California treasurer has right idea on CDS

March 31, 2010

Bill Lockyer, the California state treasurer, is asking big banks which underwrite the state’s bonds to tell him about their role in the market for related credit insurance. It’s a fair question. And this kind of disclosure could be a better way to deal with concerns about credit default swaps than a hasty and simplistic ban.

Lockyer said in letters to six big banks that he had no preconceived notions about the banks’ role in CDS markets. But some of his questions were clearly aimed at potential conflicts that have been widely aired in recent months.

One is the extent to which underwriters of bonds may in other contexts effectively sell them short through derivatives markets — an issue that has also been raised in the ongoing Greek debt crisis. Another is the possible negative impact of CDS trading on the cost and availability of debt for California, a worry shared by corporate borrowers.

If banks cannot show they only use the CDS market for legitimate purposes of hedging and market-making, Lockyer would have good reason to exclude them from lucrative underwriting roles. If the institutions come across as self-serving, that would be telling in itself. In any case, the banks would in effect set out parameters for future behaviour that Lockyer and others could hold them to.

The Lockyer approach makes more sense than calls for an outright ban on CDS or on unhedged positions in these securities. Also sensible is the separate ongoing toughening up by regulators of collateral and capital requirements for derivatives, including CDS instruments.

Speculation and herd behaviour in derivatives markets can add to price volatility in underlying markets, but CDS instruments have genuine value for hedging and other purposes. For instance, they can reward investors who legitimately doubt the natural optimism and spin of politicians, company managers and hired bankers.

A ban or a severe restriction might make borrowers’ lives easier, but that is not certain, nor is it necessarily an appropriate goal. But customers — especially big ones like California — should press banks for disclosure and commitments about good practice. Lockyer is on the right track.


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default swaps are a cheap form of gambling with much better than Vegas house odds

Posted by Story_Burn | Report as abusive

Bill Lockyear is the one most well qualified individual in California governance and should have been governor. I suspect he understood the risks of running against “Ahnie” the governator and bowed out. He remains the bright star in California state governance. Bill Lockyear needs to be cloned, quickly…

Posted by gramps | Report as abusive

A great idea, but by itself it is not enough (as the article mentions).

The regulations governing capital requirements and collateral must be made much tighter than they previously were.

Even so, I think derivatives are a bad idea.

I remember listening to a discussion of derivatives on public radio back when they were first concocted and wondering about the safety of financial instruments that have no intrinsic value, only the value people apply to them based on their expectations of what they might be worth in the future.

It amounts to little more than a naked bet.

As time went by and the concept survived, I could never quite understand how they ever gained acceptance by the financial community.

Even now, after the Great American Debacle, the financial community still embraces them.

Go figure.

There must be something in it for the financial community because their is nothing in it for me except the risk that they might bet really big and be so wrong that I’ll be expected to help them cover the bet.

Posted by breezinthru | Report as abusive

The State’s job is to prosecute shady financial dealings, not engage in them. Lockyer’s on track to bury CDS, if a little gradually, not to praise them. And so it begins…

Posted by HBC | Report as abusive