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CDS Still Viable - For Those Who Know How to Use Them


Only dangerous in the wrong hands.

I hope this never happens, but what if a commercial airliner were to be piloted by someone who falsified training documentation and successfully impersonated a real pilot - and the plane crashed? How would the relevant policymakers respond?

They would, hopefully, move to implement stronger identification standards. But they wouldn't be inclined to make air travel illegal. The latter course, presumably, would only be followed if it became clear that it was simply impossible to be reasonably certain that pilots were in fact who they claimed to be.

A lot of people are taking shots at the credit default swaps market these days. I recently wrote a commentary on what I considered a misguided piece by the usually splendid Gretchen Morgenson in Sunday's New York Times. Today, no lesser a light than George Soros is saying CDS are "toxic and should be used only by prescription." While I don't always agree with what Mr. Soros says, I am quite mindful of the gap between his long-term investing record and my own, so I take him very seriously.

Moreover, when I traded convertible bonds, even as CDS became an increasingly important part of a hedging strategy and I used them in a number of situations, I never particularly cared for them. I felt they were too difficult to trade and that the code of conduct ("my word is my bond") that applied to every other asset class I traded was often ignored in the CDS market.

Here's an example: One of the primary uses for CDS involved convertible arbitrage. When a new convertible bond was issued, certain investors would seek to hedge the credit risk of the bonds by buying credit default swaps. Since some hedge funds would only buy convertibles if they could obtain such a credit hedge, Wall Street CDS dealers would know that if they were asked to make markets in such a credit on the convertible's first trading day, it was highly likely that the customer requesting the market would be a buyer, not a seller, of the credit protection.

As a result, if the customer was a known player in the convertible market, the dealers would tend to raise -- rather significantly -- the price they would charge for the protection.

Well, it so happened that a firm I used to work for not only managed convertible bonds but also actively participated, as both a buyer and seller, of credit default swaps. When one new convertible was announced, I called a major international dealer and asked for a 2-sided market in CDS on the company. What the dealer didn't know was that I was actually calling on behalf of one of my colleagues, who was actually interested in selling credit protection on this particular issuer.

After the dealer made the market even higher than we expected, I responded by trying to sell CDS for my colleague.

"You can't do that," the astonished salesman responded.

"Why not?" I asked. "You made me a 2-way market, and I hit you."

"But you're a convert guy. You had to be a buyer."

"But I wasn't."

The dealer refused to honor the trade. And this was far from the only experience I had like this.

So I'm no big fan of the CDS market. Having said all that, I am still concerned that the current push to invalidate the market is not the appropriate response.

What we do need, and what's being pushed, is far greater transparency and a functional clearinghouse similar to what is used for listed options and futures. This will keep us from ever again having another AIG (AIG).

Buying put options on a company's stock is conceptually very similar to buying CDS on its debt, and nobody is crying out to make that illegal. Indeed, the ban on shorting financial stocks last fall only fanned the flames by wrecking hedge funds that had been pursuing legitimate strategies, unnecessarily hurting performance and thus forcing more redemptions and selling.

We are getting dangerously close to outlawing derivatives. The idea behind them -- to help in the pricing and sharing of risk -- was and is a good one. In fact, we desperately need a workable derivatives market right now to help make the so-called "bad bank" happen. We just need to make sure we do it correctly this time.

We need to make sure the pilot knows how to fly the plane.
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