The SEC announced that it is considering reinstating short sale rules, but that won’t do any good if credit default swaps remain unregulated. It is no surprise that banks and hedge funds are on opposite sides of the short selling issue, according to the NYT.
Hedge funds and big pension funds argue that short-selling is vital to modern markets. Such trading not only enables investors to hedge their risks but also to ferret out weak companies or, as in the case of Enron, outright frauds.
But many banks, whose stocks came under attack last autumn, maintain that unfettered short-selling is dangerous. The shorts, their argument goes, helped bring down Bear Stearns and Lehman Brothers last year.
The merits of this argument lie with those who would limit short selling. Short selling in the absence of limits may well have played a role in the demise of Lehman Bros. and Bear Stearns. The American Bankers Association says so, but that doesn’t necessarily make the argument wrong. I don’t think that limits would have salvaged much, but they would have made for a more orderly market.
The bigger problem is that credit default swaps play make it possible for traders to short bonds, in fact, this is touted as one of its great benefits. It even works in the muni bond markets.
When short sales increase, or the price of protection through credit default swaps increases, it makes it look like there is a broad market belief that company is in deep financial straits. When people start doubting the financial stability of the company, that will drive its stock down faster than a bear raid.
As of today, there are only 5,281 live CDSs on Citigroup, and 11,104 on Bank of America. (This link is not permanent.) That isn’t a lot of contracts to make up a real market. Many of the contracts are held as hedges, so a few trades by speculators can easily move the market.
In the municipal bond market, moves in the CDS market can drive up interest rates for cities and states, to the massive detriment of taxpayers. Market participants don’t have to have any skin in the game when it comes to credit default swaps, they can simply gamble, and since the muni bond CDS market is really thin, a few bets can sway pricing. As an example, DTCC reports that the total number of live CDSs on the State of California is 185.
The Obama administration doesn’t have any intention of regulating the CDS market in any realistic way. In that case,why bother changing the short sale rules if credit default swaps can be used more effectively to accomplish the same purposes?
“The government wants a confidence measure right now, and that’s all this is,” said Lawrence E. Harris, a former S.E.C. chief economist.
Traders, he said, will simply find ways to circumvent the rule, but the commission probably will make the move if only to deflect outside pressure.
“Every crisis requires action,” he said. “It’s not worth fighting over.”
Everybody’s a cynic.
Well not everybody. I know we can do stuff to fix this mess, but only if we keep the financial elites from crushing real reform.
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Short selling had nothing to do with the collapse of BS or LEH. Short selling bans are silly. What is necessary is to tax speculation and thus remove the current tax incentive for speculation. Capital gains from trading should be raised, for individual and especially corporations, think GS. Short term gains should be taxed higher yet.
Gains from short term trading of all financial instruments should be higher than ordinary income. One important way to look at the mess is the stupendous amount of manic over trading going on. The ‘markets’, in all their forms, stock, bonds, futures, options and other derivatives long ago became the tail which wagged the dog that is the economy. Personally I think the majority of all derivatives should be ended, futures and option are derivatives by the way, but save that, a proper tax rate on the gains would go a long way to slay the beast that has brought us to this point.
the shorting of stocks directly, not by derivatives, is an important mechanism in maintaining a sound stock market. To the limited extent that stock markets are ever sound. Stocks are always and will always be a speculative endeavor and it should be taught in school that stock markets are the realm of geeks, grifters, shills, con men and crooks.
The relentless lowering of capital gains is the root of our problem. For 50 years were were told we needed more ‘investment’ to grow the economy. The result was the dismantlement of many parts of the economy and the expansion of debt to gargantuan levels. Americans and everyone love to get rich quick and the way to do that is not by work but by inflating asset prices with speculation.
The hedge funds are criminal enterprises betting on the destruction of our American financial system. They should be put out of business. No one should be allowed to participate in the electronic oil futures markets unless they are able to take physical delivery of ten-thousand (10,000) barrels of oil.
Credit default swaps and derivatives should also be outlawed.
O/T:
From the Halls of the Wasilla Sports Complex to the Shores of Lake Lucille, we fight our country’s battles in the air, on land and sea… well, at least in our vivid overheated rightwing imaginations or in a video game or a dream or what the fuck… Let’s hit that ole reset button, you betcha!
Reading Christy’s piece on the Supreme Court, nomination process and Alito lies, one wonders where regulation, law, and order are to be found in our very own country. Is anyone waking up here?
why aren’t banks being turned back from the casino business back into the banking business?
Because they are playing with our money, our economy, our lives… with little or no real risk and very little cost of buying/lobbying to keep it that way?
There is a big difference between a bear raid and normal short selling. The old uptick rule, and some other minor steps had a salutory effect in limiting the possibility of bear raids. The complaint was that Lehman and Bear Stearns were targets of a bear raid. I think there is some evidence for that, even if we can’t prove it right now.
Your ideas, taxes and other limits, are the very kinds of regulation that aren’t in the mix for the weaklings of the Obama administration.
An uptick is a good idea as I wrote last December. The problem here is the lack of coherency in the Obama response to the financial crisis. Some of what they are doing are really bad ideas like the PPIP, the TALF, the TARP, Geithner’s defense of CDSs, even naked ones, and his new program to screw over mortgagees who are up to 25% upside down in their mortgages. Then there is something like this. It’s a good idea, but lost among all the dumb and unworkable ones.
What are the consequences of getting rid of CDS all together how can this be done? I think short sales are stupid they work unless the government does a bailout and you can’t predict that.
The argument that short sales bring companies down well they make worse the mistakes the banks already made.
The banks need regulation and no more CDSs more than they need a ban on short sales.
The banks need to live with the idea of smaller profits.
They still have not fixed this market? I hope Obama is getting us tax payers a big cut off the profits of CDSs at the banks that owe us money.
Not a lot. They are basically unregulated insurance. If a company wants to make a deal and there is increased risk, it could buy regular insurance. Otherwise if the company needs a CDS to make the deal work, it is probably a bad deal and the company should not enter into it.
All of those CDSs would fall into the non-standard category so they wouldn’t be trading on the exchanges that have been set up for derivatives. Did I mention that the banks control the ICE so it’s not like their being traded on such an exchange would necessarily make much difference.
So we can get rid of them with little problem? If so then lets do it the downside is worth more than the risk.
It’s not that they mind doing real investing, it’s just that the more activity they can create (regardless of real utility) the more they can rake the pot and get rich.
For America they will have to be regulated.
Nothing like importing senior executives from those to be regulated and putting them in charge of the regulating. I thought Mr. Bush had brought that to new heights. Mr. Obama and Goldman are stretching them further.
I really agree with you on the mortgages, as you know. If you look at Morgenson’s article in today’s NYT, you learn that the foreclosures for Wells Fargo are producing losses of 36%, but the modifications are interest rates, not principal. If they modified for principal, they could increase their returns. That was the idea of bankruptcy cramdown.
Stupid is as stupid does.
This is a complicated problem. My posts on modeling are attempts to work through the problem. Right now, I’m pretty sure that until models improve, the downside is too risky to justify any benefits they might suggest.
I agree with you on the failures of the administration. The bankruptcy cramdown failure is a perfect illustration. Gretchen Morgenson in today’s NYT tells us that a study of 3,500,000 loans in securitized pools overseen by Wells Fargo, specifically the 35,000 foreclosures, shows that:
Obviously it would be better to reduce principal so homeowners might be able to make payments. Yet only a tiny percentage of modifications reduce principal.
Morgenson doesn’t mention cramdown.
I misread the article. The correct data is in comment 17.
Morgenson uses some double negatives or maybe it was the wine with dinner.