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Hunting The CDS Demons

The latest quest for financial weapons of mass destruction (hint: try looking in Syria) has a concerted push against Credit Default Swaps. Michael Lewis, cranky former banker turned cranker former writer slaps them with a left handed insult or two in The Atlantic last week, and random blogs ranging from The Market Ticker to Deal Journal to the electronic memo press at Wachtell Lipton Rosen & Katz regularly throw up missives bemoaning the very existence of the CDS market.
This from The Market Ticker:

"Naked" CDS, that is, swaps written or purchased not to hedge a bond or other business relationship but instead to speculate on the firm's fortunes are effectively the same thing as a naked short, in that there are NO boundaries on how many CDS contracts can be written against a firm and by having them cash-settle they amount to nothing more or less than a gambling contract with no limit as to the leverage that can be employed.

We tend to be highly skeptical of any efforts to reduce pricing information. That is effectively what this is. Short selling bans and CDS bans only really reduce information available to the market. It is amazing to argue that credit default swaps (about the only counter balance to the insanity that was rating agency analysis) in the hands of evil hedge funds somehow precipitated the destruction of firms that were otherwise on the soundest of footing. Returning to Mark-To-Myth accounting and abandoning "What My Assets Are Really Worth At The Time Of This Writing" accounting amounts to the same insanity. Anyone who claims that such marks are "unrepresentative because they are at fire sale prices" is merely imposing their long-term price forecasting on accounting policy. We've seen how well these long-term forecasters predict prices, so we'd like to pass on that plan, thanks.
What most anti-short, anti-CDS proponents miss is that a firm with sufficient capital, a reputation for transparency and limited spin doctoring shouldn't have to worry about short-sellers or credit default swaps- or should use the dip caused by such panic to buy back shares and move on. If pricing information on a thinly traded CDS contract somehow swings equity prices in dramatic ways it is because the market gives the disclosures offered up by management and ratings agencies almost no weight. This is exactly as it should be. When you are in a leveraged business, credibility is absolutely essential. Lehman didn't fail simply because it was heavily leveraged. It failed because no one believed Erin Callan anymore and even a seriously interested party like David Einhorn was so obviously making so much more sense than Erin and the Lehman PR apparatus. Does anyone still doubt that the Lehman at $0.00 was the wrong price for that firm at the time?
Time to face facts. Propping up failed firms by artificially inventing prices (we are looking at you, Treasury) and then removing any ability of the market to contest those marks is Fantasy-Capitalism. We are all for a rich fantasy life. (Without it we wouldn't have Marcus Schrenker). This said, we'd like it kept out of our Capitalism Cheerios, 'kay, thanks. The CDS market is effectively the only market that was getting it right in the second half of 2007. Gutting it is a bad, bad idea(tm).