When The Gun Is In YOUR Mouth…. (CDS / Merkel)

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suddenly politicians “get religion” about making damn sure it has no bullets in it:

“We’re of the opinion that a quick implementation of actions in the area of CDS has to happen,” Merkel said. Citing “ongoing speculation against euro-region countries,” she called for the “fastest possible” implementation of new rules. Europe must “do everything to avoid unhealthy speculation,” said Juncker, who heads the euro-area finance ministers group.

Where ‘ya been Angie?

Oh, and you too Papandreou:

“Europe and America must say ‘enough is enough’ to those speculators who only place value on immediate returns, with utter disregard for the consequences on the larger economic system,” Papandreou said yesterday in a speech in Washington.

And, of course, Sarkozy.

Note that I’ve been calling for these things to be either exchange-traded with central counterparty “blinding” (on purpose) as is the case with the regulated option and futures markets or be torn up since The Ticker began publication.

Why?  Because it is my position and remains so that unless you have this sort of market these contracts are all a scam.

They are a scam because:

  1. The counterparty cannot pay in aggregate for the exposure they have on.  This, in turn, “allows” them to write these swaps at an uneconomic price, which means that in effect these are all “side letter” deals.  That is, they’re intended to cheat regulatory capital requirements as everyone involved knows there is no possibility of actual performance.  In these cases everyone involved should be rotting in prison – the buyer for purchasing a knowingly-bad “insurance policy” against an event that they know can’t pay off for the singular purpose of defrauding a government regulatory agency (and/or the shareholders!) and the seller for putting forward a contract they know they are incapable of performing on.
  2. The entire purpose of off-exchange trading of these instruments is to severely-damage the purchasers of these swaps in the retail market by obscuring the essentials of the transaction, including the bid and offer from other participants.  This also has the effect of allowing collusion, either active or passive, among sellers – nearly all of which are big banks and financial institutions.  This collusion, by the way, either is or should be a felony violation of anti-trust laws.  Finally, concealment of the market’s opinion on price and activity allows outright bribery and other very-unlawful acts such as allegedly occurred in Jefferson County, Alabama.

The solution to this is simple, it’s elegant, and I’ve been railing about it since The Ticker began publication, but there’s no time like the present to re-state the demands and make sure they’re clearly communicated to everyone.

In short, we must make all of these derivatives, including interest rate, currency and credit swaps:

  1. Trade on public exchanges where blinding of counterparties takes place.  This is exactly identical to what is done with the OCC for listed options and the CFTC for listed futures.  If I buy a PUT on a company I have no idea who sold that PUT in the market, and further, if I exercise a long PUT the person who originally sold it may not be the one who gets assigned – that’s handled by lottery among all who are short that contract.  This makes abuse of these contracts by the buyers, who then seek to destroy the sellers, extremely difficult as they have no idea who to target.
  2. Have the exchange is the buyer for every seller and the seller for every buyer.  Since the transaction is effectively “blinded” from the counterparties the exchange is thus in the position where it must make certain that anyone who is short has the capital posted and held as margin to guarantee performance or the exchange will wind up insolvent.  The exchange has nothing to gain and everything to lose by allowing people to “game” collateral and margin requirements – thus, it doesn’t happen.  Further, as volatility rises the exchanges tend to increase margin requirements in order to protect themselves against sharp and unexpected moves – exactly what would be expected of a prudent counterparty.  In short this process makes the market “safe” for both buyers and sellers, and even in times of extreme stress such as the 1987 crash nobody has ever had a regulated futures or options contract fail to be honored.
  3. Break up those “custom” contracts that are so esoteric that only a handful of people want to trade them into standardized contracts that a lot of people want to trade.  Let’s say that someone wants a custom derivative that is comprised of the price of oil and the price of John Deere’s stock.  Perhaps they’re a major farming interest that is concerned not only about the possibility of Deere failing (they have combine orders stacked up that would be VERY expensive to replicate on the spot market) but also the price of oil since they have to fuel those combines.  That’s a custom contract that almost nobody would want to trade, but it can be deconstructed into a PUT on John Deere and a short on the oil futures. In essentially every case these “custom” contracts can be deconstructed into two or more things that lots of people will want to trade, which immediately destroys the argument for “custom” OTC contracts.

For those financial parties who “resist”, the solution is simple: either relent or those contracts which you refuse to migrate to such an exchange are torn up as void ab-initio as you have refused to demonstrate both ability and intent to perform.  They are thus not valid contracts – end of discussion.  If the buyer wishes they can (and should) go sue to seller for return of their premium, since they bought something that was sold under false pretense.

Congress must take this action now, and if it will not, then the executive must by whatever means are necessary – including executive order.  It’s all the better if Merkel, Sarcozy and others on the world stage have finally come to realize what I’ve been saying now for the last three years when this mess first began:

These over-the-counter derivatives are an outrageous-destabilizing force and, in many cases, are outright fraudulent instruments as the selling entity lacks the capacity to perform as agreed.

The essence of the AIG mess was that the company lacked the financial capacity to perform.  It really is that simple.  Knowingly entering into hundreds of billions of dollars of financial commitments without the ability to perform should be treated as a felonious act, but apparently we have no cops anywhere in the world interested in massive and outrageous acts of this sort, as I have yet to see hundreds of perp walks up and down Wall Street.

Well, if the next-best thing is to prevent it from ever happening in the future, I guess we’ll have to settle for that – even though it is, on balance, wholly-insufficient when one considers the damage that these people have caused to the global economy and financial system.

Tuesday, March 9. 2010
Posted by Karl Denninger in Editorial at 10:14

Source: The Market Ticker

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