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Time to Shut Down CDS Casino

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Bets hold markets hostage.

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When I look at the situation facing the financial sector, I can't help but bring myself back to the Credit Default Swaps (or CDS) market. A CDS is basically an insurance contract that pays if a company/entity defaults on its debts.

The situation with Lehman (LEH) is well documented, but the question that really needs to be answered is whether the CDS market is creating a hostage situation for the US/world government and regulators. Let me explain why I think this may be the case.

We know for a fact that the CDS market is many times larger than the underlying bonds that the CDS contracts are written on (The CDS market is $65 trillion as of the last available report from the bank of international settlements). This means we effectively have a huge unregulated casino operating amongst the various financial players (hedge funds, pension funds, banks, brokers, insurance companies, etc.).

The problem with the CDS casino is the settlement/payment of these contracts only gets triggered when a company/entity defaults or declares bankruptcy. But CDSs involve the use of tremendous leverage. A hedge fund trader once told me that they insured/sold 50 times their capital in CDS with the counterparty being a very large, well-known investment bank.

When I asked him if he was worried about that kind of leverage, he responded by saying that is the bank's problem because if he is wrong about writing all these insurance policies (in the form of CDSs), they can only lose their investment capital in the fund. This is the ultimate moral hazard trade, in my opinion, and is a problem with the hedge fund industry right now.

In addition to this problem, you have financial players who've bought CDSs to speculate on the failure of various companies to pay off their debts/bonds. Everyone has to remember that these speculators want the companies to fail or declare bankruptcy.

The amount of speculation is hard to determine in the CDS, but it's interesting to note that the CDS market exploded in the past few years from a very tiny market just 5 years ago. This makes me stand up and wonder how many of these bets (CDS) are actually speculative bets.

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What would stop the speculators from buying up significant stock (like Lehman) and vote against any and all offers to buy the distressed company, which will inevitably cause a bankruptcy filing and increase the value of the CDS that the speculators bought.

But will the speculators be able to collect on their large bets? That is where you get the contagion worries about the entire banking system and where regulators get nervous about
the systemic risk.

In conclusion, I wonder if it's time to have a banking summit in Washington to sort out/rid ourselves of this unregulated betting market known as CDS - and ensure that regulators don't have to be held hostage by the fear of contagion when addressing problems with companies.
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No positions in stocks mentioned.

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