Felix Salmon

How the Fed slept through Lehman

Felix Salmon
Mar 16, 2010 17:20 UTC

Andrew Ross Sorkin today notes that the Fed and the SEC didn’t do anything about Lehman Brothers, despite the fact that they knew full well that there were problems.

Where was the government while all this “materially misleading” accounting was going on? In the vernacular of teenage instant messaging, let’s just say they had a vantage point as good as POS (parent over shoulder)…

Indeed, it now appears that the federal government itself either didn’t appreciate the significance of what it saw (we’ve seen that movie before with regulators waving off tips about Bernard L. Madoff). Or perhaps they did appreciate the significance and blessed the now-suspect accounting anyway.

Yves Smith found the most telling part of the report on Thursday: it’s on page 1,488 of the report, which is page 445 of this PDF.

Liquidity was an important factor in the stress testing that Lehman was required to run under the CSE Program. After March 2008 when the SEC and FRBNY began on‐ site daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress‐testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank. The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.” Lehman failed both tests. The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed. However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed. It does not appear that any agency required any action of Lehman in response to the results of the stress testing.

The CSE program, which stands for Consolidated Supervised Entities, was the SEC’s way of trying to supervise too-big-to-fail banks from the inside. But even the SEC didn’t think it was qualified to actually do that, which is why the SEC brought in Geithner’s New York Fed as a partner — note the bit above about the SEC “deferring” to the Fed to put together stress tests.

Clearly the CSE program was an abject failure: it could put together stress tests, but then the SEC and the NY Fed ignored the results. There’s obvious bad news here: that the Fed is such an incompetent regulator of systemically-important institutions that it can’t even get alarmed when one of those institutions fails its own stress tests. But there’s a possible glimmer of good news too: that the Fed had people capable of putting together a decent stress test, and that the SEC sensibly deferred to those people in terms of stress test design. In other words, the Fed has the ability to regulate; all that’s needed now (and was missing in 2008) is the willingness to do so and to bare teeth once in a while.

A good way to institutionalize that is to implement what David Merkel calls “dumb regulation” — once you put simple rules in place, it becomes much more difficult (although never, of course, impossible) to override those rules or to ignore them. The problem with Lehman was that there were no simple rules, and that no one at the Fed or the SEC felt comfortable making up new ones on the spot, like “you’ve got to be able to pass the stress test which we invented five minutes ago”. I, for one, wouldn’t want to be the regulator who had to receive the phone call from Dick Fuld after implementing a rule like that, using dubious legal authority.

One of the problems with giving lots of supervisory authority to the Fed is that the Fed is run by economists who care primarily about setting monetary policy, as opposed to being run by bankers who care primarily about bank regulation and systemic risk. The base-case scenario is that unless and until we start staffing the Fed with a bunch of poachers-turned-gamekeepers, the biggest banks are likely to be able to smooth-talk their way past the Fed’s regulators. The Fed is still the least bad institution to do this: any other alternative would be even worse. But that doesn’t mean that I have any confidence in it.


The Fed didn’t sleep through Lehman. They were wide awake and as active as ever they get, which is why rendering the Fed unconscious once and for all is becoming an ever more attractive proposition.

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Will consumers be protected?

Felix Salmon
Mar 16, 2010 15:00 UTC

Color me happily surprised by the consumer-protection rhetoric yesterday of both Chris Dodd and Barack Obama. HuffPo has the best single overview of the bill, along with Dodd’s reasonably compelling explanation of why housing the agency in the Fed doesn’t mean it isn’t independent — and in fact helps to insulate it from the kind of regulatory capture which is endemic to regulators who are funded by those they regulate.

As for the egregious carve-outs for the like of auto lenders, Obama did the right thing and stepped up to the plate yesterday, releasing this statement:

“I will not accept attempts to undermine the independence of the consumer protection agency, or to exclude from its purview banks, credit card companies or non-bank firms such as debt collectors, credit bureaus, payday lenders or auto dealers.”

As I understand it, Dodd’s consumer protection agency can make rules for just about anybody; the constraints are on the entities where it’s allowed to enforce those rules. That’s a reasonably good start; if it gets beefed up in reconciliation, we could yet emerge from this process with a genuinely useful new agency. Assuming, of course, that the Republicans allow anything to get through the Senate at all. We’ll probably find out this week how likely that’s going to be.

On the other hand, Mike Konczal asks an excellent question about why the Democrats aren’t making full use of the timing here, with the Dodd bill being released right in the wake of the Lehman report:

One thing that I’m finding surprising is that the President and the Treasury Secretary aren’t out there beating the hell out of this story. As a financial reformer, this report should be like a “Get 2 Free Financial Reforms” monopoly-style card falling out of the sky. They should be thumping the hell out of this story.

He also answers that question: the Treasury Secretary, Tim Geithner, ran the New York Fed at the time, and was a central part of the government apparatus which gave Lehman all the nods and winks that it needed to get away with its shenanigans. Sometimes the real reasons for what does and doesn’t happen in politics are the very worst ones.


What is your suspicion about Mike, Uncle_Billy? Is he being paid by Raul Castro or Rupert Murdoch?

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Magazines on the iPad

Felix Salmon
Mar 15, 2010 21:34 UTC

Wired’s design director, Scott Dadich, unveiled what the magazine’s iPad app is going to look like at a packed SXSW session this morning which was sold as an introduction to the “digital rebirth” of Wired in particular and of magazines in general.

The app does look very slick; Richard Baum shot a little bit of video which should give you a decent idea of how it works.

Wired’s strategy, here, is both the obvious one and the sensible one, but that doesn’t mean I have to like it. But in order to understand the dynamics it helps a lot to understand Wired’s famous “Berlin Hall”, as discussed at enormous length in one of the highest-quality comment threads ever in the history of the blogosphere. Condé Nast bought Wired long before it bought Wired.com, and, after years apart from each other, the magazine and the website are still very different and self-sufficient beasts, reaching different readers in different ways. Yes, the magazine’s content does appear on the website, but largely as something of an afterthought: the bulk of the website’s content and pageviews is not magazine content.

Dadich kicked off his presentation by showing a photo of the large art and design team at Wired, and noting that the website can’t boast anything like that kind of staffing dedicated to making articles look good and read well online. He’s excited about the iPad app, because it gives the magazine’s team a chance to play in a highly structured closed environment, like the magazine, and to create something just as minutely designed while at the same time being much more wired in terms of being able to play with multimedia. It was great watching him geek out over things like font kerning — the custom fonts he’s using for the magazine have over 10,000 kerning pairs, or different spacing between letters depending on which letters you’re using. (26 squared is only 676, so this goes way beyond just having custom kerning for each pair of normal letters.)

But it’s pretty clear that the iPad is going to make the Berlin Hall even wider than it is at moment. As far as I can tell there are no plans to port content from Wired.com onto the iPad, and it even seems that Wired is going to regress to its old habit of waiting a week, after the magazine comes out, before stories go onto the website. That practice came to an end when Condé bought Wired.com, but now Condé very much wants people to read the magazine on a paid iPad app, rather than on the free website, and wants to minimize the number of people who pass on the iPad app because they know they can get the same content online for free.

For much the same reason, wonderful multimedia online presentations of Wired magazine content, like the cutthroat capitalism game from last year, are clearly now a thing of the past. They’ll still exist, but they’ll exist in paid-for online form, rather than being freely available on the website. Even the bare-bones text content from the magazine is only really appearing online so that Wired’s readers have something to link to and share and tweet; it’s notable that the social-media functionality in the iPad app is going to be missing at first, and that Wire’d designers are concentrating for the time being on nailing down the design.

The inability of the iPad to multitask doesn’t help here, either. Wired doesn’t want to allow simple links in ads or stories which would open up in the iPad web browser, since opening the browser means closing the Wired app. Instead, web links will open in a pop-up window within the iPad app, which then gets closed, returning you to the position in the magazine that you came from. The whole ethos is a magazine-like one of a closed system with lots of control — the exact opposite, really, of the internet, which is an open system where it’s very hard indeed to control the user experience.

From a media-company point of view, this is all good. The ads on the iPad are not going to be annoying interruptions, like they are online and on TV; instead, they’re going to be attractive reasons to buy the app in the first place, just as people love to flick through the glossy ads in other Condé publications, or love to stand in front of the huge animated American Eagle billboard in Times Square. From a brand-advertising perspective, the iPad could bring serious high-end ad dollars into the digital realm for the first time.

From an open-web perspective, on the other hand, the Wired iPad app marks a clear retreat back towards what were once known as walled gardens. You can’t link to an iPad app, and it’ll probably be a while before Disqus or someone similar even allows you to comment on a story there, with the comment stream being merged with the comments on the web version. An iPad app or story can never go viral, can never break out and achieve a life of its own, can never be remixed or reinvented. I’m not even sure whether there’s going to be any interest in updating iPad stories after they first appear.

And for the time being, everything iPad is clearly being driven by the design team, much more than by the editors and journalists, whose job is still to write and wrangle text. It’s also, necessarily, being driven by the fact that Wired is a print magazine, and that everything on the iPad needs to be able to appear in print as well. If you get too inventive about new ways of telling a story, then the core franchise will find itself left out in the cold, and nobody at Condé wants that.

I’m very excited about both reading and writing for the iPad, I think it’s going to be lots of fun. I just hope that it doesn’t result in magazines deserting the web.


Relative to the production costs of the printed product, iPad production costs simply aren’t that big a deal.

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The Big Short

Felix Salmon
Mar 15, 2010 16:35 UTC

After my review of Michael Lewis’s new book was posted on Friday, Sandrew asked for a bit more detail on this bit, about the people who shorted the subprime mortgage market:

What these men did was not “socially useless,” to quote the chairman of the UK’s Financial Services Authority, Lord Turner. It was worse than that: it was actively harmful, since they provided the fuel which kept the subprime mortgage furnace burning even when the country was running out of new junk mortgages to write. In most financial markets, bearish bets act as a dampener; in this one, they were a necessary part of the subprime-mortgage machine, and a Deutsche Bank mortgage trader named Greg Lippmann ended up making billions of dollars for his employer — not to mention a $50 million bonus for himself — by aggressively going out and finding fund managers to put on the short bets needed to keep the market ticking.

The point here is that credit bubbles, like all bubbles, feed on trading activity and upward momentum. If you look at the history of the subprime mortgage market, it started off small and then slowly sped up as Fannie and Freddie started accepting increasing amounts of subprime paper. Then banks started selling private-label subprime CDOs directly to investors, bypassing the GSEs; a lot of the profits in that activity came from taking the unattractive lowest-yielding tranches and insuring them with AIG.

Then, after AIG exited the market, everything should have ground to a halt. But it didn’t, because banks continued to build synthetic subprime CDOs out of the credit default swaps which were being bought by Greg Lippmann and others. The demand for those CDOs from investors like Wing Chau was enormous, and helped to ratify the valuations that everybody else was placing on their own subprime assets. Remember that this is a market with almost no pricing transparency in the secondary market: because all securitization deals are unique, the only way to get a feel for the health of the market is by looking at where primary deals are pricing. Whenever anybody said that the marks being put on subprime assets by banks and hedge funds were delusional, it was easy to point to the booming market in synthetic subprime CDOs to prove them wrong. No one, of course, remarked on the irony that the synthetic subprime CDO market was only booming because John Paulson and others were providing a huge amount of demand for bearish bets.

My review got quite a lot of attention elsewhere, too, largely because of the last line, where I call Lewis’s book “probably the single best piece of financial journalism ever written”. It is a very good book, but at the same time there’s a faintness to the praise. As I wrote back in 2002,

With the possible exception of Michael Lewis at the New York Times Magazine, the financial journalism which appears in the generalist press (John Cassidy in the New Yorker; Joseph Stiglitz in the New York Review of Books) aspires more to authoritativeness than it does to any kind of lasting style.

Lewis’s achievement with The Big Short is that he’s written a book that a huge number of people will love to read: it’s not just for finance geeks. It’s pretty much the first crisis book about which that can be said, because Lewis has expended enormous effort on the kind of things that most financial journalists consider optional extras: carefully-structured narrative, intimately-colored characters, beautifully-written prose.

The churlish pushback against Lewis’s book, then, is misplaced, especially because The Big Short is a book-length refutation of the notorious column that Lewis wrote in January 2007, where he called the subprime bears wimps, ninnies, and pointless skeptics. Lewis clearly did an enormous amount of research for this book, which is more detailed and more accurate than anything he’s written in his Bloomberg column or for a glossy Condé Nast magazine.

Of course, in any book it’s possible to find mistakes, but people like Michael Osinski should be careful about throwing stones: I’m not at all sure he’s right, for instance, that the subprime CDS market ever “overwhelmed the actual market in the underlying bonds”. For what it’s worth, my quibble with the Lewis book is when he starts talking about the ABX index as being indicative of prices more generally, a mistake which Gillian Tett also made multiple times in her book. But that really is only a quibble. The Big Short isn’t ambitious in the sense of trying to explain everything that happened over the course of the financial crisis, but it’s very ambitious in the sense of trying to get a great book out of the crisis — one which can compete not only with finance books but also with fiction and non-fiction books more generally. I just wish that someone other than Michael Lewis would share that ambition.


I’m about a third of the way through “TBS” and I have to say I’m nearly as angry as I was after 9/11. It’s clear there’s a huge gap between the average intelligent person and Wall Street. I could sense it while watching the committee hearings with Goldman Sachs yesterday. The people who defend these kind of instruments can’t possibly understand how ridiculous this appears to an intelligent person on the outside. There’s a danger: understanding something, or at least thinking you do, becomes the rationalization for it’s existence. It’s payday someday, folks. This is such a joke that people are actually rationalizing the existence of a market that existed only on the back of one that should have never existed because “that’s the way it works.” Shame on this country.

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Personal finance online

Felix Salmon
Mar 14, 2010 16:13 UTC

I attended a predictably utopian Banking 2.0 panel at SXSW yesterday; is it normal that most interesting discussion at these events tends to take place in the Twitter backchannel? Still, two interesting questions did arise, around the cool’n'webby financial services companies like Smarty Pig and Mint and Credit Karma which were on the panel: are they basically engaging in regulatory arbitrage, and are they also helping to entrench the too-big-to-fail banks in their existing market positions?

The moderator of the panel, a relentlessly upbeat woman named Jennifer Openshaw, was particularly impressed that the webby panelists had more Facebook fans than the biggest TBTF banks. But the audience wasn’t. Any bank on that list probably has more compliance officers than the total number of employees of all of the companies on the panel combined, and when it comes to things like embracing social media, the job of compliance officers is basically to say no, or to try to mandate things like adding the words “Member, FDIC” to the end of every tweet.

The web-based financial-services firms, then, are rushing into the vacuum left by the biggest banks, which generally confine their messaging to spaces like their own websites, or their own mailings — things where they can remain in control of as much as possible. Certainly the banks still have a lot of room for improvement when it comes to things like personalization, but to degree that might surprise you, their absence from the open web is necessitated by the regulatory constraints within which they work.

One question, from John Davis, touched on this directly: insofar as the financial crisis was caused by largely or entirely unregulated institutions, shouldn’t we be naturally suspicious of financial-services companies operating outside any kind of regulatory oversight? It’s true that these companies aren’t banks, or depositary institutions, but the same could be said for many an unregulated mortgage lender of old. And even when they never touch money themselves, they’re still responsible for major financial decisions being made my millions of Americans. So far they’re mostly on the side of the angels — although not entirely, as we’ll see — but the “trust us, we’re on your side” schtick is never particularly compelling, and I for one would love to see them voluntarily register with any new Consumer Financial Protection Agency to get its stamp of approval.

One hint of a business that many of these customers might object to came later in the afternoon, at the Data is Money panel, where Mint’s Aaron Patzer, after saying what was by far the stupidest thing I’ve heard at SXSW so far, then started talking about the rich value of all the store-level data he was sitting on. For instance, he said, he can see pretty much in real time how much money his huge database of customers is, in aggregate, spending at Blockbuster vs Netflix vs Redbox, or any other set of retailers — and that kind of information would surely be extremely valuable to hedge funds. It was clearly something he’s talked a lot about, and he never said that he wasn’t already selling that data to the highest bidder. If that kind of activity is going on, especially if Mint is using data retrieved using the username and password to my own personal bank accounts, then I would certainly want some kind of regulatory oversight.

Another potential problem for these companies is that they’re aligning themselves very much with the biggest of the TBTF banks, which have retail footprints spanning the nation and which also have enormous online marketing and customer-acquisition budgets. In a country with a lot of anger against those banks, and which is largely sympathetic to the Move Your Money campaign, the web-based companies facilitating the online operations of America’s biggest banks don’t look particularly harmless.

When asked about this, the web companies tend to talk a lot about simply doing what their customers want, and providing their customers with impartial information, and working just as happily with community banks as they do with BofA. But I, for one, am not convinced. Community banks aren’t set up to work with websites like these, and credit unions, with their restricted fields of membership, certainly aren’t — so far there isn’t even a good online tool enabling consumers to work out exactly which credit unions they’re eligible to join.

I see personal-finance websites, then, as playing straight into the hands of banks whose business model is predicated on dominating the market, even if on the face of things those websites allow all financial institutions to compete on a level playing field. That’s one reason I’m more well disposed towards peer-to-peer lender Lending Club, which right now is only offering 3-year unsecured loans, but which will surely, in future, move into other areas such as auto loans and small business lending. If small businesses can get a loan more easily from Lending Club than they can from their local Wells Fargo, and if Lending Club can somehow compete with Wells Fargo in terms of how it’s featured on sites like Mint.com, then maybe the internet can help a little bit in the move away from TBTF banks. But I still worry that overall, the trend online will be in the opposite direction.


Is there a dark side to Smartypig? I just signed up over there.

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Whither Ernst & Young and Linklaters?

Felix Salmon
Mar 12, 2010 16:56 UTC

Blogging’s going to be light-to-nonexistent today, since it’s a travel day for me. But with all the renewed attention on Lehman Brothers (be sure to check out Antony’s piece on the report), it’s worth wondering what might happen to Ernst & Young, in the US, and to Linklaters, in the UK.

Linklaters was the chief enabler of the notorious repo 105 transactions, giving a ludicrous-on-its-face opinion that they were a “true sale”. And this just isn’t credible:

In a statement, Linklaters said Friday that Valukas’ report doesn’t suggest the legal opinion it gave under English law was wrong or improper.

“We have reviewed the opinions and are not aware of any facts or circumstances which would justify any criticism,” the law firm said.

There’s been a lot of noise, of late, about how banking became corrupted when it ceased to be a profession, and that lawyers and doctors somehow remained noble. But these lawyers don’t seem very noble to me.

And if anything E&Y is in even worse shape, given this:

The Examiner concludes that there are colorable claims that Ernst & Young did not meet professional standards either in investigating these allegations and in connection with its audit and review of Lehman’s financial statements.

Enron brought down Arthur Andersen. Will Lehman do the same for E&Y? Or even Linklaters?


If you value competition you want E&Y to survive, there are 4 major accounting firms right now: EY, PWC, Deloitte and KPMG. Grant Thorton is a distant fifth.

These firms make amazing amounts of cash and the average partners income would make you cry. If you think that EY should go down becaue Andersen went down well thats just foolish. Three large firms would only increase the profits of these firms. Competition is slim these days.

Andersen went down because there was a crisis of confidence, not because their audit proceedures were faulty or anything systematic. Each office and you could argue each partner have certain independence to customize an audit to their liking. One partner, or a handful of partners or even an office being lazy or even corrupt does not mean an entire GLOBAL accounting firm should suffer a similar fate.

These firms are in every major city in the world – do the Toronto, Sydney, Moscow, Madrid, Johanesburg E&Y offices have anything to do with Lehman in NYC?

Andersen never should have failed…neither should E&Y. Do you know how many partners at Andersen were reprimanded, who lost their CPA license? Very very few.

They should go after those responsible for the shoty auditing with everything they’ve got but the firm itself should not fail as a result.

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Felix Salmon
Mar 12, 2010 06:49 UTC

Kate Kelly and Dennis Berman to CNBC? — Mediabistro

The RSS debate, cont: Jack Shafer piles on — Slate

The full Lehman report — Jenner

The Breslin’s forkage fee — NYT

Was the runaway Prius a fake? — Jalopnik

NYU Law Professor Charged With Criminal Libel in France for Refusing to Take Down Critical Book Review — CIT Media Law

All 119 words banned by Tribune’s CEO, in one sentence — NPR

What’s the instability risk of CDS markets?

Felix Salmon
Mar 12, 2010 00:48 UTC

Kevin Drum has a couple of good questions about credit default swaps, and the final link in his post literally made me laugh out loud, so I’ll do my best to answer him.

If the bond issuer does default, and there are a hundred speculators who own CDS protection on one of its bond, you’ve gone from, say, a $10 million event to a $1 billion event. Basically, when things go bad — and eventually they always do — widespread CDS protection can cause things to spiral far more out of control than they would otherwise.

And what’s the upside of allowing this? The argument I hear most often is that broad market trading of CDS provides an efficient price discovery mechanism for the underlying securities. Moody’s may rate that bond AA, but the CDS market will tell you what traders really think.

I guess I have two questions about that. First, does it really work? Are CDS marks really reliable indicators of creditworthiness? That’s debatable. Second, even if they are, is this a big enough benefit to make the instability risk worth it?

The first thing to do here is to dispute the premise. Yes, things will always go bad. But when things go bad, is it true that “widespread CDS protection can cause things to spiral far more out of control than they would otherwise”? Kevin is honest enough to note that when things went bad in 2008, that didn’t happen. And conceptually, it’s not the existence of credit protection which is a problem. People who have bought protection make money, they’re happy. The problem is the people on the other side of the trade — the people who wrote the CDS, not the people who bought them.

Indeed, that’s exactly what we saw in 2008: the people who bought lots of credit protection made lots of money, while the big losers were triple-A-rated companies like AIG and MBIA which had written the protection and which, by dint of being triple-A, didn’t have to put up collateral against the CDS which they sold.

Today, there isn’t a company in the world — not even Berkshire Hathaway — which can write CDS protection without having to put up collateral. And even if credit default swaps aren’t moved to an exchange, they will likely move towards a much more centralized clearing mechanism, which will institutionalize collateral and margin calls and make sudden bankruptcies even less likely than they are now.

But the most important thing to note is that the true villain here is not CDS so much as it is leverage. If I buy a bond and it goes to zero, I lose money, but there are few systemic consequences. If I’m a leveraged institution, however, and I bought that bond with borrowed money, then the consequences can be dire. Writing CDS protection is essentially the same as buying a bond, and writing CDS protection while putting no money down — as AIG did — is just as dangerous as buying a bond on zero margin.

So now ask yourself exactly what’s going on in Kevin’s hypothetical, where there are a hundred speculators who own CDS protection on a single credit. As we’ve seen, the speculators who bought protection don’t pose a systemic risk, although they might alter the likelihood of a bankruptcy filing. The real risk comes from the people who are net sellers of protection on that credit. And who might those be?

Think about what’s going on here, for a second: we have a lot of speculators making a negative-carry trade, where they pay regular coupon-like insurance premiums and get paid a lump sum in the event of default. Negative-carry trades are almost exclusively the province of hedge funds: long-only investors almost never make them. Indeed, it’s the long-only investors who are on the other side of the trade — institutional investors who wrote CDS rather than buying bonds, because the yield was higher or because they simply couldn’t locate bonds to buy, or just because CDS are more liquid. For those investors, CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.

The middlemen in the picture, the broker-dealers, are leveraged, but they are nearly always pretty flat when it comes to their net CDS positions. Insofar as there’s a big net position in the market, with one group of people net buyers of protection and another net sellers, the net sellers of protection — the ones posing the systemic risk — are unlikely to be leveraged, and if they’re not leveraged, nothing spirals out of control.

Sensible CDS regulation can and should, then, put tight limits on how much leverage a net seller of credit protection can be allowed to have. And by all means, if you want to keep things symmetrical, apply the same limits on how much leverage a bond investor can be allowed to have. But the CDS market is more dangerous, just because it’s so much bigger.

As to Kevin’s two questions, the first asks what the upside of the CDS market is, and the answer is simply liquidity — which is much more than just price discovery. The CDS market worked, during the crisis, even as the market in corporate bonds failed: bonds weren’t pricing, and CDS were. Selling bonds is hard and opaque — that’s why bond traders make so much money. Buying protection on bonds you own is cheaper and easier and much more transparent. And don’t even get me started on loans. People will invest in bonds if they believe they can exit their positions when they want. And the existence of CDS makes exiting a bond position much easier than it ever used to be — which in turn makes the bond market much more efficient. If you banned CDS, the price of credit would surely rise.

And Kevin’s second question is whether this benefit outweighs what he calls “the instability risk”. I think it does, just because the instability risk is hard to quantify and easy to regulate. The bellyaching of the Greeks notwithstanding, there’s no real evidence that the existence of the CDS market makes credit markets more volatile. Indeed, I believe that it can keep primary credit markets open when otherwise they would be closed. So let’s consider the upside of the CDS market before banning it for no good reason.

Update: Kevin, clever chap that he is, sees a flaw in this argument:

To a large extent, the superior liquidity and price discovery of the CDS market is attributable to its greater size, which in turn is attributable to leverage. If you tightly limit leverage, don’t you also constrain the size of the CDS market? And if you do that, will it still provide any noticeable liquidity benefits compared to the market in the underlying securities themselves?

I have to admit I was wondering this myself, as I left the office this evening. And really, there’s only one way to find out. But I suspect that CDS will always be significantly more liquid than the bond market, just because most bonds are buy-and-hold investments which are very difficult to find or sell on the open market. You will always be able to find a broker-dealer willing to quote you a price on a credit default swap, because they can simply conjure one out of thin air by writing a contract with you. If you want to find a specific corporate bond, however, that can be all but impossible most of the time, and in any case it might well be trading well above par, or have some other attribute which makes it much less attractive than a CDS of the same duration. People who are used to the stock market are always shocked at the illiquidity and opacity of the bond market: insofar as credit default swaps are a positive financial innovation, it’s because they managed to bring equity-like liquidity and transparency to a market in desperate need of them.


Greycap –

So nice of you to mention jump risk. That is precisely the thing. It is not accurate to say that CDSs *have* jump risk. They *are* jump risk. A credit will either default or not, and if it does a counterparty will lose massively. As default looms, it is 100% certain that there will be a ‘jump.’ In other words, it is 100% certain that the market have a discontinuity because there will be nobody on whom to pass the counterparty role when a default is really coming.

And enough with the protestations that the counterparties are ‘hedged’ for if they are then that is not a true counterparty. For every true buyer of CDSs, there is a true seller that is on the hook.

You cite the Lehman example as having worked so well, because they went bankrupt. Care to go around saying that in polite company? For whom? For a few of Lehman’s counterparties? How about for Lehman Brothers itself? And how about for the rest of humanity? That those collateral calls were able to destroy it (taking your word that that was what did them in) is evidence that Lehman had written bogus CDS insurance without the ability to pay. This continues to be common now. If Lehman was surprised by the ‘jump’ they should not have been. CDSs, by their nature, become 100% illiquid in the end. The market of private entities that will become CDSs counterparties as default really arrives has zero members.

Regarding your other point, if Felix had to work things out in order to make a blog post that would be an big improvement, because his wrong statements are terribly troublesome. Reading his post, you would think that a big part share of CDS counterparties have covered the notional amount in cash. “CDS are bond substitutes, and they’ll buy a CDS for the full cash value of the amount being protected, just as they would a bond. They’re not leveraged.” Felix even italized that last sentence. If this were true, there is nothing to talk about and there is no risk at all. It is false of course: there are huge amounts of leverage on the counterparty side.

Posted by DanHess | Report as abusive

Whither financial reform?

Felix Salmon
Mar 11, 2010 23:00 UTC

Many thanks to Tim Fernholz, of The American Prospect, and Taylor Griffin, of Hamilton Place Strategies, for helping me out via IM this afternoon to explain to me what on earth is going on with Chris Dodd and the financial regulatory reform bill. The Reuters headline says that talks have failed, and that Dodd is going solo, but in fact it’s not quite as bleak as that.

The important context to bear in mind here is that Dodd, in Griffin’s words, “is staring down the barrel of a April recess and knows he needs to get something moving”. Or, as Simon Johnson puts it, “a week or two lost now can derail completely opportunity for reform along any dimension”. It’s all well and good for Dodd to negotiate with Corker in good faith, but if the talks are dragging out far too long, it makes sense for Dodd to put some deadlines on negotiations with the Republicans. And the way that he’s doing that is by taking a bill to the full committee, and allowing just one week for it to sit there in markup.

“I think the most important thing about the story is that putting a deadline on these talks could sharpen everyone involved’s focus on getting a workable bill,” says Fernholz, “because there are plenty of Democrats who fear that Republicans are just trying to drag out negotiations”.

The worst-case scenario at that point is that not a single Republican votes for the bill in committee, the Dodd bill passes the committee on a party-line majority vote, and then Dodd hopes that someone, somewhere (Olympia Snowe? Susan Collins? Scott Brown? George Voinovich?) will break ranks with the Republicans and provide the 60th vote necessary to get the bill through the full Senate.

But that’s a long shot: Griffin says that the Republicans will stay unified on this, especially now that they’re angry at the Democrats over the reconciliation of the healthcare bill. “I don’t see it passing with one Republican,” he says: either it has some important measure of Republican support, or it fails.

Fernholz points out that Democrats, too, want decent Republican support, saying that “moderate Democrats on the committee are leery of portions of the bill and would prefer to have Republican cover”: his datapoint here is that of the 13 Democrats on the committee, only 7 have gone on the record saying they’d support an independent CFPA.

So Dodd’s going to design his bill to have the best possible chance of getting Republican support once it comes out of markup, while still being acceptable to the left wing of the Democratic party. It’s a hard line to walk, to be sure. Will the Republicans play along? Griffin says that “some people on the Hill that I’ve talked with think that a bipartisan compromise might have been reached by Monday”; he also thinks that derivatives reform will probably turn out to be a bigger sticking point than the CFPA, where Dodd and Corker were very close.

What this move by Dodd certainly does is move the focus of attention on the Republican side away from Corker and back onto Shelby, who’s being very quiet right now and who holds a lot of cards. If he really wants the bill to die, it will probably die, although Corker could still end up supporting the bill, providing the crucial 60th vote, and bringing a few other Senators along with him.

In any case, financial reform is not dead yet: we’ll have a much better idea at the end of next week what its real chances are.

And while I’m on the subject, one idea: there seems to be a lot of debate about who should be regulated by the CFPA and who shouldn’t; at the moment it seems that payday lenders, auto lenders, and others might well get carved out. But might they not have the ability to voluntarily submit to CFPA oversight? Of course it’s not as good a solution as forcing them into compliance. But some might do it, and an official CFPA-compliant badge might well be a competitive advantage in the market. Anyway, just an idea.


The Reuters headline is bizarre – it totally oversells the story, and I don’t see anything in the body of the story to substantiate the “going solo” line. What the story actually says is that Dodd will have to compromise and get some Republicans on board. How is that going solo? The actual article is fine – it’s basically saying, with decent evidential support, that it’s increasingly likely the bill won’t get passed this year. It just doesn’t have much in the way of news. Which makes the headline even weirder. I’m willing to bet the reporter put a fairly bland headline on it and a sub decided it had to be spiced up.

Posted by GingerYellow | Report as abusive