Absolutely! How do you think Goldman Sachs et al. has been making a killing? They've been buying life insurance policies on the very companies whose stock or bonds they've been hired to bring to market years ago, knowing the intimate details of their financial condition. They can even get the government to intervene with hundreds of billions (170 billion) of tax payer donations to just one company (i.e. AIG) if it looks like that company can't meet its CDS or CDO payout to Goldman, otherwise.
I guess this elicits the "so what" response from me. Cases of pro-active, malicious profiteering (like the breakfast club shenanigans) need to be investigated and prosecuted. Otherwise, the market decides what default risk cost is. if the company can't assure potential CDS buyers that they're wasting their money, then something is wrong. Maybe they shouldn't be borrowing... We've learned what relying on credit ratings agencies gets us. why not have another, market driven indicator? Maybe it'll become even cheaper for companies to borrow, because lenders can insure themselves against the old fashioned haircuts they had to take. Parties with too much market power do need to be watched though, so that they don't load up on CDS's and then short the stock into oblivion, refuse to lend to the target company, spread bad rumors, refuse to trade, etc. That's criminal.
1) Do you not understand the socio-economic benefits of bankruptcy proceedings? To ensure that assets that benefit society have a second lease on life even when not economically viable in the strictest sense? Allowing bond-holders to hold CDS and have an economic interest in allowing a firm to fail is counter-productive to this aim. 2) Allowing firms like Goldman to use CDS on firms that they sold toxic waste to is like allowing a Doctor to gamble that his patient is going to die after he knowingly implants a malfunctioning liver transplant. The possibility of such a conflict of interest should obviously not exist.
For every CDS protection buyer there is a CDS protection seller... In fact, in the standard industry terminology, when you "buy" (or go long) a CDS, you are betting that the company will not fail.... so I fail to see how CDS investors as a whole want companies to fail. That being said, there is a good argument that CDS, like all derivatives, make it easier to create moral hazard... But at the same time, I argue the right regulations to discourage the moral hazard itself, not the tools.
Bingo. There's not NEARLY enough regulation to discourge moral hazard and market manipulation potential due to the plethora of derivatives out there entirely unlinked from cash settlement values.
CDS were intended for bond holders to protect themselves should a company defaults on its loan. However, when much more were invested in CDS than the value of the bonds outstanding, it can be a problem. Big banks like GS bought so much CDS on Lehman from AIG that the taxpayers end up bailing it out. They talked about taxpayers made money on the GS deal. They forgot the the money that the GS got from the AIG bailout. The other item that was not mentioned was the tax guarantee of GS bonds.
"unlinked from cash settlement values" - I have no idea what this is supposed to mean. Equity, in many ways, is far more opaque than almost any derivative. It's value is linked to an invisible future earning stream. Derivatives, at least, are priced on (mostly) observable assets. The problem, as a derivatives trader in a very hard hit part of fixed income, is not so much "valuation" or "repricing" or the usual bylines. If everyone had adequate capital, it wouldn't have been a problem. Price discovery in a relative illiquid market is nothing new to the world. The problem is fiduciary-duty-by-ratings type of incentive that regulations created in the first place allowed otherwise low-risk-tolerance investors to invest with leverage in stuff with a lot of embedded risk; and when that blew up, these large investors (AIG, pension funds, etc) took the system with them. Meanwhile, all this talk of CDS bringing companies down are just scar mongering. Vulture distress funds have been around for ages and act perfectly within their legal (and I argue, economic) obligations. CDS, if anything, gave them a little more efficiency. But what's wrong with that. Again, I advocate that we regulate incentives, not tools. We'll never win the arms race against smart motivated people. And if we do, we lose anyway (in terms of productivity, efficiency, etc)
Not true. The "physical settlement" short squeeze aspect played out in 2005. There's a cash-auction settlement protocol since. There hasn't been any short squeeze from settling defaulted names in a LONG time. If anything, the fast cash settlement process actually priced the recovery value of defaults upward. Also, this has nothing to do with AIG and goldman. The problem there was counterparty and novation risk. I speak of this as a CDS trader.
Sfan do you deny that bankruptcy has various social and economic benefits for employees and customers of the firm who desire and require stability? Not to mention for bondholders who want at least a portion of their money back in the event of a failure and have a mutual incentive toward restructuring? All of these benefits of a well-done Chapter 11 are moot when you have a single bond-holder who happens to be long cds and would rather have the company fail than attempt any far more socially desirable outcomes. It is unethical and easily legally avoidable if we disallow cds holders to possess bonds in the same firm.