Credit default swaps should only be allowed with an offsetting credit exposure

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 ?

Equity compensation is the root of all Corporate evil

What Obama and Barney Frank need to focus on is the nefarious practice of Bankers being compensated through restricted stock or stock options. The basic premise of equity compensation is that Manager interests are aligned with shareholder interests through this practice. This theory is flawed for the following reasons

1. The actual cash value of payments in shares are never recognised in the Financials of the company. Share payments are recognised as part of the capital account and not in the operational earnings, as a cost.

2. The amount paid is not a fixed expense amount. Instead, it is a share of the company.

3. You cannot give away the farm to align a managers interest with the owner. To provide an analogy, if I pay my housekeeper, a share in my property so as he does not damage my property, eventually he will own my house and I will be the housekeeper.This is the same concept.