Cops and CDS

Let's start with Richard Shelby and Charles Schumer, both Senators, and the bill introduced today:

"He and Senate Banking Committee ranking member Richard Shelby, R-Ala., introduced legislation that would spent $110 million to hire 500 FBI agents, 50 assistant U.S. attorneys and 100 SEC enforcement-division employees. These staffers would focus their energy on responding to fraud in the financial crisis.

Both Schumer and Shelby say that the financial crisis and complex fraud investigations require greater resources to identify lawbreakers. "In order to restore confidence, those who perpetrate fraudulent acts must be brought to justice," Shelby commented.

Oh really?

Two comments: This is a good start, and you need to add a zero to that headcount.

As to how to pay for the new staff (which was asked on CNBC yesterday afternoon) I have a simple solution to that - get very aggressive with clawbacks and forfeiture actions.  After all, most of the people who this group should be chasing (if they're doing their jobs right) have net worths in the hundreds of millions or even billions of dollars, and nearly all of that money was obtained during and as a consequence of their alleged illicit activity - and thus is subject to clawback or forfeiture.

We can start with Henry Paulson himself and Goldman, who allegedly was shorting bonds they had packaged up and were selling to customers in the next room over! 

Next, how about the CEOs of Bear Stearns and Lehman, both of whom appeared on CNBC in the days and weeks before their firms imploded making claims of solvency and more-than-adequate liquidity?

We can then move on to Lewis of BAC and Thain of Merrill, both of whom appear to be involved in intentionally hiding material facts from investors, intentionally dissipating a firm's assets when that firm was about to receive a bailout from the public's Treasury (without disclosure), or both.

Then there are the Madoffs - it seems not a day goes by where we don't hear of another Ponzi Scheme or just plain old-fashioned scam where the alleged perpetrator has either disappeared, faked his own death, or (in a few cases) done the honorable thing and thrown himself in front of a train after allegedly ripping off investors for millions and/or lying about profitability.

More important, however, may be the following article from IRA; I will reproduce only the punch-line paragraph:

"Unless and until Chairman Bernanke and the other regulator are willing to tame the CDS tiger, there will be no success in bringing stability to the US banking system or foreign banking markets. And the longer Bernanke & Co refuse to say an emphatic "no" to Goldman Sachs (NYSE:GS), JPMorganChase (NYSE:JPM) and the other CDS dealers, the financial crisis affecting global banking institutions will continue to worsen.  Making this change may force GS and other dealers into mergers or liquidations, but such is the cost of reform. The US economy can live without the major Sell Side dealer firms, but we cannot survive without commercial banks, insurance companies and commercial companies, all of which are targets for the CDS Mafia and the unlimited leverage that they use as weapons against us all to generate speculative gains.  We have the power to fix this aspect of the financial crisis immediately, but do our leaders have the courage and the vision to close down this reckless, speculative market before it destroys what remains of our economy?"

It certainly is nice to hear more voices rise against this madness.

The CDS monster has not only been left alone he has been eating firms by the day.  This has been and remains a serious problem as Credit Default Swaps permit players to effectively short firms at an infinite leverage ratio as there are no capital requirements to place these trades, no margin supervision and no mark-to-market requirements.

Many people have railed about "naked shorting", which is the illegal practice of selling short shares that do not in fact exist.  That is, instead of borrowing shares and then selling them (an ordinary short) the person abusing short sales in the "naked" fashion literally counterfeits the shares.  This places incredible downward pressure on the share price as the naked shorter has literally diluted the "float" of common stock by pretending that there are more shares outstanding than were issued.  Taken to extremes any firm's stock price can be collapsed in this fashion!

"Naked" CDS, that is, swaps written or purchased not to hedge a bond or other business relationship but instead to speculate on the firm's fortunes are effectively the same thing as a naked short, in that there are NO boundaries on how many CDS contracts can be written against a firm and by having them cash-settle they amount to nothing more or less than a gambling contract with no limit as to the leverage that can be employed.

Now consider that in the present situation what Treasury and The Fed are doing is allowing speculators to write checks of infinite size against the taxpayer!  That is, by declaring that they will not allow these institutions to fail, backing that claim up with real money (both Citi and Bank America have received multiple infusions of TARP money and credit guarantees in the hundreds of billions of dollars) Treasury and The Fed are allowing a certain select few dealers to plunder the Treasury by entering into what amount to synthetic short positions against the bonds of these firms, with Treasury and The Fed on the hook for the bill when values decline.

Why is this effectively a short position?  Because the person who writes the contract has to hedge in some fashion, lest he be exposed to the full face value of the CDS (against a defaulted bond that might be worth only a dime, as was the case for Lehman.)  How does the writer hedge?  He can short the stock, buy PUT options, or otherwise take some sort of action that grows in value as the likelihood of a triggering event grows.

This posture is dramatically and intentionally adding to the instability in our capital markets generally and both stock and credit markers specifically, producing insane price swings in the equity of these firms on a daily basis.  Over the last three days we have seen Citibank and Bank America move in stock price by 10, 20, even 30% - in a single day!  State Street was whacked for more than HALF of its value yesterday, then rose today by 23%.

The pure insanity of this policy should be obvious to anyone with an IQ larger than their shoe size.

Treasury must immediately put a stop to this.  IRA has some good ideas as to the changes necessary in this market; I'll offer mine:

• Bar by executive order the writing of any new CDS on any firm that has taken TARP money, without exception.
• Prohibit the collection of a CDS payout unless the holder tenders the underlying bond against which the CDS provides protection.  This will immediately extinguish "speculative" CDS contracts while leaving those that were entered into as legitimate hedging transactions intact.

Yes, I know all about the argument related to abrogation of contracts.  But the fact remains that manipulating stock prices is unlawful, naked shorting is illegal, and writing unlimited, no-margin-required CDS against a firm is exactly identical in effect to naked shorting a firm's bonds.  I can't do it with stock so why should I be able to in the bond market?  Whether shorting the capital structure of a company is legitimate isn't dependent on where in the capital structure I do so.

Speculating on a firm's (or index) health (or lack thereof) is perfectly legal, and there are already plenty of ways to do that such as the use of exchange-listed Options and Futures contracts. 

The distinction between shorting stock, options, futures and CDS is that in all but the last you have margin supervision and capital requirements that are marked to the market nightly, open interest is public information and so is the fact that you executed these trades.  These features prevent the use of these vehicles as a looting mechanism as your leverage is tightly controlled.

In fact, it is precisely the LACK of such controls that makes the CDS market so attractive to these market participants.  Because there is no margin requirement on writing CDS it is entirely possible to set up enough Credit Default Swaps to literally consume all of the money in the banking system should they be triggered, and in fact this has occurred several times over, compelling Treasury and The Fed to write checks of infinite size to prevent the triggering of contracts that, were they to "go off", would instantaneously destroy the currency of the United States, the entire banking system, and now that The Fed and Treasury effectively "own" these firms and their liabilities, the government itself.

It is time to put a stop to this outrageous practice by labeling it what it has become - an implicit threat to overthrow and destroy the United States Federal Government.

For over a year I have been calling for exchange listing of CDS contracts and strict margin supervision, but it has not been done.  Instead of taking strong and decisive action Treasury and The Fed have intentionally continued to allow their "favored Sons" to profit via this scheme.

Since it is no longer private companies that are at risk but rather the Taxpayer's Balance Sheet it is obvious that Treasury, Congress, President Obama and The Fed have justification, a mandate and duty to put a stop to this abusive practice right here and now.