The plot on Capitol Hill to ban so-called “naked” credit default swaps would have a devastating effect on the entire market for swaps, and most likely make credit far less available to all but the safest companies.
The targeted swaps are considered “naked” because the buyer purchases credit insurance without owning the underlying bond. To some policy makers this seems as ridiculous as buying car insurance without owning a car. Others view it as positively dangerous, an invitation for market manipulation.
There’s even a naked-short seller conspiracy theory angle. The story line goes something like this: shorts snap up credit default swaps, pushing up prices, making creditors nervous and credit more expensive. Stock investors notice the credit markets look nervous so they start to sell off. Shake, rattle, roll, and profits flow into the pockets of shorts.
All this has more than a little bit of panic thinking in it. If cooler heads are to prevail, we need to understand many “naked” buyers of credit default swaps aren’t really naked at all. They have a legitimate interest in buying credit defaults swaps. What interest? They’re hedging against a swap position they sold.
Look at it this way. Suppose you run the swap desk at an investment bank. You sell swaps on the debt of CIT, confident that the market is over-pricing the risk of default. Of course, your bank is nervous about taking on too much risk itself—what if the the Obama administration surprisingly decides not to bail out CIT?—so you want to cover your position. How do you do that? You buy a credit default swap from someone else.
Now you are, of course, officially a “naked” buyer of the CDS. You don’t own the bond. But you did have the functional equivalent of a long position in the bond—that CDS you sold. If we ban naked credit default swaps, we’re telling people that they can’t hedge their own CDS sales.
Guess what happens when dealers find they are prohibited from hedging their own CDS sales? First, it becomes much more expensive to buy credit default swaps since the sellers have larger, unhedged risks. Second, a lot of institutions will simply stop selling CDS altogether because they don’t want to take on the risk without a clear exit strategy.
So the rule prompted by fear that manipulators were causing the prices of credit default swaps to spike would actually cause the price of credit default swaps to spike. Causing the very thing you are trying to remedy should be the first warning sign that a policy is ill-conceived.
The next thing that happens is the supply of credit contracts, especially for risky borrowers. With the price of hedging bond exposure increasing, the interest rates on bonds will increase to compensate. Now, again, this is the very thing that those worried about credit default swap market manipulation say happens thanks to manipulators—swap prices increase and credit gets tighter. Only this time it is the result of government policy rather than some nefarious hedge fund trader.
There are many ways to improve the markets for credit default swaps and reduce the way they are used by financial institutions to game regulatory capital requirements, but banning naked credit default swaps isn’t one of them. And given the broader credit market implications, it’s the last thing we should do during a credit crunch driven recession.
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