Shorting a stock, the CDS way

I had just finished comparing the synthetic CDS market to carrying life insurance on a stranger/public personality and along comes a story of the logical next step already in play. I would surmise that the logical next step after buying life insurance on someone you don't care much about would be to arrange for the passing of the said person. e.g. if the person was already admitted to a hospital, and you have some sway there, you would guide matters towards reduced treatment or even euthanasia.

Now the economist brings us news, that is precisely what CDS holders are doing to companies. They have already bet on the demise of the company and stand to gain from that demise, so they now play hardball on their original debt and encourage bankruptcy courts (isn't that the hospital you take sick companies to?) to take actions that will accelerate collapse rather than recovery.

The economist piece proposes solutions like regulation, disclosure etc. really speaking we should apply the existing legal standards. Under current law, one cannot collect the insurance policy above because, the act of accelerating the demise is a crime and you cannot profit from crime so the policy will not be paid out to you. Apply the same standard, the CDS is rendered worthless.

Wall-street-just-learnt-what-bookies-have-known-for-long department

In my earlier post I took a Free market advocates position while looking at the recent WSJ story. In this post the same story is viewed through a different lens which yields a pro-regulation conclusion.

For all the high falutin terminology and complexity, a CDS is just a bet placed with a bookie. The industry (even the article wrongly makes this argument) keeps likening it to insurance, fact is if you carry life insurance on a stranger/public personality (say a racing driver), that is not insurance, that is a bet that he will die! (soon?) In this case most of the buyers of the CDS did not hold the security so same deal, these are bets. Now any bookie knows that if enough bets are placed and the book gets skewed enough, the bets will produce the result not the other way around, (games, fights and races are rigged all the time for this very reason). That is the ugly reality of big money betting.

If you want to cleanup a game, you have to curb betting on it. By this argument, if you want to cleanup the ABS business you have to outlaw CDS purchase without proof of ownership. Just as I can’t buy auto insurance on a car I don’t own, a bank should have not be permitted to buy “insurance” on what they don’t own. So make it truly like insurance and regulate it the same way. Outlaw betting/gambling on wall street in line with federal law, which prohibits betting except on a game of chance (dice etc.). CDS on ABS, is a game of serious skill, not chance.

The Real Reason Why a Daring Trade Has Wall Street Seething - A Pure Free Market Argument

(Original WSJ story)

Anybody on wall street “seething” at this for any reason other than “why didn’t I think of that earlier” is not fit for wall street!!!

CDS’s are part of the “free markets” rejection of regulation, the contention has always been that free markets are self regulating, nobody is saying what the nature of the self-regulation will be. One critical process that markets rely on for self regulation is arbitrage, arbitrage opportunities are market imperfections, people who step in and trade that opportunity are the critical force that trades the arbitrage away and brings the market to steady state again. These agents are automatically rewarded in the process for this crucial contribution!

Thus in this case, the craziness with CDS’s is actually the market imperfection. The fact is we did not have enough smart operators like amherst step in early enough to plug the hole. If wall street had been smart about spotting the arbitrage opportunity as they should have been, these trades should have happened at the start of the decline quickly till the market had stabilized to an appropriate level of CDS play, also one trade for a few million is too small.

So, from a pure free market standpoint, I’m “seething” that this did not happen enough and early enough! That is the failure of the market.