A. G has no real credit exposure to B. However, it has a clear incentive to buy a credit default swap (these are cheap relative to the Notional. The premiium is an accrual and does not have to be paid right away. It has to be paid over the life of the swap). G has every incentive to short the stock of B and create an artifical credit panic for B. If the market is shaky, the fundamentals of the company do not matter. Banks will pull the credit lines of Company B and push it into a liquidity crisis. G will get away with the equivalent of collecting protection money. If dumb insurance company A does not post collateral, its friends in the Federal government will post margin. Depends on how big and dumb is A (or just corrupt).
2. A CDS exchange will not solve the above problem.
3. A CDS should be allowed only for the legitimate creditors of the company to buy protection against any outstanding exposure. A naked CDS is evil. It should be banned atleast till the CDS market is symmetrical and very liquid.
4. A CDS should require upfront payment. If they quote a 1000% CDS spread, the guy buying a CDS should put up a 1000%. This will quickly cap all CDS rates to a 100% of the exposure. The 1000% default spread is a bogus number and should not be allowed as an indicative price.
So there. Can someone please forward to Obama, Barney Frank, Michael Moore and the other CDS-haters ?
No comments:
Post a Comment