By John Hintze
Naked credit default swaps appear to have gotten Congress’s attention. Critics have long said that buying a naked CDS is akin to buying insurance on your neighbor’s house and then hoping it burns down. The financial reform law passed earlier this summer could make that harder to do, depending on what the Commodities Futures Trading Commission decides to do.
Naked CDSs are used to buy insurance against the default of a bond or bond index without owning the underlying security, a common shorting technique of hedge funds. A similar practice—naked short selling—is illegal in the U.S. equity market.
Now a little-noticed provision of the financial reform legislation could have the same prohibiting effect on CDSs since it reempowers the CFTC to halt trading in derivatives contracts it deems contrary to the public interest.
The law specifically mentions derivatives that enable market participants to bet on events contrary to U.S. law or involving terrorism, assassination, war or gaming, but it doesn’t stop there. A sixth catchall category covers “other similar activity determined by the Commission...to be contrary to the public interest.”
Harvey Pitt, a former chairman of the Securities and Exchange Commission who is the chief executive of global consultancy Kalorama Partners, says his preliminary read of the new law suggests that to avoid regulatory fallout, swaps must have a legitimate economic hedging function and not simply provide “some hedging benefit.”
Nor can the hedge involve a bet against the public interest, which Pitt calls “the tricky part.”
“Regulators might be tempted to opine that such a bet involves profiting from a disaster that is decidedly against the public interest,” he adds. That might occur even if there is a legitimate hedging use.
Such bets could include CDSs used to short bonds issued by governments or large corporations. Some policymakers around the globe have talked about banning their use. On May 18 Germany’s Federal Financial Supervisory Authority did so, outlawing naked shorts on European Union member state debt, although it revoked the ban at the end of July.
Other critics have included hedge fund notables George Soros and Rick Bookstaber, the risk management expert who previously worked at both FrontPoint Partners and Bridgewater Associates. Bookstaber is now senior policy adviser with the SEC.
Should the CFTC (which declined to comment) choose to take a hard stance on CDSs, a market with a total notional value of $30 trillion, hedge fund players that make up a huge portion of this market would be some of the first to feel the pain. However, they argue that even companies merely trying to hedge risk could be hurt.
“It would change the face of the entire economy,” says David Rubenstein, chief financial officer and general counsel at $4 billion BlueMountain Capital Management, a credit hedge fund that uses CDSs in its strategies. Rubenstein says the ability to short CDSs without owning the underlying bonds is key to the market’s liquidity and a boon to participants using CDSs to hedge exposures as well as to speculate. Perhaps more importantly, Rubenstein says, finding a seller of that protection may become much more challenging.
Hedge funds like BlueMountain sell CDS protection if they can turn around and hedge that risk, often by purchasing CDS protection on a credit with similar characteristics and risk that it doesn’t own—technically, shorting it.
Other relative value funds also use CDSs in this way. If the CFTC deems holding that uncovered CDS position to be against the public interest, or is likely to do so, the fund is unlikely to provide the initial protection. “It won’t be hedge funds or the banks [selling credit protection] if we can’t buy protection on the other side,” Rubenstein says.
Ari Bergmann, managing principal of Penso Advisors, which manages systemic risk for hedge funds and other institutional investors, says the ambiguous language opens the door for the CFTC to declare virtually any CDS contrary to the public interest. Bergmann, who helped design some of the first CDS contracts at Bankers Trust, says soaring costs for CDS protection that generate precarious borrowing costs for the debt holder—especially a state or municipality but even a large corporation—could trigger political pressure, pushing the CFTC to ban contracts.
“The closer the institution gets to bankruptcy and the more valuable the CDS become, the more real this issue will become,” Bergmann says, adding that because CDS payouts are predicated on defaults, the swaps are especially sensitive to the charge of undermining the public good.
“For politically charged enterprises like sovereigns, municipalities and companies that employ a lot of people, I think a CDS is the wrong instrument.”
The provision does not specifically mention credit default swaps, but its promoters acknowledge that they intended it to include those contracts, which have been pilloried since the recent financial crisis.
“This [provision] specifically includes swaps, including credit default swaps, traded in regulated markets,” says the office of Senator Diane Feinstein (D-Calif.). Feinstein promoted the provision along with Senator Blanche Lincoln (D-Ark.), chair of the Senate Agriculture, Nutrition and Forestry Committee. Lincoln played a big role in swaps regulation when she proposed an amendment that would force banks to separate their swaps unit from the federally insured bank.
Although Sen. Lincoln was unsuccessful in completely separating banks from their swaps units, the new law gives regulators nearly absolute power to control the types of derivatives that can trade. The vast majority of swaps will have to be traded through regulated clearinghouses, potentially subjecting them to a CFTC ban. In a note to clients, law firm Davis Polk & Wardwell notes that “the agencies could subject swaps that are not eligible for clearing at any clearinghouse to the mandatory clearing requirement, thereby effectively banning transactions in the affected categories of swaps.”
Banks are already starting to clear most CDSs. The Depository Trust & Clearing Corp. says that $25 trillion of the total CDS contracts are standardized, and banks have committed to clearing 95% of these. IntercontinentalExchange cleared $10 trillion in CDSs as of July 23, according to a spokesperson, who says that ICE’s number may understate its volume due to the clearing function’s netting process. She added that ICE plans to begin clearing CDSs on sovereign credits in the second half of this year. At that time, the volumes of CDSs cleared by competitors CME Group and LCH.Clearnet Group were much smaller.
CDSs were designed by banks as a way of hedging lending risk, but they have since become a world unto themselves. In June the Depository Trust & Clearing Corp. recorded more than $2.3 trillion in notional CDS protection sold against sovereign credits alone, and just under $3.3 trillion against financial company bonds.
In addition, uncovered CDSs turned into a major tool for speculation. Lynn A. Stout, a finance professor at the University of California, Los Angeles, said in testimony before Lincoln’s committee on June 4, 2009, that by 2008 the total notional value of CDSs had reached $67 trillion. At the same time, Stout added, the total market value of the underlying bonds issued by U.S. companies outstanding was only $15 trillion.
“When the notional value of a derivatives market is more than four times larger than the size of the market for the underlying, it is a mathematical certainty that most derivatives trading is speculation, not hedging,” Stout said. (The market apparently has been halved since the crash of 2008.)
Policymakers and other critics have focused on naked CDS ever since Richard Fuld, CEO of now-defunct Lehman Brothers, blamed them for the widening CDS spreads on Lehman’s debt, contributing to its bankruptcy. Higher costs to buy CDS for protection usually results in higher borrowing costs for the debtor and often are a precursor to a downgrade by the rating agencies.
But it may be a difficult, or at least impractical, to regulate naked CDSs. BlueMountain’s Rubenstein questions how the CFTC could confirm the CDS investor holds the hedged asset in question, or whether a market participant could buy a CDS on an index of bonds if it owns only 20 of the index’s 125 referenced bonds. “These are multitrillion-dollar markets. If the government tried to ban CDS contracts in the United States, they would trade somewhere else in the world,” Rubenstein says.
Robert Colby, a partner at Davis Polk & Wardwell and a deputy director of the SEC’s division of trading and markets until February 2009, says the new language serves in part to empower the CFTC to preapprove the derivatives exchanges’ rule filings, a power the Commodity Futures Modernization Act of 2000 stripped away.
The law also immediately empowers the CFTC to ban contracts meeting its specified categories. He adds that the final catchall category appears to be aimed at any new and problematic versions that Wall Street’s wizards concoct in the future.
“I don’t think this provision is aimed at the standard contracts that we know today,” Colby says, adding that that approach would be “very disruptive” to the markets.
Colby acknowledges that the CFTC will retain the power to place other CDSs in the miscellaneous category, but he says it will be able to do so only after adopting the change through the rule-making process involving public comment. “I think it would be very difficult to say a CDS on a sovereign entity or company is against the public interest, since Congress considered this area very carefully and didn’t put such language into the bill,” Colby says.
Neither, however, did market participants expect the SEC to ban short sales on 1,000 financial services stocks in fall 2008.
Bergmann cautions that the provision’s impact may be minimal now, but investors must be aware of the door it opens. “The only thing worse than having no hedge is having a hedge that doesn’t work,” he says.
