Time To Close Down The CDS Market

This week, we learned that a hedge fund and the credit default swap (CDS) market had pushed a regional telecom company, Windstream Holdings Inc. (Nasdaq: WIN) into bankruptcy. The toxic CDS product caused havoc in 2008, and regulators have been their usual ineffectual selves in failing to grasp it since. There is no legal way to make CDS legally watertight, and Wall Street lacks the expertise to manage the product’s risk exposure. It’s time to close this casino down.

CDS represent a long-standing dream among bankers, rather as human flight did among humanity as a whole. Loans form the greatest part of most banks’ balance sheets, yet they are naturally illiquid, and their risk is impossible to manage because of that illiquidity. For decades, indeed for centuries, banks have longed to find a method whereby the risks of those loans could be offloaded when desired, so that a bank could reduce its exposure to a particular country or class of borrower, or even to an individual borrower.

When the derivatives business came along in the 1970s and 1980s, banks looked far and wide for ways to use derivatives techniques to manage loan portfolios. As I was running a derivatives business in the early 1980s, I looked at this possibility intensively myself but came to the conclusion regretfully that there was no way to create a bank-loan derivative that could be valued and managed on a sound basis.

In the same way, inventors throughout the nineteenth century devoted large amounts of money and energy to developing a heavier-than-air flying machine. (Balloons had been developed by the French Montgolfier brothers as early as 1783, but they were subject to wind and almost impossible to steer, hence did not truly solve the problem of man’s wish to fly from A to B.) In the United States towards the end of the nineteenth century, those experiments were made at the highest level, by Smithsonian Institution Secretary Professor Samuel Pierpont Langley, with government funding and backing from Assistant Secretary of the Navy Theodore Roosevelt, who during the course of the experiments became President – you can’t get higher-level backing than that!

Langley’s experiments began in 1894 and were funded by a $50,000 grant from the U.S. Army in 1898. Finally, in the autumn of 1903, the new machine the Langley Aerodrome was ready. Launched by catapult over the Potomac River, on two separate occasions, it plunged into the river, fortunately without killing its test pilot Charles Manly (Professor Langley was nearly 70 by this time, so doubtless thought discretion was the better part of valor). By future aviation standards, the Aerodrome had plenty of engine, but its control systems were rubbish.

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(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of "sell" recommendations put ...

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