Friday, July 24, 2009

Nudity in the swaps market?

AlphaNinja - The house financial services committee is pondering legislation to restrict "naked" CDS trading.

CDS, or Credit Default Swaps, allow a holder of a company's debt to hedge against the possibility of the company defaulting on that debt.

Here's a peek at today's movers in that market, courtesy of CMA Datavision. Basically, if you own $10million of Con-way (CNW) debt, you must pay 148basis points, or $148,000 per year to insure against that default. You can see below that the Conway CDS have dropped in price by 52basis points, and that is because the company had a fabulous earnings report this morning, obviously reducing the chance of default -->> thus, the cost to insure goes down. If you owned the CDS, they'd be losing money today.

What congress is concerned about (and frankly I agree), is that people are allowed to buy CDS "naked," meaning they are betting on insolvency when they DON'T own the bonds. Critics of this tactic say that this drives up the CDS price, implying a higher chance of default that in turn becomes a self-fulfilling prophecy (in the case of Lehman Brothers, people bid up the CDS prices, which spooked Lehman's clients, who pulled their accounts, etc etc etc). Defenders of the practice say that these speculators add "liquidity" to the market, and actually HELP the company because people are able to effectively hedge their debt.

The debate could go on forever....

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