Friday, March 6, 2009

Commenting On The Insanity Of The CDS Market, And Other Regulatory Issues

The unregulated credit default swap (CDS) market has gone completely insane. General Electric (GE) Capital -- full disclosure, I am long GE calls - credit default swaps were trading at 17.5 yesterday. For those who are unfamiliar with the jargon, this means that investors seeking to hedge $10 million worth of GE Capital bonds against a default would need to pay $1.75 million up front and $500,000 per year to protect $10 million of senior bonds for five years. In insurance premium terms, therefore, the cost of protection is 22.5% in the first year! In the cash market, $5 million of the GE Capital 4.25% of Dec. 1, 2010, traded at 92.93 cents on the dollar, for a yield to a worst of almost 9%. That is a massive spread to comparable Treasuries and basically unheard of for a AAA-rated company.

It is possible that GE's CEO and CFO, both of whom have made continual assertions that their franchise is healthy, are both lying. I guess it is also possible that both of the above guys are completely, criminally clueless about the levers affecting their firm's financial position. I think the more likely explanation is that the CDS market has gone totally insane. The only question in my mind is whether or not the CDS market is criminally insane, i.e. is being manipulated willfully in an attempt to "wag the dog" with some of our country's biggest and best companies - or if it is simply being driven haywire by the lack of liquidity and absence of any kind of exchange-based clearing system.

I'm very concerned that the CDS market is being manipulated (in a legal way, to be sure) to produce a negative feedback loop in certain widely owned and widely respected corporations. Jim Cramer's been writing about this sort of thing a lot lately, along with the ultra-short ETFs and some of the other short-selling techniques that are out there. I agree with much of what he has written, and he says it better than I ever could.

I'm as free-market a guy as you'll find. I believe in the purity and beauty of free markets, I've got my own 20-year-old, dog-eared copy of Atlas Shrugged, etc., but parts of our capital markets right now are out of whack. For starters, they are not really "free." From naked shorting (enforcement still a joke) to the absence of the uptick rule to levered ETFs to unregulated CDS trading, there's a dysfunctional quality to the clearing mechanism of the capital markets. I could go on and on. The fact is that the insanity needs to stop.

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